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Market Recap Friday, August 18, 2017

In Brief

  • U.S.: Home builder sentiment climbs in August 2017 and consumers still likely pent up demand for housing; 10-year breakeven inflation rate rose in July for the first time in five months; NAFTA changed U.S. trade with Canada, Mexico; dollar fell in July against most other currencies
  • EU: The hard data released this week reconfirmed the recovery remains on track and broad based
  • U.K.: Pound fell after U.K. inflation disappointed
  • Japan: Better second-quarter growth than expected; quarterly profit climbs for 68% of the listed companies; Abe reaffirmed plan to complete doubling of consumption tax in 2019
  • China: M2 money supply 9.2% vs. 9.5% forecast; IMF raises China 2018-2020 growth outlook; economy moderating but no imminent risk; China reclaims spot as biggest holder of U.S. Treasuries
  • Thought: Consider a more diversified approach to global credit markets

On the U.S.

U.S. home builder sentiment, as measured by the National Association of Home Builders (NAHB) Wells Fargo Housing Market Index, increased to 68 in August, up four points from 64 in July and the highest level since May; a reading above 50 generally indicates more builders view sales conditions as good. On the other hand, the level of reading is still far from their pre-recession peak. One explanation for the mismatch is home builders are confident about the outlook for the U.S. economy but in short supply of materials and qualified workers.

The U.S. 10-year inflation breakeven inflation rate, the difference between nominal and real yields and a measure of inflation expectations, rose in July for the first time in five months. It began with a rate at 1.74% in July, about the same level it had been just prior to the U.S. election. President Trump’s surprise victory had propelled the rate to as high as 2.08% on the back of expectations for fiscal stimulus and its likely inflationary effect. The subsequent slide in the breakeven rate had been a mixed result of falling oil prices, underwhelming inflation data, and diminishing expectations for the extent of fiscal stimulus. The increase in July’s rate to 1.82% was contributed by oil prices rising again, but stimulus expectations, inflation data, and Fed policy will all continue to be factors in the direction of the rate moves.

The Trump administration set an intense tone on August 16 at the beginning of the renegotiation of the North American Free Trade Agreement (NAFTA), driving a wedge into its relationship with Canada and Mexico. The U.S. is also pledging to make reducing its trade deficit a priority, a point that Canada and Mexico partners sought to rebut. While the growth of the U.S. economy has followed trade, the changing dynamics have also prompted concerns about decreasing employment, especially in the well-paying manufacturing sector and the rising trade deficit.

The U.S. dollar fell again in July against other developed market currencies, as captured by the U.S. Dollar Index (DXY), touching 13-month low in its fifth consecutive monthly decline. Fed Chair Yellen’s more cautious testimony and soft inflation data contributed to the decline in the U.S. dollar, but developments in other developed markets also added to the appreciation of other currencies. In particular, euro gained 3.6% in July, yen nearly 2%, and pound 1.5%. Emerging market (EM) currencies also saw gains against the U.S. dollar, as captured by the JP Morgan Emerging Market Currency Index. Index gains were generally broad based and helped by Asian and Latin American currencies.

On the EU

The seasonally-adjusted GDP rose by 0.6% in both the euro area (EA)and the European Union (EU) during the second quarter, compared with the previous quarter, and rose by 2.2% in the EA and by 2.3% in the EU, respectively, from the same quarter of the previous year, according to a flash estimate published by Eurostat, the statistical office of the EU. The hard data reconfirmed that the recovery remains on track and broad based; even in Italy, the GDP grew by 0.4% from the previous quarter and by 1.5% from the same quarter of the previous year.

On the U.K.

The British Pound falls to almost eight-year low against the euro after another disappointing inflation report. The U.K. prices rose at an annual rate of 2.6% in July on the consumer price index measure, matching the June print and below economists’ expectation of 2.7%, lowering the likelihood of an imminent interest rate hike form the Bank of England. The near-instantaneous response from markets after that inflation print came in was a drop in GBP.

On Japan

The growth of Japan continues to be an under-the-radar story. The second-quarter GDP expanded an annualized 4.0% versus a forecast of 2.5% growth; compared to the previous quarter, the GDP grew 1.0%, much stronger than expected. Real GDP was more diverse than in the past, with investment contributing 0.7%, consumer spending 0.5%, and government spending 0.1%. Net trade was a drag. The Japan GDP deflator rose to 102.6 after falling the last four quarters.

The Nikkei 225 remains almost 17-year high in both JYP and USD terms. Japan’s corporate earnings have broadly recovered, with a record 68% of nearly 1,600 listed companies booking higher net profit for the second quarter, as growth among makers of autos and electronics spread to their materials and equipment suppliers.

To restore Japan’s fiscal health, Prime Minister Shinzo Abe remains committed to a plan to complete the doubling of the consumption tax to 10% in October 2019. Under the initial plan, the consumption tax was to be raised to 10% from the current 8% in October 2015, but Abe has already postponed it twice to try to ensure a solid economic recovery.

On China

Growth in China’s broad money supply, as measured by M2 or the money supply that includes cash, checking deposits, savings deposits, money market securities, mutual funds, and other time deposits, slipped to a new record low, indicating the People’s Bank of China (PBOC) is not letting up in their drive to control excess borrowing and safeguard the financial system. Aggregate financing stood at 1.22 trillion yuan ($182.7 billion) in July, the PBOC said on August 15, compared with an estimated 1 trillion yuan in a Bloomberg survey. New yuan loans stood at 825.5 billion yuan, as compared to a projected 800 billion yuan. M2 increased 9.2%, versus economists’ forecast of a 9.5% growth rate. The slower increase in M2 will become a “new normal,” and “The relevance of M2 growth to China’s economy and its predictability has reduced, and its changes should not be overinterpreted” the PBOC said in its quarterly monetary policy report. The divergence between M2 growth and aggregate financing mirrors that the PBOC is attempting to adjust cutting leverage while ensuring enough funds to support the real economy.

