On Economy

Voluntary job separations continue to trend higher in the U.S., which is a healthy sign. Additionally, the NAHB housing market index hit a new cycle high in March.

The Fed is picking up the pace in its quest for normalization. The central bank raised rates +25bp, putting the fed funds rate target in a 0.75%-1.0% band. The Fed remained committed to a gradual pace of rate hikes in 2017. The neutral level of the federal funds rate remains low, and just a few more rate hikes will move to that neutral rate quickly.

While the data-dependent Fed is in a tightening cycle, and the data is good enough to continue. The Fed’s forecasts haven’t changed much, and the FOMC members are still not discussing in detail particular fiscal policy measures. Chair Yellen did note that the Fed balance sheet was discussed at last week’s meeting, but no decisions were made and more work needs to be done. There is no specific fed funds rate that would trigger a balance sheet decline, but rather a sense that the economy will continue to make progress plus confidence that there is no particular concern about adverse risks.

On Energy

European stocks and U.S. futures edged lower Monday as a pullback in oil prices pressured shares of oil and gas companies. Declines in the oil price kept shares of energy companies depressed with Brent crude oil last down 0.4% at $51.55 a barrel, weighed by signs of increased drilling activity in the U.S. Italian bank shares edged up 0.3%.

On Stocks

Stocks in Europe and Asia pulled back Wednesday after major U.S. indexes posted their steepest decline of the year. The Stoxx Europe 600 was down 0.8% in the early minutes of trading and Asian markets were lower across the board amid a retreat in global bank shares. Futures pointed to a 0.3% opening dip for the S&P 500. Continued weakness for the dollar this year is likely contributing to the strength in many global markets. Consumer Discretionary is about as scattered of a group as we can remember in some time. On one side, the Retail stocks remain in pronounced downtrends with many on the verge of or hitting new lows this week. Aside from Internet Retail, it remains a difficult space to be.

The small-cap rally that took Wall Street by storm late last year has petered out. Shares of smaller companies have lagged behind the market this year, underscoring investor concern over the likely timing of economic-policy changes by President Donald Trump’s administration and rising U.S. interest rates. The Russell 2000 index of small-cap companies is up 2.5% this year, while the S&P 500 is up 6.2%. Small-caps rose 14% between Election Day and the end of 2016, while the S&P 500 climbed 4.6% over the same timeframe.

White House Preps Pair of Executive Orders on Trade

Trade is likely to move back into the spotlight in the next few weeks as the White House prepares to release two new executive orders: one ordering a reexamination of all existing trade deals, and one aiming to review and change procurement policies. Both orders would represent steps toward fulfilling some of Trump’s signature pledges. The executive orders also have added the benefit of changing the current narrative from more damaging stories involving the White House to a place where the president can really shine.

Interesting Charts

Lipper Large-Cap Core Ave Return Relative S&P 500 Total Return vs. CPI

Annual S&P 500 Performance vs. % of Active Managers Outperforming

Sector Performance during Fed’s Balance Sheet Expansion

A Look at the Markets Eight Years Later

S&P 500 Historical Bull Markets 1928 to Present

Tax Reform High on Trump Agenda as U.S. is Least Competitive

Source: Strategas Research

A Few Thoughts

Higher bond yields, whether they signal a healthy economy or stretched stock valuations, appear to have staying power. U.S. bond yields are topping a key measure of the dividends that large U.S. companies pay, which is a shift that has broad implications for investors who have viewed higher stock yields as underpinning an eight-year-long bull market. According to FactSet, at 2.50%, the yield on the 10-year U.S. Treasury note last Friday exceeded the 1.91% dividend yield on the S&P 500. The dividend figure reflects annualized payouts by companies in the index as a proportion of their current share price. Rising bond yields generally send a signal that the economy is healthy and that demand for goods and services is rising. But increases in long-term yields over time also stand to shift investor preferences that recently have been strongly skewed in favor of stock investments.

