- Strong earnings season and positive fundamentals are driving the market higher, but risks are escalating as the market cycle grows older.
- Interest rates continue to trend higher as the yield on U.S. 10-Year Treasuries climbs past 3%.
- A stronger U.S. Dollar, buoyed by heightened expectations of 3 more rate hikes, has punished both Emerging Market debt and equities.
- Lots of moving pieces surrounding global trade, including NAFTA renegotiations and China, all lead to higher uncertainty for global growth.
- Oil continues to surge higher in the wake of increased demand and tensions in the middle east.
It appears for the time being that both the market and the economy are once again moving higher and in the same direction. U.S. equities have generally performed well in May, and are now trading firmly above their 50-day moving average. The S&P 500 total return index was up 2.5% year-to-date through May 17th, led by technology stocks which were up an impressive 10.19%. In a reversal from last year, small-cap stocks as represented by the Russell 2000 index have now resumed leadership, and are up 6.3% YTD. Overall, Growth stocks are still handily outperforming Value stocks, as the Russell 3000 Growth index is up 5.8% compared to -0.14% for the Russell 3000 Value index. The best performing sectors are Technology, followed by Energy (+9.84%) and Consumer Discretionary (+6.86%). The worst performing sectors are Consumer Staples (-12.19%) and Utilities (-6.23%), which have been punished along with bonds as interest rates keep rising.
The CBOE VIX volatility index, which spiked as high as 37 back in February, is back around 13 which is not far off from where it was most of last year. Much of this can be attributed to the lack of headline worthy macroeconomic news, outside of the ever-changing trade disputes and noise out of Washington. Also, first quarter’s earnings season is almost complete, with 96% of the companies in the S&P 500 having reported earnings as of May 18th. The results have been extremely positive, with 78% of the companies reporting positive earnings surprises, according to Factset Research.
In terms of money flows, the largest inflows into exchange traded funds (ETFs) over the past month have been into the S&P 500, and the EAFE index (which tracks International Developed countries), followed by 1-3 Year Treasuries, and the Nasdaq 100 index. The largest ETF outflows over the past month (through May 14) have been Emerging Markets, followed by Gold Miners, Energy, and Investment-Grade Corporate bonds. Overall the inflows have been solid, with positive flows of $26 Billion over the past month, and $385 Billion over the past year, which are both reflective of a healthy risk-taking behavior.
Interest Rates Continue to Rise as the U.S. 10-Year Treasury Yield Breaches 3%
After stalling at around 2.9%, and pulling back to 2.73% in April, the U.S. 10-year yield is once again on the rise. The benchmark yield was as high as 3.12% (as of May 17), which is the highest level it has reached in seven years. There hasn’t been any one particular driver to explain the recent backing up in yields, however peak-cycle concerns, the rise in oil prices, fiscal stimulus from the government spending bill, and the current deficit have all been cited as possible sources. These factors in aggregate help affirm higher inflation expectations, despite that April inflation came in softer than expected. Note, April “core” CPI inflation came in at 0.1%, for a 2.1% 12-month rate, just barely above the Fed’s 2% target. On the other hand, PCE inflation (which is what the Fed pays more attention to), came in at 1.9% year-over-year, which was in line with forecasts but 0.3% higher than the previous month.
For fixed income investors, the rise in yields has been detrimental to bonds, especially those with longer maturities (a.k.a. duration). The Bloomberg Barclay’s U.S. Aggregate Bond Index was down -2.98% as of March 18th, and could continue to decline as rates rally. U.S. Treasuries are down -2.72%, while the Bloomberg/Barclays U.S. Credit Index has fared even worse, and is down -3.91%. The only U.S. fixed income categories in positive territory are short-term treasuries (just barely) and Leveraged Loans which were +2.0%. Unfortunately, it is more likely than not that the pain in fixed income will continue in 2018, as the Fed is set to raise rates at least two, if not three more times this year. A rate hike of 0.25% to 1.75-2.0% is almost a certainty at the June meeting, and it is highly probable (72.9%) that the third rate hike of the year will occur in September. Fairly recently the odds of a fourth rate hike in December has risen to 43.8%, but of course this is all data-dependent, and much could change between now and then.