The International Monetary Fund (IMF) raised the growth outlook for China for the period between 2017 and 2021 but cautioned the projected sharp increase in nonfinancial sector debt could hurt growth. Although China’s retail sales, investment, industrial production, and lending all slowed further in July, they remain rapid. There are imbalances in the economy, but probably few immediate risks.

China’s holdings of U.S. bonds, notes, and bills rose to $1.15 trillion in June, up $44.3 billion from a month earlier, according to Treasury Department data released August 15 in Washington. Japan owned $1.09 trillion; Japan had overtaken China in October 2016 as the largest holder of U.S. Treasuries. China and Japan account for more than a third of all foreign ownership of Treasuries.

Thoughts

Low market volatility continued to fuel risk appetite, driving equities higher and interest rate curves steeper. The MSCI World Index rose 2.4% amid a strong start to the second-quarter earnings season, taking year-to-date gains to 13.3%. With a robust 6% return in July, EM equities, as measured by the MSCI Emerging Markets Index Daily Net TR, extended their positive run in 2017 to over 25%; Brazilian stocks reacted positively to the conviction of former President Lula on corruption charges, Russia benefitted from higher oil prices, and Chinese equities were supported by better-than-expected second-quarter GDP growth.

After a turbulent 2015 and inconsistent start to 2016, global credit markets have since bounced back and continued to rally. This has led investors to ask whether there is still value in corporate bond markets and how they can balance their return objectives against the downside risks. Many credit investors focus on specific areas of the global credit markets, such as U.S. investment grade corporate bonds, high yield bonds, EM debt, and securitized loans. In addition, many investors attempt to time their allocations to various credit sectors. An active, tactical, multi-sector approach to credit investing can produce better long-term results through structural diversification, bottom-up credit selection, and the ability to scale into and out of risk as relative valuations become more or less compelling.

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Market Recap Friday, August 11, 2017

In Brief

  • U.S.: Producer prices recorded the biggest drop in 11 months; productivity rose 0.9% in 2Q17, consistent with the climb in the JOLTS Quits
  • Eurozone: Soft and hard data in Germany eased slightly but remain robust; Bank of France sees economic growth of 0.5% in 2Q17
  • U.K.: The Brexit dulled another quarter of the economic activity but has not yet impacted employment and is disappearing from inflation; the U.K. economy was better in 2Q17 with real GDP growth accelerated
  • Japan: Recovery persisting with economic data stayed encouraging, buoyed by domestic demand as consumer spending recovered and firms increased capital investment
  • China: July FX reserves unexpectedly hit nine-month high on boost from weak dollar; initiatives to deflate asset valuations and detox the debt market are working; China’s 751 million Internet users are equivalent to entire population of Europe
  • LEIs: Still solid but milder 2H17 global activity

On the U.S.

U.S. producer prices, as measured by the Producer Price Index (PPI), unexpectedly fell in July 2017, recording their biggest drop in 11 months and pointing to a further moderation in inflation that could delay a Federal Reserve interest rate hike. The PPI for final demand declined 0.1% in July, seasonally adjusted, according to the U.S. Bureau of Labor Statistics (BLS), as compared to the up 0.1% in June and unchanged in May. On an unadjusted basis, the PPI for final demand increased 1.9% for the 12 months ended in July. Over 80% of the July decrease in final demand prices is attributable to the index for final demand services, which fell 0.2%. Prices for final demand goods edged down 0.1%. The index for final demand less foods, energy, and trade services was unchanged in July, following a 0.2% advance in June. For the 12 months ended July, prices for final demand less foods, energy, and trade services rose 1.9%. Inflation, the Fed’s another mandate, remains below the 2% target.

U.S. worker productivity picked up more than expected in the second quarter, as hours worked rose at the fastest pace in one and a half years. Nonfarm business-sector productivity increased at a 0.9% seasonally-adjusted annual rate, and between the second quarter of 2016 and the second quarter of 2017, U.S. productivity increased 1.2%, reflecting a 2.7% increase in output and a 1.5% increase in hours worked, according to the BLS. The panelists at National Federation of Independent Business (NFIB), America’s leading small business association, were saying they were planning to raise worker compensation and finding qualified applicants is a top issue. The qualified labor shortage is a factor causing historically low production.

A better second-quarter productivity is consistent with the climb in the Job Opening and Labor Turnover Survey (JOLTS) Quits. The number of job openings increased to 6.2 million as of the last business day of June. Over June, hires and separations were little changed at 2.1% and 1.2%. Within separations, the quits rate and the layoffs and discharges rate were litter changed, according to the BLS.

On Eurozone

Firms, investors, and consumers in the euro area are reacting positively to the recent diminishment of political uncertainty and anti-euro threats. Eurozone economic, business and consumer confidence made new highs in July. Soft and hard data released this week eased slightly, but remain robust.

Emmanuel Macron has won the hearts of business leaders in France, who are counting on him to push through radical reforms to sustain an economic recovery. Confidence is at a six-year high, and executives from Société Générale SA to building materials firm Cie. de Saint-Gobain SA have spoken of a brighter mood since the new president was elected in May. On August 9, the Bank of France reported a better-than-forecast jump in manufacturing confidence and said the economy could grow 0.5% this quarter.

