Stocks love the jobs report, while bond markets remain wary

Brian Nick

The past week’s market highlights:

Quote of the week:

“Be careful what you wish for, you may receive it.” — Anonymous, quoted in “The Monkey’s Paw” by W. W. Jacobs
As part of our new format, we are presenting our featured weekly topics in the context of the major themes listed below from the Nuveen 2018 Outlook:
  • U.S. economy: Conditions are still running closer to “just right” than “too hot.”
  • Global economy: Overseas economies are improving, but the time for surprises is over.
  • Policy watch: In an unusual twist, U.S. fiscal and monetary policies are diverging.
  • Fixed income: Bond markets offer few places to run to, even fewer places to hide.
  • Equities: Stronger corporate earnings growth should drive stock prices higher.

U.S. economy: Strong job creation, soft wage growth strike the “Goldilocks” balance

After January’s upside surprise in wage growth raised the specter of higher inflation and set off last month’s correction in equities, the stock market embraced February’s employment report as evidence that the U.S. economy is once again in “Goldilocks” mode—running strong, but not too “hot.” This is consistent with our view that U.S. growth will accelerate this year without an unpleasant inflation surprise.

Here are some key data points from the February jobs release and what they mean:

  • Although payroll gains of 313,000 in February far surpassed consensus expectations, average hourly earnings (AHE) grew at a slower year-over-year pace of 2.6%, versus 2.9% in January. This is a return to the trend of healthy job creation and soft wage growth that has generally prevailed in the U.S. labor market since 2010.
  • The unemployment rate remained stable at 4.1%, thanks to an increase in the labor force participation rate to 63.0%—tied for its highest level since 2009. People still entering the labor force at this late stage of the economic cycle are either new, younger workers with lower skills and wages, or the long-term unemployed rejoining the job market. In both cases, companies needn’t resort to offering greater pay to lure employees. This tends to limit upward pressure on wages, a key driver of overall inflation.
  • In isolation, the jobs report implies little need for a steeper path of rate hikes from the Federal Reserve, because some slack remains in the labor market that should prevent a spike in wages and price inflation. Nonetheless, elevated monthly payrolls, if sustained, could potentially pressure the Fed to accelerate its tightening, especially if accompanied by other robust economic indicators. If February retail sales (to be released March 14), for example, come in better than anticipated, the added growth momentum could bolster the prospect of a higher terminal federal funds rate in 2019 or 2020.
The upbeat employment report proved to be a happier story for equities than for bonds, as equity valuations look more reasonable when top-line revenues can keep growing with little risk of inflation on the horizon. Against this backdrop, the S&P 500 Index celebrated the ninth anniversary of its March 9, 2009 trough by gaining 1.74% for the day and 3.5% for the week as a whole.
Fixed-income markets, meanwhile, took a dimmer view of the landscape. Higher rates and a steeper yield curve may depress bond prices somewhat, with spreads that are unlikely to tighten meaningfully throughout the year. In the past week, the 10-year Treasury yield ticked up 4 basis points (0.04%) to close the week at 2.90%, while the 2-year finished 2 basis points higher, at 27%. Most non-Treasury fixed-income sectors were struggling with outflows and modestly negative returns leading up to Friday’s employment report.
On a separate note, unlike the previous week, we saw a generally sanguine market response to continuing global trade tensions, which dominated financial and political headlines alike. A number of U.S. trading partners retaliated against the President Trump’s steel and aluminum tariffs, and trade-friendly White House economic adviser Gary Cohn resigned. But equity markets seemed assuaged by the announcement that Mexico and Canada would be conditionally exempt from the new tariffs, and that other countries could apply for exemption.
Ironically, this muted reaction might result in still more protectionist policies in the not-too-distant future. If stocks had experienced another 10% correction in reaction to the tariffs, the Trump administration might have been more cautious about future measures. In addition, the White House may choose to further its penchant for protectionism to make up for an expected lack of progress on major legislation like infrastructure ahead of the 2018 elections. Lastly, we think it’s clear the U.S. trade deficit will continue to widen this year, which the president regards as problematic and a reason for further policy action.

Fixed income: Corporate bonds wrestle with rising U.S. rates and a falling dollar

Heading into 2018, our asset class outlook called for intermittent volatility, occasional pullbacks, and spread widening in credit markets. Based on Bloomberg Barclays index data, the investment-grade corporate bond sector has thus far matched our projections, lagging most other areas of the fixed-income market with a year-to-date return of -2.74% (as of March 8)—a sharp reversal of its strong 2017 performance (+6.4%). Because corporate bonds are a major component of the investment-grade aggregate benchmark and a large portion of overall U.S. debt issuance, it’s important to understand whether their recent underperformance is an aberration or evidence of a longer-term trend.
We think there are largely two factors at work: (1) concerns about dollar weakness among non-U.S. investors, who own roughly one-third of U.S. investment-grade corporate debt; and (2) a spike in Treasury yields since the beginning of 2018.
  • Demand for U.S. securities among foreign buyers has recently declined amid a drop in the value of the dollar versus other currencies. The euro, for example, has strengthened from $1.06 a year ago to $1.23 today, and in our view could rise to $1.30 by the end of 2018. Such currency fluctuations can become a disincentive for international investors, who find themselves incurring hedging costs to help protect their returns. Longer term, currency concerns are exacerbated by implications that a weaker U.S. dollar may be not only tolerated but welcomed.
  • A steep increase in Treasury yields has also influenced the performance of U.S. investment-grade credit. Because corporate bonds as a market segment tend to have a longer duration profile than Treasuries, they typically underperform when rates rise suddenly. Moreover, spreads on U.S. investment-grade credit are generally narrower than those on high-yield bonds, leveraged loans, or emerging-market debt. This can make them even more sensitive to rising Treasury yields.
For the remainder of 2018, we believe performance of investment-grade corporate bonds will be shaped primarily by new-issue supply, foreign demand, and the overall stability of rates. In our view, the sector is fairly valued, with these risks appropriately priced in.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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