Credit risk is a strong driver of both bond and equity performance. What is more, the fear that a weak credit will continue to slide is one of the most pronounced risks to individual stocks. Simply put, liquidity cannot solve a solvency problem, but lack of liquidity can make solvent credits insolvent, thereby drastically reducing the equity stake in an otherwise viable name. As such, when credit markets close in on a name, equity investors need to take notice. The names and sectors may not surprise, with energy still the highest risk sector. High yield default rates hit a near-term peak of about 4.6% for 2016, and appear to be heading lower in 2017. Currently, high yield spreads imply about a 3% default rate for the next 12 months. Energy is still the outlier group within the S&P, with estimated default risk of about 1.5%. This is still 3 times the next closest sector, basic materials, and is reflective of still high debt loads and volatile asset prices. Financials come in as the third most at risk sector, at roughly 0.35%.

As widely anticipated, the FOMC unanimously raised the federal funds rate by 25 bps at its December two-day meeting as the committee found current labor market conditions and inflation sufficient. The move by the Federal Reserve was near-certain, but what remains uncertain is the Fed’s rate path for 2017. The materials released show the FOMC aims for three rate hikes next year – more than three would be risky – and reinforces the committee will remain data dependent. This time last year, the Fed aimed for four rate hikes the following year. Yet, international events and uninspiring data throughout the year sidelined the Fed. Thus, only one rate increase occurred in 2016.

Data dependency allows the committee the freedom to respond how it sees best, especially next year which holds great uncertainty from the shifting political landscape. Furthermore, the strength in the US$ has functioned as a tightening of financial conditions in its own right. Yet, market participants tuned into Chairwoman Yellen’s press conference to try deducing from her words any further guidance. During the Q&A session of the press conference, Chairwoman Yellen refused to speculate or give any instruction about fiscal policy, confirmed she intends to serve her four-year term, and emphasized the outlook is too uncertain and thus, the committee will adjust its stance as visibility improves.

Global Equity Markets

Global equity markets have shown a fair degree of volatility in 2016, initially impacted by expectations of weakening global growth and tumbling commodity prices, and then by the uncertainties resulted from the outcomes of the Brexit decision, and more recently Donald Trump’s election to the White House.

On U.S. Equities

Despite the environment and the uncertainties surrounding the Trump administration, investors appeared focused on the president-elect’s promises of expansionary fiscal measures, and the performance of the U.S. equities remained resilient. As of December 19, 2016, the S&P 500 Index rose 10.48%[1] year to date, with the S&P 500 Value Index grew by 15.10%[2] and the S&P 500 Growth Index by 6.12%[3] during the period. Meaningful dispersion returned across equity sectors: A steeper yield curve and the prospect of a shift toward deregulation buoyed financials, while the treat of trade barriers weighed on technology companies dependent on global supply chains. More interest-rate-sensitive sectors such as utilities also underperformed in the month. In addition, small-cap stocks performed well on the potential for reduced competition from foreign firms and a more pro-business domestic political environment, as evidenced by the 10.27%[4] gain in November and 20.03%[5] gain year to date.

On Non-U.S. Developed Markets Equities

The Euronext 100 Index was up 2.14%[6] as of December 19, 2016 and the FTSE 100 Index ended the period up 11.99%[7]. After being pounded for months, the European banking sector is back in vogue, as evidenced by the fact that the Stoxx Europe 600 Banks Index turned positive year to date, a huge reversal for the sector that spent the year as one of the region’s worst performers. Spurred by the prospect of looser regulations and higher interest rates, investors are piling back into the sector. The Australian equity markets, as measured by the S&P/ASX 200 Index, returned 5.11%[8] year to date. Japanese equities rallied on the back of a weaker yen and modestly higher yields, benefitting export-oriented firms and financial companies, respectively; financials have led the Japan equity market to a fresh high for 2016.

On Emerging Markets Equities

In emerging markets, the potential for protectionist trade policies in the U.S. under the Trump administration and a stronger U.S. dollar weighted on returns. Emerging markets equities experienced their largest monthly drawdown since January. Brazilian equities fell 4.6% in November amid a renewed focus on political corruption in the President’s cabinet. Indian equities also fell 4.5% as investors feared that Prime Minister Modi’s currency crackdown could prove disruptive to the cash-dependent economy. Chinese equities, however, gained 4.8%, pushing stocks into bull market territory as government efforts to curb surging property prices may be driving more investment toward the stock market. Russian equities rallied the most among emerging markets, returning 5.8% during the month in reaction to President-elect Trump’s apparent willingness to mend relations with Moscow.

