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U.S. equities show signs of being fed up with higher interest rates
The last week’s market highlights:
Quote of the week:
“Keep cool; anger is not an argument.” - Daniel Webster
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.
Policy watch: The Fed stays on course
To no one’s surprise, the September 26 meeting of the Federal Open Market Committee (FOMC)—the group within the Federal Reserve that sets monetary policy—concluded with a 25-basis-point (0.25%) increase in the federal funds rate, to a target range of 2.00%-2.25%. This was the Fed’s eighth hike since 2015 and third this year.
As shown in the Fed’s summary of economic projections, since June the median FOMC member has become more optimistic about growth and more supportive of further rate hikes through 2019.
In his third press conference as Fed Chair, Jerome Powell emphasized that the U.S. economy is strong, supported by fiscal stimulus and not yet harmed in aggregate by new tariffs. Indeed, the Fed essentially confirmed what economic observers already knew: U.S. growth has strengthened this year, thanks to a combination of cyclical forces and fiscal stimulus. As a result, further tightening is needed to maintain a balance between the risk of declining growth (and in turn, higher unemployment) and the risk of higher inflation.
Inflation, as measured by the PCE index, the gauge preferred by the Fed, continues to hover around the central bank’s 2% target. And with unemployment still below 4%, the Fed’s dual mandate is largely fulfilled. But there are still two broad challenges facing Powell and his fellow FOMC members: one, deciding when to stop raising interest rates to avoid pulling the reins too hard on growth; and two, correctly assessing the sum total impact of the tightening actions taken to date.
In the weeks leading up to the September 26 meeting, bond markets appeared to be getting the message that interest rates will be rising further in the coming quarters. The fed funds futures market now reflects a nearly 50% implied probability that the Fed will hike at least three more times before mid-2019. This would bring its target range close to its current 3% estimate of the longer-run fed funds rate, often called the “neutral” rate. That seems like a convenient place for the Fed to pause for a breath or two, assuming risks to the economy don’t look all that different nine months from now than they do today.
Over the near term, we expect inflation to remain benign—near 2%—and unemployment to hold at its current level or perhaps move a bit lower. If we’re right, another interest-rate increase in December and at least two more in 2019 would be justified, in our view.
Equities: In the third quarter, U.S. investors said, “There’s no place like home.”
U.S. equities improved on solid second-quarter performance with their best quarter (+7.7%) since 2013. The S&P 500 Index shrugged off global trade concerns to advance in July (+3.7%), August (+3.3%) and September (+0.6%). For the year to date, the index has returned a healthy 10.6%. And thanks to standout corporate earnings, valuations have actually become slightly more attractive during the year—from 18X next 12-month earnings in January to 16.7X in September. (They did tick up in the past three months, however.)
Among individual sectors, Health Care and Industrials led the pack. In contrast, Materials and Energy lagged. Buoyed by a jump in oil prices, Energy stocks staged a fierce September rally to finish the quarter in positive territory.
In a reversal from the first and second quarters, small cap stocks (+3.6%) trailed large- and mid-cap shares (+7.4%, and +5%, respectively), as the tax-cut-fueled earnings momentum enjoyed by smaller companies has waned. The dollar’s slight weakening since mid-August has also taken some of the shine off small caps. That’s because they tend to be more domestically focused, with lower exposure to exports. In contrast, a falling dollar often helps sales and profits of multinationals, which are typically larger cap, by making their exports more competitive in overseas markets.
Major overseas equity indexes trailed the S&P 500 during the third quarter in U.S. dollar terms. Developed-market shares (+1.4%) outpaced their emerging-market counterparts (-1.1%). Stocks in the Eurozone fell 0.4% even as the pace of business activity in the region remained solidly in expansion territory. Meanwhile, Japan’s Nikkei 225 Index (+6.1%) closed the quarter near a 27-year high, bolstered by improving corporate profits, a stronger economy and a weaker yen.
Despite this underperformance, the discounts available on stocks in developed markets and in most emerging markets are among the highest we’ve seen in the past decade. Moreover, it’s unlikely U.S. firms will repeat their 2018 standout profit performance. Even if S&P 500 companies meet the current consensus 10% earnings growth forecast in 2019, U.S. equity market returns will likely be lower next year.