German industrial production unexpectedly fell for the first time this year in June, but remain near May’s historical high. Output declined by 1.1% on the month after rising 1.2% in May, but factories and construction firms in Germany produced 1.8% more in the second quarter than the previous quarter. Order levels, along with business climate indicators, pointed to the upward trend continuing.

German export and import growth disappointed, with exports falling 2.8% month on month and imports 4.5% month on month. The trade surplus though improved to EUR 21.2 billion from EUR 20.3 billion, leaving the total for the second quarter at EUR 61.3 billion, up from EUR 59.9 billion in the first quarter. German exports and imports are still upward trending which is an encouraging sign of global economic activity.

On the U.K.

The Brexit continued to have varied effects on the U.K. economy. The Brexit dulled another quarter of U.K.’s economic activity but has not yet impacted employment and is disappearing from inflation. The U.K. Headline CPI softened to 2.7% year on year and the core series slid to 2.5% year on year in June. However, another step down in the exchange rate would likely lead to an additional bout of inflation, so risks remain.

U.K. employers continue to hire, sending the employment rate to its highest level ever and the unemployment rate down to 1975 levels in May. This seems counterintuitive given the uncertainty Brexit is generating. One explanation could be hiring is quicker and more reversible than CapEx to meet short- to medium-term demand.

The U.K. real GDP growth accelerated to 0.3% quarter on quarter in the second quarter, which was better than the first quarter, despite it is still far from the 0.5% of the post-crisis average. Economic activity was buoyed by services during the quarter; services comprise 78% of U.K.’s GDP and the sector grew by 0.5%. Production and construction contracted. Agriculture grew 0.6% but comprises a sliver of the economy. Film activities comprise 8.2% and supplied a one-off boost.

Retail sales growth slowed in July, but grocery sales continued on an upward trend due to inflation. Overall sales for the industry edged up 0.9% year on year, according to the British Retail Consortium (BRC), down from a growth of 1.1% of the previous year.

On Japan

Japan’s economic data stayed encouraging, buoyed by domestic demand as consumer spending recovered and firms increased their capital investment. Consumers’ appetite for durable goods remains persistent as auto sales for June grew 7.9% in 12 months year on year. The Q2 Tankan Survey showed domestic demand, financial position, lending attitude, and prices all improved across all firm sizes while production capacity and employment became more insufficient.

The Cabinet Office’s leading index, which measures the future economic activity, improved to 106.3 in June, a three-year high. The coincident index, which reflects the current economic activity, came in at 117.2, the highest since March 2014. Export growth slowed to 10.5%, but the pace is still impressive.

The total value of machinery orders, a leading indicator of production which tracks trends in Japanese machine tool orders placed with major manufacturers in Japan, increased by 2.1% in June from May on a seasonally adjusted basis. In the second quarter, it increased by 1.7% compared with the first quarter. Private-sector machinery orders, excluding volatile ones for ships and those from electric power companies, decreased a seasonally adjusted by 1.9% in June and showed fell by 4.7% in the second quarter. Robust global demand boosted Japanese business confidence to a three-year high in the second quarter, heightening policymakers’ hopes that cautious companies will finally increase spending on plant and equipment.

On China

FX Reserves rose for a fifth month to $3.08 trillion in July partly due to that the yuan strengthened around 0.8% against the dollar in July. Capital controls are working. Meanwhile, the pricier currency has affected trade volumes. Export growth slowed for a second month to 8.9% year on year; import growth decelerated for a third month to 14.2%. The stronger currency has been coinciding with milder inflation.

Initiatives to deflate asset valuations and detox the debt market are working. Property prices eased overall and by tier in June; the 70-city average growth rate cooled for the sixth month to 9.4% year on year. On the other hand, aggregate financing and new yuan loans remain in up trends. This hot credit is warranting further regulatory changes.

China’s population of Internet users rose 2.7% over the first half of the year to 751 million, exceeding the population of Europe, according to the China Internet Network Information Center (CINIC). The increase in Internet users in China indicates how the rise of mobile internet services has driven growth in China’s online population and its Internet penetration. In China, 96.3% of internet users had access through their cell phones, an increase of 1.2% from the end of 2016. Among mobile internet applications, food delivery, wealth management, and bike-sharing put up some of the biggest growth numbers. At the end of June, online food delivery services had 274 million users, a 41.4% increase from the end of 2016, making it the fastest-growing sector. The number of people that used the Internet to manage their money grew 27.5% over the first six months to 126 million. China’s online payment industry has also taken off over the last six months, hitting a record 502 million online payment users, making China one of the most cashless countries in the world. Users of bike-sharing services are another major growth group. The number of users surged from zero just over a year ago to 106 million in June, accounting for 14.1% of all internet users, according to the CINIC report.

On LEIs

The OECD’s Leading Economic Indicators (LEIs) continue to indicate economic activity for the second half of 2017 will be milder in most G7 countries, as the nominal reacceleration concludes, the “spinach” period commences in U.S. politics, and real growth drivers are delayed till early 2018.

Looking ahead, activity for the second half will temper in most G7 countries, according to the July release of LEIs. The reacceleration in the global economy this year has bought time, but the recent batch of LEIs plus inflation growth peaking stresses the urgency of real growth drivers, e.g., fiscal policy, to carry forward the momentum. Unlike the rest of the world, the LEIs for European countries are indicating the expansion will continue to steam ahead.

