The last week’s market highlights:
Quote of the week:
“The greatest truths are the simplest, and so are the greatest men.” – Julius Charles Hare
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: A GDP four-spot in Q2
According to the government’s advance estimate, second-quarter GDP grew at an annual rate of 4.1%. This was just below forecasts of 4.2% but still far better than the first quarter’s 2.2% pace—and the fastest quarterly growth since the economy’s 4.9% expansion in the third quarter of 2014.
The improvement was driven by the return of the “missing” consumer. Personal consumption expenditures jumped by 4.0%, versus just 0.5% in the first quarter. Moreover, private investment growth in structures, equipment, and intellectual property continued to be strong. In contrast, residential investment declined for the second straight quarter.
Tariffs are having a big impact on the composition of GDP growth. U.S. taxes on Chinese imports (and China’s reciprocal tariffs) went into effect on July 6. Well aware of this deadline, exporters of goods like soybeans hurried to draw down inventories and ship as much as possible ahead of time. As a result, inventory declines subtracted about 1% from growth, while exports added nearly the same amount. These are the two most volatile components of the GDP calculation, and their figures are often revised in future estimates. Looking ahead, exports are unlikely to provide as big a boost. Levels of inventory reductions shouldn’t remain as high, either.
Importantly, final sales to domestic private purchasers, which strips out inventories, trade, and government spending, grew a solid 4.3%.
The GDP report also included substantial upward revisions to personal savings rates over the past few years. The second quarter savings rate came in at 6.8%, a modest drop from the prior quarter’s 7.2%. Contrast these figures to the 2.5% low recorded in 2005, and we can see that household balance sheets are in better shape at this late stage in the cycle. If such frugality persists, it could provide a cushion when the next recession hits.
Fixed income: The Land of the Rising Sun sends global yields higher
Although the Federal Reserve’s asset purchases ended in 2014, quantitative easing (QE) programs from the European Central Bank and Bank of Japan (BoJ) have helped anchor sovereign bond yields, especially longer-dated ones. Indeed, it’s been our view that the lingering effects of global QE have contributed to a flatter-than-usual U.S. Treasury yield curve—a theory corroborated early last week.
On July 20, reports surfaced that the BoJ was considering scaling back its monetary stimulus in order to support the country’s banking sector, which has struggled amid years of super-low interest rates. In response, the yield on 10-year Japanese government bonds (JGB) rose by five basis points (0.05%), to 0.08%, on July 23. While modest, this increase still represented the largest one-day jump in JGB yields in nearly two years and sent JGB prices down sharply. (Bond yields and prices move in opposite directions.) German and U.S. 10-year yields took their cue from Japan, with each reaching a five-week peak that day. At the same time, the yield gap on 2- and 10-year U.S. Treasuries, which had narrowed to just 24 basis points (0.24%) on July 19, steepened to 32 basis points.
We can chalk up this one-day sell-off in Treasuries to pure speculation over a change in BoJ policy. Some of the usual drivers of higher U.S. Treasury yields were absent. For example, the U.S. economic data calendar was quiet. And investors were hardly in a “risk-on” mood that might have led them to shed the perceived safety of Treasuries in favor of U.S. stocks. (The S&P 500 rose just 0.2% on July 23.) In our view, the global bond market’s reaction to the mere possibility of a central bank tightening monetary policy highlights how sensitive investors have become after years of unprecedented stimulus.
The 10-year U.S. Treasury yield closed the week at 2.96%, up 7 basis points. Because major sovereign bond markets are often “tethered together,” European or Japanese yields, for example, would have to rise substantially before longer-dated U.S. debt can follow suit. We don’t think these overseas moves are likely this year. Consequently, our forecast calls for the 10-year yield to finish 2018 somewhere below 3.25%.