The last week’s market highlights:
Quote of the week:
“A fool tells everything he knows.” – Finnish proverb
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Midyear Outlook:
- U.S. economy: Running ahead of its peers.
- Global economy: Trade a bigger concern outside the U.S.
- Policy watch: Central banks aren’t all on the same wavelength.
- Fixed income: Starting to prefer higher-quality assets.
- Equities: Earnings are supporting prices, but expect plenty more volatility.
- Asset allocation: Remain risk on, but focus on quality.
U.S. economy: An on-course Fed and a (slightly) steeper yield curve
In his semiannual testimony to Congress, delivered on July 17-18, Federal Reserve Chair Jerome Powell painted a mostly optimistic picture of the U.S. economy, citing a strong labor market, healthy growth in business investment, and increased consumer spending. He made only a brief mention of current global trade tensions, observing that it’s “difficult to predict” how they will affect the economy.
Regarding monetary policy, Powell deviated very little from his previous public statements. He expressed his belief that continued rate hikes represent sound policy—for now—with the unemployment rate at 4% and inflation finally reaching the Fed’s 2% target.
Financial markets currently expect three to four Fed rate hikes in the next 12 months, in line with our forecast. This pace of tightening would raise the target federal funds rate to the Fed’s current “longer run” figure of 2.875%. If, by next summer, the unemployment rate is still near currently low levels and inflation is running at 2% (or hotter), the Fed will likely remain on a tightening path that could take its target rate above 3%.
While Powell’s optimistic remarks boosted the dollar to within striking distance of late June’s one-year high, they did little to move Treasury markets. The yield on the Fed-sensitive 2-year note closed at 2.60% on July 20, after beginning the week at 2.59%. Meanwhile, the bellwether 10-year security ended the week at 2.89%, up 6 basis points. This widened the 2-year/10-year spread to 29 basis points, still near an 11-year low. The gap was as wide as 78 basis points about five months ago.
Some market observers have raised concerns that the flattening yield curve could herald an economic slowdown. We don’t think so. In our view, the bond market is not signaling “lights out” for the nine-year expansion—at least not yet. Although the curve may continue to gradually flatten, we expect the 2-year/10-year to remain positive for the remainder of 2018. The short end of the Treasury curve has already largely priced in expected Fed tightening, while the long end should manage to edge up on evidence of stronger growth and higher inflation.
But even if we’re wrong, and the curve does invert, history suggests that a recession would still be at least a year—and possibly two years—off.
Equities: Does the (growth) bull still have legs?
While a few companies (mostly Financials) have announced second-quarter results, earnings season really picks up momentum this week. We’ll be watching growth-oriented sectors such as Information Technology, Consumer Discretionary, and Health Care to see if corporate profits can continue to support rising stock prices. Equity investors seem to think so. They’ve shown a preference for growth (companies with accelerating earnings) over value (more staid, predictable earners) for six consecutive quarters, according to Russell indexes. Year to date, the gap is dramatic: the Russell 3000 Growth Index has produced a double-digit gain (+11.8%), while its value index counterpart has returned a meager 0.6%.
Historically, the disparity of returns between growth and value has been less pronounced than we’ve seen over the past year and a half. In fact, according to Russell, growth has led value by just 17 basis points (0.17%) per year, on average, since 1995. But the current market cycle has favored growth more emphatically, with average annual outperformance of 3.6% versus value since 2009.
Why hasn’t value been able to catch up? Take Financials as an example. In the path toward interest-rate normalization, one would expect rising rates to be good for the sector. In the last cycle, between 2000 and 2006, value trounced growth by 11.9 percentage points per year. But the current cycle has been characterized by a slower pace of economic activity and uneven rates of profits growth. When growth is scarce overall, stocks of companies with higher structural growth rates tend to be in higher demand. Technology and e-commerce stocks, in particular, have sustained relatively high valuations thanks to quarter after quarter of impressive earnings.
We are now entering a period in which improvements in consumer confidence, GDP expansion, S&P 500 earnings growth and leading indicators appear to have peaked. Against this backdrop of still solid (but not accelerating) economic performance, growth stocks remain in favor. A true economic overheating would likely tilt our preference from growth to value, but that doesn’t seem to be in the cards with the Fed on its steady path toward normalization.