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Market Recap Friday, August 4, 2017

In Brief

  • U.S.: 10-year yield slips to lowest in a month; The DJIA closed above 22,000 for the first time; U.S. companies post profit growth not seen in six years; a very strong jobs report for a maturing cycle
  • Manufacturing tailwind continues: Manufacturing in the Eurozone, U.K., and the U.S. continues to enjoy a significant tailwind despite the political landscape
  • Non-manufacturing declined: Significantly below consensus forecasts and the lowest reading for 11 months
  • Equity strategy: Considering incorporating ESG to portfolios

On the U.S.

U.S. Treasury yields fell to more than one-week lows on Thursday after the Bank of England kept interest rates at a record low and downgraded its economic and inflation forecasts, raising concerns about global economic growth. Investors had begun to price in the chance that the BoE might raise interest rates this month for the first time in a decade. Thursday’s decision sent yields on 10-year UK government debt tumbling to their lowest since June 28.

The Dow Jones Industrial Average (DJIA) on August 2 notched a psychological milestone at 22,000, highlighting a steady record ascent for the blue-chip benchmark. The DJIA hit its 32nd record close of the year, powered by a rally in shares of Apple Inc. and Boeing Co.

The largest companies in the U.S. are on pace to post two consecutive quarters of double-digit profit growth for the first time since 2011, helped by years of cost-cutting, a weaker dollar and stronger consumer spending. Earnings at S&P 500 companies are expected to rise 11% in the second quarter, according to data from Thomson Reuters, following a 15% increase in the first quarter. Close to 60% of the firms in the index have reported second-quarter results so far.

U.S. payroll employment rose 209,000 month on month in July, which is very solid given that the economy is near full employment. Gains were broad based. Household employment rose 345,000 month on month. The U.S. unemployment rate declined to 4.3%, with underemployment remained at 8.6%. Wages rose 0.3% compared to the previous month and 2.5% compared to the previous year.

Manufacturing Tailwind Continues

Manufacturing in the Eurozone, U.K., and the U.S. continues to enjoy a significant tailwind despite the political landscape. For the seven months of 2017, both the Eurozone and the U.S. PMIs have averaged 56.4 and the UK posted 55.2 for the period. Manufacturing is enjoying strong growth easily outpacing Non-Manufacturing which is typically slower to respond.

The Eurozone PMI (56.6, -0.8) fell back from its highest level in 74 months but still looks quite strong. The continuing expansion is led by Austria, Netherlands, and Germany. Even more encouraging, all eight Eurozone countries, including Greece, reported a PMI above the 50 mark for the second consecutive month.

The UK PMI (55.1, +0.9) rose above the monthly average for the post BREXIT period, helped by a “near-record” expansion in new export orders – the biggest surge in export orders since 2010. The U.K. also reported employment at almost record levels. The U.K. PMI exceeded the consensus forecast of 54.4 in a Reuters poll of economists.

According to China’s Official Report, the CFLP PMI (51.4, -0.3) continued above 51 for the tenth consecutive month. The Caixin China General Manufacturing PMI (51.1, +0.7) signaled the second month of expansion after a one-month decline. Realistically, the China data reflects little variability making the measurement of change problematic.

Noteworthy is the significant decline in the India (47.9, -3.0) Index which reflects the impact of a new Goods & Services Tax is implemented. Also, Taiwan (59.0, +1.4) continues to post very strong numbers as current and anticipated product rollouts drive the semiconductor industry.

In North America, Canada reported growth for the 17th consecutive month, with an average of 55.0 for the first seven months of 2017. Mexico recorded its 48th consecutive month of growth. The rate of growth of the U.S. manufacturing sector, as measured by the ISM PMI™, slowed to 56.3 during July, but it still tells a story of significant month-over-month expansion. Overall, of the 18 manufacturing industries, 15 reported growth in July.

Non-Manufacturing Weakens

The ISM Non-Manufacturing Index (NMI) (53.9, -3.5) decelerated during July, indicating weaker growth in the sector, particularly in the key components of the NMI. The NMI averaged 56.9 for the first half of 2017, which places the July Index significantly below average. The deceleration in the NMI was led by New Orders and Business Activity, while the Employment Index fell to its lowest level since April. Supplier Deliveries contributed to the deceleration in the composite index. The 15 non-manufacturing industries reporting growth in July.

Other Thought: Incorporating Social and Corporate Governance (ESG) 

First, the ESG metrics have been strong indicators of future volatility, earnings risk, price declines, and bankruptcies. Second, trends in the U.S. investment landscape suggests that trillions of dollars could be allocated to ESG-oriented equity investments, to stocks that are attractive on these attributes. Most importantly, ESG-type investment strategies may be a self-fulfilling story.

ESG’s growth in the US is just gathering momentum. Estimated assets under management (AUM) of traditional US-domiciled sustainable, responsible and impact investing (SRI) assets has grown to nearly $9 trillion, an impressive 33% 2-year growth rate, but are still just one-fifth of assets. In Europe, ESG is part of the investment decision for 60% of AUM. As interest in ESG investing moves from specialists to generalists, areas for potential growth include pensions and endowments, millennials, and quants or passive.

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Market Recap Friday, July 28, 2017

In Brief

  • U.S.: Consumer confidence steadfast ahead of political turmoil; U.S. dollar weakened notably
  • Eurozone: “Euphoric” soft data points and growth spurt loses momentum for second month running
  • Germany: The Ifo business climate index rose to another record high at 116.0 in July; German private sector output growth eases in July
  • France: July PMI to further robust increases in output and employment; French confidence also remained elevated
  • U.K.: Brexit weighing down economic activity; U.K. CBI showed still-solid industry
  • Japan: Encouraging data package; the IMF revised up its outlook for Japan
  • China: GDP forecast raised by economists after growth beats estimates; better growth is extending window for officials
  • Fed’s July 26 meeting and its implications

On the U.S.