U.S. Dollar is Showing Signs of Strength, which Spells Trouble for Emerging Markets
As mentioned previously, outflows in Emerging Market equity ETFs were the highest of any category over the past month, which is largely a reflection of the strength of the U.S. Dollar. A rising dollar is often associated with decreased risk appetite for foreign investors, as they pull out of Emerging Markets. A strong U.S. Dollar can also be negative for Emerging Markets companies who have U.S. denominated debt. The greenback had been particularly weak since early 2017, but has rebounded significantly over the past few months. For example, the Euro-to-Dollar ratio was about $1.20 USD to EUR at the start of the year, then went up to $1.25 around March, and now is down to about $1.18. The path for Japanese Yen per U.S. Dollar is roughly the same, although the Yen is still worth slightly more than it was at the start of 2018.
As can be seen in the chart on the preceding page, the U.S. Dollar index is now back to around 94, which makes up for all its losses this year. (Note: The U.S. Dollar index is a measure of the value of the dollar relative to a basket of currencies of the U.S.’s largest trading partners.) Interestingly, the chart also shows how the path of the 10-year yield has been correlated with the dollar index over the past 3 years. Some notable exceptions certainly exist, but overall as rates have risen sharply, so too has the Dollar. This is intuitive, given that interest rates are one of the more significant contributors to currency strength over the long run. However, rates alone are not enough to drive currency exchange rates in the short run, which are known to move dramatically and irrationally at times. The recent strength in the U.S. Dollar may be a bit of a correction after last year’s decline, or it may be reflective of the strength in the U.S. economy, or perhaps decreasing concerns of a global trade war. Either way we will be monitoring the strength of the U.S. Dollar closely, as it may impact our bullish outlook on Emerging Markets in the coming months. For now we continue to like emerging markets based upon fundamental growth opportunities and attractive valuations, but we are cognizant of the risks associated with currency fluctuations.
Lots of Moving Pieces on Trade, Some Good, Some Not So Good
It should be noted that by the time you read this, it will most likely be old news and there will be a new development unfolding. As we try to stay on top of the Administration’s protectionist trade efforts, it seems that every day there is both a positive and a negative spin on the negotiations. On Sunday May 20th , it was announced that both the U.S. and China have pulled back from the brink of a trade war. Over the weekend, both sides agreed to suspend tariffs, and continue negotiating towards a deal that would help reduce the U.S.’s trade deficit with China. Hardliners in the U.S. were upset that Trump was backing down from his demand that they reduce the deficit by $200 Billion, but the market received the updates positively as the markets rallied on the news. However, no consensus was reached on relief measures for Chinese telecom giant ZTE, which is facing a 7-year ban of sourcing U.S. components after violating sanctions on Iran and North Korea. It also appears that no real progress has been made in enforcing U.S. complaints about Chinese intellectual property theft. As mentioned above, this story is evolving, and as long as both sides are shown to be working together to find a resolution, the markets will likely have a positive response.
The other big trade story has been President Trump’s efforts to renegotiate the North American Free Trade Agreement (NAFTA), which has largely been a failure. Congress had self-imposed a May 17th deadline to come to a framework agreement, to allow enough time for the new legislation to make its way through Congress this year. As May 17th has come and gone, it appears that the U.S., Canada, and Mexico are still nowhere near a deal, which means that any new agreement might have to wait until 2019, in which the Republicans might not have control of both houses of Congress. It should be noted that the U.S. trade deficit was $566 billion last year, and in February 2018 reached its highest level in decades, before bouncing back in March.
Driven by Global Demand and Increased Supply Tensions, Oil Continues its Climb Higher
Finally, as we discussed last month, the price of crude oil is still climbing and is now up almost 20% YTD. While this will likely translate into higher gas and energy prices for consumers, it bodes well for energy companies and commodity investors. Global demand has increased along with the improving economy, and the supply backlog has been depleted due to OPEC and Russia’s joint efforts to limit production. More recently, tensions in the middle east surrounding the U.S.’s backing out of the Iran Nuclear deal, as well as moving the U.S. embassy in Israel to Jerusalem, has helped elevate concerns about stability in the area. Finally, Venezuela is suffering an economic crisis, and is likely to face further sanctions from the U.S. after President Maduro’s re-election which some opponents have questioned the validity of the results. These factors, along with a forward curve which makes it profitable to roll future positions into shorter dated contracts, all support higher crude prices in the short run.
Unfortunately, the costs that many will pay at the pump will offset some of the benefits received from last year’s tax cuts, but the pain should be limited. We believe it is unlikely that we will see oil prices above $100 in the immediate future, as this would imply a 67% increase within one year We continue to be positive on the fundamentals in the global economy, and feel that the market is once again reflecting that viewpoint. Higher interest rates will cause some pain along the way, but we have a way to go before they have a damaging effect on future growth.
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