Global Credit Markets

Yields in global credit markets spiked to levels not seen since the end of March as a Fed rate hike in December appeared to be a near certainty, and global investment grade credit returned – 2.0% for the month of November. While spreads widened modestly during the month, overall they have tightened about 60 bps from the wide levels in February, due to continued strong investor demand for stable income above that of global government bonds.

On U.S. Credit

Developed market yield soared in a post-election reflation trade: Investors priced in greater potential for fiscal expansion and infrastructure spending in the U.S., along with a faster Fed hiking path. The reaction was strongest in the U.S., where the 10-year Treasury yield jumped 56 bps to 2.38%. As rates on the long end of the yield curve climbed higher, the spread of 10-year yields over two yields widened 28 bps.

On U.S High Yield Bonds

As investors contended with the sharpest increase in Treasury yields since the Taper Tantrum in 2013, global high yield bonds experienced their first monthly loss since January. Yields rose by close to 30 bps over the month but were far outpaced by the increase in government rates, resulting in spreads that were narrower by about 10 bps.

On Non-U.S. Credit

Other developed markets followed suit, with the German 10-year higher by 17 bps. In Japan, 10-year rates inched into positive territory during the month, but ultimately ended only 7 bps higher at the new target of about 0% after the Bank of Japan successfully defended its new yield curve targeting policy through open market operations.

On Inflation-Linked Debt

Global inflation-linked bond (ILB) markets lost ground in November as rates across the globe moved sharply higher. In the U.S., breakeven inflation rates suddenly jolted higher in the wake of the surprise presidential election result. Ten-year inflation expectations in the U.S. ended the month at their highest level in more than two years as investors perceived Present-elect Trump’s proposed policy measures as inflationary. An OPEC-induced rally in crude oil prices at month-end also served as a tailwind for breakeven inflation rates. The election results reverberated through other ILB markets as well: most notably. Mexican inflation expectations skyrocketed as the peso sharply depreciated, and yields spiked as the Bank of Mexico attempted to curtail the impact of the currency decline on inflation.

On Emerging Market Debt

EM debt assets came under considerable pressure in November following the U.S. presidential election. President-elect Trump’s campaign rhetoric raised uncertainty about the future of global trade agreements, and EM economies most reliant on the current global trade construct posted the weakest returns. Even as developed market yields moved higher, index spreads over U.S. Treasuries for EM external debt widened, EM local yields rose and EM currencies weakened considerably against the U.S. dollar. Investors pulled nearly $10 billion from the asset class, with the outflows serving as an additional headwind. Bucking the trend, oil exporters across the EM universe generally outperformed as OPEC reached a long-awaited agreement to cut production, sparking a rally in crude oil prices on the final day of the month.

Currencies

The U.S. dollar surged in November. It gained against nearly all global counterparts as Treasury yields soared following the surprise election of Donald Trump. Among G10 pairs, the Japanese yen was notably weaker – down more than 8% against the U.S. dollar – as the interest rate differential between rates in the U.S. and those in Japan widened. The dollar also strengthened substantially against EM currencies on concerns over more protectionist U.S. trade policy under the new administration. The Mexican peso fell almost 9% versus the dollar for the month. China, frequently in the crosshairs of the president-elect, fixed its currency weaker as capital outflows showed little sign of abating. The British pound was the lone currency to beat the dollar on the month after the U.K. high court indicated parliamentary approval is necessary to trigger the country’s exit from the EU.