Despite the political tumult, U.S. consumer confidence strengthens and remains at 16-year highs. The Confidence Index rose to 121.1 in July 2017, beating Economists’ expectation for a decline. Consumers in the U.S. found the current environment to be improving and are more hopeful about the future.

U.S. dollar has weakened notably recently. A weakening currency typically would lead to concern about inflation. Theoretically, a weaker U.S. dollar should significantly help corporate earnings. A weaker U.S. dollar historically has been associated with higher commodity prices, which could be a concern for consumers. But the recent decline in oil, which looks mainly driven by supply and technology, is inhibiting this relationship. The bottom line is business cycles do not end with profits up and wages up together. The weaker U.S. dollar should support business profits now. Full employment in the U.S. should support wage gains, and cheap energy should make these real wage gains.

On Eurozone

Soft data continues to be upbeat in Eurozone as the recovery firms and political uncertainty subsides despite certain geopolitical tensions persisting. the eurozone started the third quarter on a solid footing and the Eurozone PMI Composite fell for a second successive month in July, down to a six-month low of 55.8 from 56.3 in June. The Eurozone Manufacturing PMI recorded 56.9 compared to 58.7 in June. Manufacturers, buoyed in particular by further robust export order book growth, continued to report stronger output growth than service providers, despite the rate of expansion easing to the weakest since January. The Markit PMIs softened but still well in expansionary territory.

On Germany

The German’s Ifo business climate index rose to 116.0 from 115.2 in June, beating Reuters’ consensus forecast for 114.9. German business and consumer confidence hit a record high as “euphoric” manufactures, shrugging off the impact of a strong euro, anticipated a surge in already robust exports from the biggest economy in Europe.

On the other hand, German private sector output growth slowed for the second month running in July but remained strong overall. Germany PMI Composite was down to 55.1 in July from 56.4 in June, a six-month low, a trend reflected in both manufacturing output and services business activity. New business inflows increased at the softest rate since the start of 2017. That said, job creation quickened during July and outstanding business continued to grow solidly, reflecting manufacturing backlogs. German firms remained as optimistic regarding output expectations in July as they had been in June.

On France

The France Composite Output Index posted well above the neutral 50.0 level at 55.7, while down from 56.6 in June and marked a further decline from May’s six-year peak. The rate of expansion remained sharp overall. Softer increases in output were seen across both manufacturers and service providers in July. French private sector companies also noted a steep increase in overall new business at the start of the third quarter. Greater output and new orders prompted companies to add to their payrolls for the ninth month running in July. Despite higher staff numbers, capacity pressures persisted in July as highlighted by a further solid rise in backlogs of work. French July PMIs signaled greater average input costs faced by French private sector firms.

French confidence remained strong and is holding multi-year highs. While services companies expressed a weaker degree of optimism towards 2018, the level of confidence across the manufacturing sector improved to its strongest in the five-year series history

On the U.K.

The U.K. economy was a bit better in the second quarter, but the data is still ominous. U.K. real GDP growth accelerated to 0.3% quarter over quarter in the second quarter. The pace is better than the first quarter, but still far from the 0.5% level of post-crisis average.

Economic activity was buoyed by services in the second quarter. Services comprise 78% of the U.K. GDP and grew 0.5%. Production and construction contracted. Agriculture grew 0.6% but comprises a silver of the economy. Film activities 8.2% supplied a one-off boost. CBI business optimism was also slightly better but still lackluster compared to prior business cycles, due to the Brexit and the rollercoaster ride resulting from it.

On Japan

Japan is improving glacially and quietly in the background of the global stage. The Markit Mfg PMI ticked down fractionally to 52.2 due to mixed results. The third quarter started with exports stagnating, but hiring and optimism hit multi-year highs according to the July reading. All in all, The Japan Mfg PMI is steading in expansionary territory. Moreover, the IMF revised its Japan outlook, where positive surprises to activity in late 2016 and early 2017 point to solid momentum, which is also encouraging.

On China

China’s GDP will expand by 6.7% from the previous year in the third quarter and 6.6% in the fourth quarter, according to the median of 57 economist estimates in a July 17-24 Bloomberg survey. Both points were 0.1% higher than a year ago. Economists raised their forecasts for China’s economic output after growth in the first half beat estimates. The robust activity is giving policy makers’ room to curb excessive and speculative borrowing.

In the IMF July World Economic Outlook Update, the IMF mentioned “The unchanged global growth projections mask somewhat different contributions at the country level. China’s growth projections have also been revised up, reflecting a strong first quarter of 2017 and expectations of continued fiscal support.”

Fed’s July 26 Meeting: Expected to Do Nothing Does Not Mean Bond Market Will Not Move

The Federal Reserve said at its July 26 meeting that the job market is still getting stronger, and it left interest rates alone after three hikes since December 2016. In a statement after the Fed’s two-day meeting, central bankers said they expected the economy to “warrant gradual increases’ in rates. Most Fed officials expect at least one more hike in 2017, either in September, October, or December.

This does not mean there cannot be surprises. Recent language from Fed speakers has seemed to deny any plans to target asset levels, but there is a difference between targeting asset levels and challenging market complacency, and challenge market complacency may be exactly what the Fed does now. True, inflation data has been too soft to justify another tightening in July, or in September for that matter, so there is little reason to expect anything hawkish on that front. And plans for balance sheet runoff appear to be going smoothly with expectations for a September announcement and October start having been well-digested. So, why risk that with a tantrum? First, expect the Central Bank to simply strengthen the view that balance sheet runoff will start in the fall. The purpose of this would be to bring any holdouts in line with the consensus view that runoff is coming and to keep the topic front and center for the rest of the summer. But there should also be some mention of expectations for continued rate hikes if the economy progresses as expected. Although this is a logical statement, the purpose here would be to keep December checked off for at least one more hike in 2017. These two points, even though they are expected in advance, could be just enough of a reminder to push yields in the 1-10 year bucket up.

