Trade talk is tough, but U.S. equities prove tougher 

Brian Nick

The past week’s market highlights:

Quote of the week:

“Facts are simple and facts are straight
Facts are lazy and facts are late.
Facts all come with points of view
Facts don't do what I want them to.”
- Talking Heads, “Cross-eyed and Painless”
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Q2 Outlook:
  • U.S. economy: Late cycle has arrived.
  • Global economy: There’s still good news out there.
  • Policy watch: In an unusual twist, U.S. fiscal and monetary policies are diverging.
  • Fixed income: Bond markets offer few places to run, even fewer places to hide.
  • Equities: The bull market’s not over, but expect plenty more volatility.
  • Asset allocation: Valuations are no longer at extremes.

Global economy: We have a new leader

The global economy entered 2018 at its strongest point in more than a decade. For the first time since the financial crisis, all 45 countries tracked by the OECD (Organisation for Economic Co-operation and Development) were in expansion mode. Last year, Eurozone data regularly beat forecasts on the back of a booming manufacturing sector, looser credit conditions, and surging business sentiment. Meanwhile, the broad emerging-markets (EM) arena concluded 2017 by registering its fastest rate of expansion in five years.
After a brief burst to start this year, though, global economic momentum, as measured by Markit’s Purchasing Managers’ Indexes (PMIs), has slowed a bit. Neither the Eurozone nor the developing world has maintained its pace of expansion. Instead, the U.S. has reclaimed its title as the world’s primary growth engine.   
Two May data releases confirm this view. The Markit U.S. manufacturing PMI hit 56.4—just below a four-year high—thanks to rising business confidence and new orders. (Readings above 50 indicate expansion.) In addition, U.S. service-sector activity jumped amid the fastest rate of growth in the consumer goods sector since 2015. This bullish data reflects robust domestic demand, which has helped shield U.S. companies from a drop in worldwide manufacturing exports. At the same time, upbeat employment data continues to roll in. On the heels of May’s stronger-than-expected payrolls release, April’s JOLTS report showed there were more job openings than unemployed people to fill them.
In contrast, the pace of Eurozone economic growth slowed to an 18-month low in May. Although both the manufacturing and service sectors remained firmly in expansion territory (54.1), the outlook for the region is less bright than it was in the first quarter. Political uncertainty, most recently in Italy, has added to this less optimistic backdrop. Meanwhile, across the Channel, the U.K. has rebounded from weather-related disruptions earlier in the year, and its survey has overtaken the Eurozone’s for the first time since January 2017.   
Like the Eurozone, EM economies are also demonstrating signs of strain, with PMI data falling back to solid but less-than-stellar late-2017 levels. Moreover, the U.S. dollar’s recent rise amid expectations of a strengthening U.S. economy and tighter Federal Reserve policy have punished currencies throughout most of the EM universe. This has increased the cost of servicing dollar-denominated debt and spurred inflation. Investor outflows from EM equity and bond funds have further fueled currency weakness.
Not all EM countries are struggling, however. China remains a growth story, with both its manufacturing and service sectors on the uptrend. And according to the World Bank, India is forecast to grow 7.3% this year and 7.5% next year, retaining its claim to being the fastest-growing major EM economy.   
What might help non-U.S. economies regain traction? Continued dollar strength makes exports to the U.S. cheaper, which should boost sales and corporate profits for overseas companies.  Also, ongoing accommodative monetary policy by global central banks would likely provide a measure of support in the event of severe economic declines. The European Central Bank could extend its quantitative easing program, for example, if conditions deteriorated on the continent.
A market-friendly resolution to the many disputes between the U.S. and its largest trading partners (e.g., Canada, Mexico, China, and Europe) would perhaps be most helpful. But that’s not a call we’re willing to make, as tensions continue to run high.
U.S. policy watch: Markets poised for another Fed rate hike
The Federal Open Market Committee (FOMC)—the group within the Federal Reserve that sets monetary policy—is virtually certain to raise the target federal funds rate at its June 13 meeting to a range of 1.75%-2.00%, despite recent shakiness in financial markets.
In late May, U.S. Treasury yields plummeted and fed funds futures swooned amid Italy’s potential political crisis and the implementation of previously announced U.S. import taxes. While neither risk has entirely dissipated, further good news on the U.S. economy has provided a helpful counterweight, likely keeping the trajectory of Fed tightening intact.
The May U.S. employment report, which showed unexpectedly robust job creation and wage gains, was the most prominent of many highly positive data releases in the past few weeks. Others included retail sales and manufacturing. This economic strength should compel the Fed to look past noisy headlines and continue to normalize rates at its preferred pace of 25 basis points (0.25%) per quarter.
A primary concern for investors will be to what degree the Fed raises its forecasts for growth, inflation, and interest rates over the next several years. We believe voting FOMC members will convey an expectation of four rate hikes for 2018 as a whole (up from three at the March meeting). This change would translate to a year-end target range of 2.25%-2.50%, the highest it’s been during this tightening cycle but low by historical standards.
Equity markets should have little trouble tolerating this week’s increase given the recent fall in valuations. The drop in the S&P 500’s forward price-to-earnings ratio from 18.6 in January to 16.6 on June 8 occurred partly as a result of expectations for higher interest rates. With overwhelmingly positive earnings and rising capital expenditures, however, company fundamentals remain strong. U.S. stocks finally appear poised to break out of the range they’ve been trading in since early February, as long as trade-war fears stay out of the headlines long enough for investors’ jitters to subside. 
Leading up to the two-day G7 summit (where allies were poised for trade discussions), the rise in U.S. equity markets seemed to indicate that trade concerns were easing after recent overreactions to tit-for-tat promises of protectionism between erstwhile economic allies. The S&P 500 Index returned 1.60% for the week, bringing its year-to-date gain to 4.8%.
Fixed-income investors will likely be focused on how, if at all, the Fed changes its language around inflation or exogenous risks like trade. According to fed funds futures, the probability that the Fed will raise rates on June 13 is around 85%, but the odds that the Fed will hike another two times (in September and December) are considered a tossup.
After the prior week’s fall in yields, U.S. Treasury markets traded relatively flat last week. The Fed-sensitive 2-year note started the week at 2.47% and closed at 2.50%. The bellwether 10-year remained below the psychologically important 3% level, at 2.93%.
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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