U.S. equities don’t want to play “Let’s Make a Deal”—or musical chairs

Brian Nick

The past week’s market highlights:

Quote of the week:

“The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.”
– Stephen Hawking
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.

Global Economy: Is Europe running out of surprises?

In our 2018 Outlook, we identified Europe as a regional standout, owing to its broad-based economic growth, surging business sentiment, and loosening credit conditions. These were descriptions rarely applied to an economy that had spent nearly a decade in virtual hibernation, but they were warranted. Indeed, Europe surpassed expectations in 2017, and upside economic surprises became the norm rather than the exception.

Two months into 2018, however, positive surprises have been harder to come by. The Citigroup Eurozone Economic Surprise Index, a broad measure of whether actual data exceeds or lags forecasts, has fallen below zero from much higher levels last year. This doesn’t mean the economy is headed for a fall—only that expectations and the actual data are now more in alignment.

Importantly, most of Europe’s economic indicators remain near generational or cyclical highs. Purchasing Managers’ Index (PMI) surveys in the manufacturing sector, for instance, slowed slightly in early 2018, but that was after a torrid pace of increases through the end of 2017. In our view, the positive longer-term trend outweighs the modest deceleration we’ve seen in PMIs over the last month or two.
There are some trouble spots in this mostly favorable environment. Europe’s large export sector has suffered in the face of the strengthening euro and the prospect of escalating protectionism. Falling stock prices in this sector have hurt the broader equity market. The STOXX 600 Index declined 0.3% (in U.S. dollar terms) for the week, as it struggles to recover from February’s global market rout. Meanwhile, the S&P 500 Index slipped by 1.2% amid heightened trade-war fears and a flurry of negative headlines out of Washington. Year to date, the STOXX 600 has returned -2.8% in local currency terms but is down only slightly (-0.7%) when translated into U.S. dollars. In contrast, the S&P 500 remains resilient, up 2.9% since the start of the year.
Although European equity markets have been less buoyant than we anticipated in our 2018 Outlook, we still think they offer meaningful opportunities. Valuations remain attractive, with a price-to-earnings (P/E) multiple of 14.2x for the STOXX 600, versus 17.2x for the S&P 500 Index. European earnings growth in the fourth quarter of 2017 was unusually strong, with upside surprises averaging 8%. Among the standouts in that period were Financials and consumer sectors—two segments we had identified as potential outperformers heading into 2018. Continued accommodative European Central Bank (ECB) policy further supports our positive view of the region.

Fixed income: The U.S. Treasury curve flattens, while the gap between U.S. and German yields widens

U.S. Treasuries again traded in a narrow range during the week, with the yield on the bellwether 10-year note declining 5 basis points (0.05%), to 2.85%, on March 16. Since reaching 2.94% on February 21, the 10-year yield has closed between 2.80%-2.90% in 16 out of the last 17 sessions. Treasuries shrugged off February’s unexpected 0.3% decline in retail sales, their third consecutive monthly drop. The market’s nonchalance likely indicates a belief that consumers will open up their wallets as the job market continues to chug along and wage growth perks up.
In our view, there are two explanations for the slump in sales, and they aren’t mutually exclusive. First, consumers may be using their heftier paychecks—courtesy of the recent tax cuts—to replenish their balance sheets following months of dipping into savings. Second, many workers may not have yet noticed their after-tax raises. Once they do, they should begin to spend more. But if they don’t, a fourth straight month of falling sales could weigh on Treasury yields.
On the short end of the Treasury curve, the 2-year yield inched up to 2.29% by March 16 in anticipation of the Fed’s March 20-21 meeting. Markets fully expect officials to usher in the tenure of new Chair Jerome Powell with a 25-basis-point (0.25%) increase in the fed funds target rate.
At the same time, the yield on Germany’s 2-year security edged lower throughout the week, closing at -0.59% on March 16. This historically wide gap of 288 basis points is largely due to the divergent policies of the Fed and the ECB. For its part, the Fed is both raising interest rates and decreasing the size of its bond portfolio. Meanwhile, the ECB is still in bond-buying mode, albeit at a slower pace, and has committed to not raise rates until well past the end of its asset-purchase program, which is likely to continue through year end.
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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