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Market Recap Friday, July 21, 2017

In Brief

  • Europe: Encouraging data now; ECB studying tapering
  • U.S.: Inflation down; housing permits back up
  • China: New data released; PBOC to coordinate work of new financial oversight body
  • U.K.: Unexpected softer inflation in June
  • LEIs: Global nominal reacceleration ending; real growth drivers needed
  • Given the magnitude and pace of change in the technology sector, it is vital to be early in identifying winning companies; key investment themes as followed

On Europe

Inflation is nascent in Europe. Euro Area (EA) CPI deaccelerated to 1.3% year over year in June, but that was mainly due to energy prices declining -0.9% month over month. Service prices, which is roughly 45% of the EA CPI, and core prices are in rebound mode, up to 1.6% year over year and 1.2%, respectively.

The ECB’s quarterly Bank Lending Survey (BLS) also showcased the economy’s progress. According to the ECB BLS, M&A activity and fixed investment made an important and increasingly positive contribution to demand for loans to enterprises in the second quarter of 2017. The general level of interest rates, inventories, and working capital also continued to have a positive impact on demand. Net demand for housing loans continued to be driven mainly by the low general level of interest rates and favorable housing market prospects. Spending on durable goods, the low general level of interest rates, and consumer confidence contributed positively to net demand for consumer credit.

The ECB opted for no decision and wants to be careful to avoid a “taper tantrum” in the bond market. On Thursday, the ECB left its stimulus measures unchanged but signaled it would discuss how to proceed with interest rates and bond buying, which is part of its bid to stimulate the regional economy in the fall.

On the U.S.

U.S. import prices fell for a second straight month in June amid further declines in the cost of petroleum products. The decline signaled less inflation in the pipeline. On a year-over-year basis, U.S. import prices slowed sharply to 1.5% since posting 4.7% in February. Import price pressures are, however, likely to pick up given the recent weakness in the dollar, which has declined 6.1 percent in value against the currencies of U.S.’ main trading partners this year.

U.S housing starts recovered and surged 8.3% year over year in June to a seasonally adjusted annual rate of 1.22 million units, despite it remains far below the pre-recession peak in level terms. Homebuilding has lost momentum after strong gains in both the fourth quarter of 2016 and first quarter of 2017.

On China

China’s real GDP grew 6.9% year over year again in the second quarter, both the service (7.7%) and manufacturing (6.4%) sectors contributed, while nominal GDP fell marginally to 11.1% year over year. Fixed asset investment rose 8.6%, property investment rose 8.5%, and retail sales rose 11.0% year over year. Property prices eased overall and by tier; the 70-city average growth rate cooled for the sixth month to 9.4% year over year.

Over the weekend, financial oversight changes were made to enhance the effectiveness of regulations. People’s Bank of China (PBOC) will be in charge of coordinating a new financial oversight body, namely, Financial Stability and Development Committee, mandated by President Xi Jinping to get China’s regulators to work together to contain rising credit risks. No indication has emerged on who could head the committee though. PBOC said on Tuesday that it would carry out the office duties of the new body, indicating the committee’s day-to-day operations might be conducted from PBOC. The new body’s responsibilities include formulating plans for the development of the financial sector, ensuring regulatory cohesion, formulating rules and regulations to fill in regulatory gaps, and holding regulators accountable when supervision is lacking.     

On the U.K.

The U.K. inflation fell unexpectedly in June for the first time in nine months; the CPI recorded 2.6%, as compared with an expected reading of 2.8% and a level of 2.9% in May. The fall was primarily driven by lower petrol and diesel prices, reflecting weaker global oil prices. Fuel prices fell by 1.1% between May and June, compared to a 2.2% rise over the same month a year earlier. Lower prices of games and toys also contributed to the fall. A softer inflation reading reconfirmed prices peaked earlier this year, after months of escalation.

On LEIs

The OECD’s Leading Economic Indicators (LEIs) are signaling activity will temper in most G7 countries in the second half of 2017. The reacceleration in the global economy this year bought time. Yet, the recent batch of LEIs plus inflation peaking year over year stress the urgency of real growth drivers, such as fiscal policy, to carry forward the momentum. Unlike the rest of the world, the LEIs for European countries continue to steam ahead. Further tapering of asset purchases by the ECB is looking more likely. The Italy election in 2018 is still a risk.

On Oil

Low oil prices are largely curbing both domestic and imported inflation pressures. Other factors such as declining prices for mobile phone services have also contributed to pushing inflation below the Federal Reserve’s 2% target. As oil prices have moved lower over the course of this year, some investors are beginning to wonder if they should brace for a repeat of 2015, when a sharp decline in oil prices led to an earnings recession, a blowout in high yield spreads and a slowdown across emerging markets. However, it is important to recognize that while the fall in energy prices may feel familiar, the results shouldn’t be the same.

First, the recent decline appears to have been driven by an increase in supply, rather than a softening in demand. Second, many of the most inefficient energy companies have defaulted, leaving the sector looking healthier than it was just a couple of years ago. These remaining companies have seen their earnings hit by write-downs of their oil-related assets in recent quarters, making it unlikely that this pullback in oil prices will have the same impact on earnings. Third, the lack of a fundamental threat has been reflected in markets – energy stocks have come under pressure as the price of oil has fallen, but as shown in this week’s chart, the relationship between oil prices and the S&P 500 appears to have broken down. Finally, high yield spreads outside of the energy sector look contained. As a result, it will be prudent to watch for signs of contagion going forward, but at the current juncture, energy sector weakness does not pose a threat to the economic expansion.