[1] Google Finance. Retrieved from https://www.google.com/finance

[2] Google Finance. Retrieved from https://www.google.com/finance

[3] Google Finance. Retrieved from https://www.google.com/finance

[4] Google Finance. Retrieved from https://www.google.com/finance

[5] Google Finance. Retrieved from https://www.google.com/finance

[6] Google Finance. Retrieved from https://www.google.com/finance

[7] Google Finance. Retrieved from https://www.google.com/finance

[8] Google Finance. Retrieved from https://www.google.com/finance

Macro Update on Oil, U.S. Job Market, Stocks and Bonds Markets, and China

On Oil:

On Nov 30, 2016, oil prices rose more than 9%, as investors were hoping a deal determined by major oil-producing nations would help oil prices break out from a punishing slump, which has lasted over two years. The percentage gains were the biggest for U.S. and international crude prices since February. The Brent global benchmark broke above $50 a barrel for the first time in November, while U.S. crude futures rose 9.3% to $49.44. After weeks of doubt that members of the Organization of the Petroleum Exporting Countries (OPEC) could resolve their differences, the Agreement to be effective from January 1, 2017 that was concluded at the 171^st Meeting of the Conference of the OPEC held in Vienna, Austria seemed to surprise many investors.

On U.S. Job Market: 

The U.S. unemployment rate declined by 0.3% to 4.6% in November. Total nonfarm payroll employment increased by 178,000. The pace of U.S. job growth is slowing, and employment gains occurred in professional and business services and in healthcare. The November report offers the final labor-market snapshot before Fed officials meet to decide whether or not to raise interest rates.

On Stock Markets:

In November, the Dow Jones Industrial Average (DJIA) rose 1.98 points to 19123. The 30-stock average rose 5.4%, which was its best performance since March; it set eight records in November and crossed 19000 for the first time on November 22, highlighting a furious U.S. stock rally that began the day after the surprise election of Donald Trump as president.  The U.S. Treasury yields reached their highest level since July of 2015, concluding a month considered by many traders as the most eventful in financial markets since the euro crisis ended in 2012. Many analysts and investors expect November’s popular trade, buying stocks and selling bonds, to remain in vogue for the balance of the year. They cite generally upbeat U.S. domestic economic reports, increasingly sanguine signs from overseas and expectations that the U.S. economy will continue its gradual expansion.

There have only been 28 other examples since 1950 where the S&P 500’s monthly close is greater than the prior month and the low of the month was lower than the prior month. In other words, this November’s price action has completely engulfed October’s trading range. The same is true on the Russell 2000 and Nasdaq charts. Historically, this has been a bullish development with above average S&P forward returns and positive hit rates.

On Bond Markets:

The worst bond rout in three years deepened on Dec 1, 2016, hammering debt issued in emerging markets and many U.S. states and cities, while sparing large companies the brunt of the impact. The yield on the 10-year Treasury note rose to a 17-month high, at 2.444%, up from 2.365% Nov 30, 2016. Yields rise as bond prices fall. The surge since July has pushed the 10-year yield up by more than 1 percentage point, only the fourth time it has risen so much so fast since 2009. Rising rates can reflect optimism about economic prospects, yet over time they can also slow growth by making borrowing more expensive for consumers and businesses. The bond rout may not yet be over; a wage print at current level would likely cause another round of bond selling. Incidentally, Strategas’ Fair Value model for the 10-year yield, which is a “cost of carry” model that, in theory, contains no term premium, is suggesting a yield of around 2.25%. Meanwhile, Strategas’ Regression model, which is a fundamentals-based model, and embeds a term premium, suggests 2.75% is the proper level. With a Fair Value of 2.25%, the current 10-year yield of 2.30% is now showing a positive term premium, while a more appropriate term premium should be about 50 bps.

On China:

The People’s Bank of China (PBOC), China’s central bank, has stepped up efforts to drain cash from the country’s financial system, as it seeks to control excessive borrowing. The cost for banks to borrow from each other rose to 3.49% in a week, as measured by the seven-day repo rate, which was a 19-month high. The surge followed the PBOC’s withdrawal of a net $18.85 billion from China’s money markets over the four trading days until November 29, which has been partially reversed. At the same time, the PBOC has been guiding major state-owned banks to restrict their short-term lending to other financial institutions.

Small Caps Have Outperformed Large Caps

Macro Update

On U.S.  

U.S. real GDP increased at an annual rate of 2.9%[1] in the third quarter of 2016, as compared to the 1.4%[2] increase rate in the second quarter. The latest U.S. inflation rate is 1.5%[3] through the 12 months ended September 2016, as published on October 18, 2016; the rate could give the Fed confidence that inflation is to reach the bank’s 2% target. Real disposable personal income increased 2.2%[4] in the third quarter, as compared to an increase of 2.1%[5] in the second quarter. Despite a slowdown in consumer spending, the U.S. economy is growing at a faster-than-expected pace, largely supported by the surge in exports and the rebound in inventory investment.

The S&P 500 Index declined -1.94% in October of 2016; it has been in a holding pattern since June. As of Oct 28, 2016, among the 58% of the companies in the S&P 500 reporting earnings for the third quarter 2016, 74%[6] of S&P 500 companies have reported earnings above the mean estimate and 58%[7] of S&P 500 companies have reported sales above the mean estimate. For the third quarter 2016, the blended earnings growth rate for the S&P 500 is 1.6%[8]; if the index reports growth in earnings for the quarter, it will mark the first time the index has seen growth year over year in earnings since the first quarter of 2015, which was up 0.5%[9].

Monetary and fiscal policy should support economic expansion, but political uncertainty may dampen capital expenditure (capex). The forward 12-month P/E ratio for the S&P 500 is 16.4[10], which is above the 5-year average (14.9)[11] and the 10-year average (14.3)[12]. Valuations remain elevated, while forward-looking guidance on margins and profitability remains weak, which is putting downward pressure on investment spending.

U.S. Companies Profit Margins

As of September 30, 2016

Historical analysis suggests that markets tend to favor incumbent candidates in the months leading up to presidential elections, likely because they represent less uncertainty to investors. Political uncertainty in the U.S. gives companies more reason to hold off on investment.

On Eurozone

The eurozone economy showed renewed signs of life at the start of the fourth quarter, enjoying its strongest expansion so far this year. The Markit Flash Eurozone PMI rose to 53.7[13] in October 2016 from 52.6[14] in September, signalling the fastest monthly increase in business activity since December of 2015. The PMI is consistent with its GDP growth rate, which was up 0.4% in the third quarter.

Policymakers will be encouraged by signs of both stronger economic growth and rising price pressures. While much of the rise in prices in October could be traced to higher oil and energy prices during the month, the increased incidence of supply chain delays suggest that pricing power is being re-established. If this continues, the shift from a buyers’ to a sellers’ market should in theory push core inflation higher – a welcome development for which scant signs have been evident in recent years.

The October survey saw an especially encouraging recovery in German growth, with the PMI pointing to a 0.5%[15] pace of expansion and the rate of employment growth climbing to a five-year peak. German PMI, Ifo Business Climate Index, and Gfk Consumer Confidence are consistent with the ZEW data released earlier this month which has been saying Germany is poised for a “Golden Autumn”.

Modest growth of 0.2-0.3% is being signalled for France, but there are various indicators which suggest that France will enjoy stronger growth in coming months, including a marked build-up of uncompleted work and a resurgent export growth, both of which rose at the fastest rates for over five years.

On U.K.

U.K. real GDP slowed to 0.5% in the third quarter of 2016 rom 0.7% in the second quarter. New UK Prime Minister Theresa May announced that Britain would begin the process of leaving the EU by the end of March 2017, which removed some of the uncertainty about how the country would extricate itself from the EU but had also heightened concerns about the potential ramifications of a hard Brexit. The continuing market uncertainty, however, will provide opportunities for patient long-term investors.

[1] Bureau of Economic Analysis

[2] Bureau of Economic Analysis

[3] Bureau of Labor Statistics

[4] Bureau of Economic Analysis

[5] Bureau of Economic Analysis

[6] FactSet Earnings Insight by FactSet Research Systems Inc., October 28, 2016

[7] FactSet Earnings Insight by FactSet Research Systems Inc., October 28, 2016

[8] FactSet Earnings Insight by FactSet Research Systems Inc., October 28, 2016

[9] FactSet Earnings Insight by FactSet Research Systems Inc., October 28, 2016

[10] Bloomberg

[11] Bloomberg

[12] Bloomberg

[13] IHS Markit

[14] IHS Markit

[15] HIS Markit