A big part of the Trump Administration’s economic agenda is to deregulate the energy sector in the U.S. Perhaps like the decision to remove price controls in the early 1980s this could be a development that is good for the economy as a whole but bad for energy stocks. Oil by shale is profitable below current spot prices while fiscal breakevens among OPEC members remain stubbornly high.

A Few Thoughts

In 2013, U.S. Treasury yields rose dramatically after then-Fed Chairman Ben Bernanke suggested the central bank might begin reducing its pace of monthly asset purchases. The so-called taper tantrum affected markets globally. Today, the Fed is openly discussing plans to begin shrinking its balance sheet in 2017 – yet Treasury yields remain stable. Two explanations for this striking disparity in the market’s response. First, unlike in 2013, both the Fed and market participants accept the New Neutral for U.S. monetary policy. Second, the Fed plans to continue buying duration and convexity risk for at least a year after balance sheet normalization begins.

Investors can seek out innovative companies that are taking advantage of megatrends in technology. These include cloud computing, the Internet, and the penetration of technology into areas such as factory automation and robotics, the automotive industry, health sciences, and aerospace. Given the magnitude and pace of change in technology, the early identification of companies with exceptional growth potential is vital.

In theory, investors should consider companies with strong intellectual property, high barriers to entry, a large addressable market, accelerating fundamentals, and strong cash flow and balance sheets. A company’s competitive advantage is key in assessing outcomes because success hinges on the ability to navigate challenging environments and market cycles. In addition, management is central to driving innovation and success, and investors should seek out leaders who can execute on their vision. Moreover, a company’s R&D pipeline and product pipeline are also important signals of a company’s innovation, but fundamental fitness is an important focus of the assessment. Beyond those, investors should seek far and wide for disruptive innovators in developed and emerging markets regions. Europe is a leader in some parts of industrial technology, including high precision manufacturing, science, and engineering. China has fostered the emergence of a strong domestic Internet industry. Japan has become a center of excellence in robotics.

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Market Recap Friday, July 7, 2017

In Brief

  • U.S. growth continues to hum along at a moderate pace
  • More hard evidence of European economic expansion
  • Capacity, labor, and price pressures accruing in Japan
  • In China government and private PMIs embody soft-landing
  • The Brexit/politics dulled 2Q17 economic activity in the U.K.
  • Equity markets performance was upbeat in 2Q17
  • U.S. government bonds rallied for most of the 2Q17 before retreating in the final week, reflecting a mix of softening inflation, falling commodity prices and firming monetary policy expectations.
  • Several ingredients create a generally supportive outlook for risk assets: Remain constructive on risk assets

Data flow over the course of 2Q17 confirmed that the global economy locked in a higher growth rate in 2017 after accelerating in 2H17. Measures of corporate sentiment moderated somewhat but remained healthy. Consumer sentiment was robust across developed markets (DM) and global export volumes accelerated modestly. International DM, led by the eurozone and Japan, were points of strength. Emerging markets (EM) were stable on balance. The U.S. economy rebounded after a soft 1Q17, bringing its first-half average growth rate to about 2%. The persistence of growth rates and positive sentiment were constructive fundamentals for equities. The supportive undertone was evident in decent upward momentum in global earnings revisions, and implied in the equity outperformance relative to other asset classes.

Slowing inflation was a lynchpin for the decline in government bond yields in 2Q17. Much of the reflationary impulse in 2H16 can be explained by evidence that global inflation was picking up, pushing nominal growth forecasts higher and garnering expectations that monetary tightening would follow. During 2Q17, the inflation outlook came under some pressure. For one, Brent crude prices fell 10%, bringing benchmark prices down nearly 15% year to date; OPEC officials believe, however, that inventory draws in July will double the levels in 2016 and will trend in the right direction. Indeed, weekly and monthly storage data are pointing to a tighter market by year end. With investors awaiting signs of a tightening oil market, July may be an important inflection point for sentiment. Inflation had been broadly softening even prior to the most recent oil price shocks.

In the U.S., the ADP nonfarm private payroll employment increased 158,000 month over month in June, and jobless claims remain low. The souring of U.S. relations will make it harder for President Trump to move forward on several matters with other nations; when it comes to North Korea, however, differences could be left at the door due to the urgency and severity of the matter. U.S. durable goods data for May indicated orders rose 0.2% month over month and shipments ticked up 0.1% versus contracting. U.S. growth continues to hum along at a moderate pace for now. Capex and employment are positively correlated to the U.S. economy as a whole.

In the EU, retail sales in volume terms continued to expand, which grew 2.7% in May compared to the previous year. This hard data is consistent with the elevated consumer and business sentiment in the region in recent months. Firms and consumers are reacting positively to the recent diminishing political uncertainty and anti-euro threats.

In the U.K., both the Services (53.4) and Mfg (54.3) PMIs were expansionary in June. Brexit- and general-election-related uncertainties have been holding back consumer and business spending for a few months. Panelists in the Services sector cited difficulties recruiting staff to fill vacancies as well as coincidently rising staff salaries, which may be the first sign of wage gains to come.

In Japan, the rises in services and manufacturing employment helped its rate of private sector job creation to reach the highest since September 2007. As has been the case in every month since November 2012, input prices faced by Japanese service providers rose in June. Moreover, Japan’s rate of inflation quickened to the sharpest in five months, amid reports of higher raw material and staff costs. According to The Guardian, Japan and EU expected to sign trade deal after a breakthrough in talks.

In China, new orders, output, hiring, and costs continue to ease. Yet, panelists remain optimistic as conditions are moderating. The Caixin Markit Mfg PMI bounced back to 50.4 in June, compared to contracting to 49.6 in May. The Services PMI declined fractionally to 51.6, but buoyed the 51.1 of the Composite index in June. In general, the milder China domestic growth becomes, the more incentive there is for policy makers to strengthen trade ties.

Thoughts

Several ingredients create a generally supportive outlook for risk assets: economic output at current levels, evidence that business cycles globally remain on a slow burn, and anticipated signs of firming inflation. The risk is best spread out more evenly across regions, with a tilt towards more cyclical markets like the euro zone, EM, and Japan. Investors should remain constructive on risk assets, with a broad-based regional exposure to equity markets.

Real yields are again leading the charge in 10-year yields. But inflation expectations, though lagging a bit, are drifting higher now too. Net, the relationship between these two now implies monetary policy is as tight as it’s been since last March, after easing for most of 2016 and 2017. The difference between the breakeven inflation expectation and the real yield may be interpreted as a measure of monetary tightness or even a first derivative on growth, with a higher number signaling looser financial and monetary conditions. Conditions in January of 2016 were at their tightest since the recession. Today, conditions are tighter than at the start of the year. Any further rise in real yields could start to weigh on risk sentiment.

The most powerful driver for yield curve flattening over the post-financial crisis period has been central banks’ active balance sheet policy, which has depressed longer-dated yields. Indeed, the rebound in bond yields towards the end of the 2Q17 has been mainly a function of heightened expectations of central bank balance sheet normalization this year. Federal Reserve statements suggest that its plan to let maturing securities roll off its balance sheet will shrink its holdings by $1.4 trillion over the next four years. As a result, an increased net supply of bonds, in tandem with a taper of asset purchases by the European Central Bank in 2018, will push up global yields. Spates of volatility over that period, as markets calibrate the pace and end points of this process, are to be expected.

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Market Recap Friday, June 30, 2017

  • In Brief

    • Momentum equity style factor is outperforming, backed by a sustained economic expansion.
    • Oil prices entered a bear market on concerns about higher-than-anticipated global supply.
    • Baa spreads hit fresh lows.
    • A notable Leadership shift since Comey’s Testimony in early June: Technology price looks corrective while financials are reaccelerating.
    • Stock volatility is near an all-time low.
    • U.S. and euro zone inflation data could shed light on the direction of central bank policies.
    • U.S. long-term yields fell in June mostly in response to another weak U.S. inflation print.

    The recent disconnect between the Fed normalization and the falling long-term rates is partly a result of markets overly focusing on softening inflation data, while the Fed focuses more on the outlook. This dynamic could persist in the near term. The sustained above-trend global growth and stabilizing inflation ahead, indicating the impact of the Fed’s pace of normalization may be greater than bond markets currently anticipate.

    The growth rate of France in the first quarter of the year has been revised up to 0.5%, which is the latest sign that the euro zone continues to recover. European companies have posted their fastest quarterly growth since the debt crisis started six years ago, but growth dipped in June, suggesting a slight slowdown. Worries over Brexit and deflation loomed over the City after a week of oil price falls. The European Central Bank has launched a bid to wrestle control of London’s euro-clearing market.

    While the S&P is roughly unchanged over the last several weeks, credit conditions remain supportive with Baa spreads hitting fresh lows last week, which marks an important difference from 2014 and 2015. Weakness in Oil and the Energy patch has not impacted corporate credit to any meaningful extent thus far. Similarly, the weakness in retail stocks and the rise in retail CDS have largely remained contained as well.

    Momentum equity style has historically outrun the broader market, but with periodic sharp drops. The biggest dips in its relative performance have coincided with recessions and financial crises. Momentum tends to perform best during steady economic expansions, which should have ample room to run.

    A Notable Leadership Shift since Comey’s Testimony on June 10

    On Technology Equity

    Recent technology price action, partially evidenced by the Nasdaq-100 Index (NDX), which includes 100 of the largest non-financial companies listed on The Nasdaq Stock Market capitalization, looks corrective. The NDX fell significantly. In the short term, this is likely a market that will continue to be difficult to hang onto, as the volatility continues to be a major issue. The alienation of technology equities from the rest of the market worsened Thursday as another violent industry rotation left the NDX with a loss that was twice as big as that of the S&P 500. With banks clinging to gains after unleashing a torrent of buybacks following Federal Reserve stress tests, money was draining from computer and internet companies. The contraction in internal momentum is also consistent with a consolidation pause in technology.

    On Financials Equity

    Financials are reaccelerating, following a four-month pause. Financials have exhibited renewed signs of momentum over the past several weeks. Internally, financials have been showing signs of reaccelerating for the better part of June. In the euro zone, banks are resuming higher and are now at a five-month relative high. The multi-month consolidation in global bank stocks is also resolving higher.

    China Urges Caution in U.S. Steel, Aluminum National Security Probes

    The Chinese Ministry of Commerce urged the Trump administration to employ caution in evaluating whether to restrict steel and aluminum imports that threaten U.S. national security. China called on countries to support the free and open international trade system and to resist trade protectionism, and exert caution with various forms of trade restrictions.

    It is expected that the Trump Administration will consider a broader definition of national security than just defense needs in the current investigation. Secretary Ross has noted that production of transformers for the electrical grid constitutes a national security concern. Steel producers have highlighted the need for steel in transportation and energy infrastructure, which could be the basis of the national security determination.