Download Market comment for the week of March 3, 2017 Beware the Ides…?

Wells Capital Management
Market comment for the week of March 3, 2017
Beware the Ides…?
Gary Schlossberg
Breathless. Stocks extended their weekly winning streak to six in a
“mini-melt-up” through Wednesday, partially reversed, grudgingly,
the following day. Declining volatility much of the week left the “VIX”
“fear” gauge approaching its late-January bottom by the end of the
week, accompanied by slippage in still-elevated S&P 500 sector
returns dispersion to a 10-week low. Equities were the stand-out
performer in a generally lackluster showing by our basket of risk
assets, virtually “flat” on the week due to declines in commodity
prices, corporate bonds, and emerging-market stocks. Nonetheless,
the group’s sideways move out-performed broad-based declines
in “safe-haven” gold, U.S. and German government securities and
the Japanese yen in lifting “risk” to its highest reading against the
comparable safe-haven index since the height of the pre-“meltdown”
“boom” in July 2007.
a March rate increase by the Federal Reserve. Financial services
unsurprisingly led the way on the lift to prospective net interest
margins from rising interest rates, while dividend-oriented telecomm
services, real estate, consumer staples, and utilities were hit hardest
by increased yields on competing bonds. Promised fiscal stimulus
continues to be an important driver of market performance, as well,
though the greater impact is on broader, economically-sensitive
stocks than on policy-sensitive industries and companies. Since the
Friday before the November elections, cyclically sensitive stocks have
out-performed the narrower policy-sensitive group by more than 7%.
Investor exuberance put a positive spin on stocks’ key drivers, as the
market headed toward this Thursday’s eighth anniversary of its March
2009 low point. “Soft spots” in the latest economic data paled next
to strengths, viewed as providing enough support to an earnings
recovery already supercharged by easy year-earlier comparisons. Lack
of policy specifics in the president’s much-anticipated address to
Congress? The encouraging tone of Trump’s remarks was enough to
keep investors satisfied at least until the president’s mid-March budget
report, if not beyond that. A threatened Fed rate hike this month?
That decision was viewed by investors more as a stamp of approval
by the Fed for economic growth sufficient to sustain an adequate
earnings recovery.
Anticipating satisfactory profits growth, the market sent the S&P 500
high enough to lift its price-earnings ratio to an even 18 times projected
profits—a new 13-year high near the top of the first quintile of P/Es
since 1979 excluding the over-extended “dot.com” period. Much—
but not all—of that valuation premium centers on energy stocks, still
not adjusted fully to a more subdued earnings outlook. Beyond that,
investors may be banking on a distant corporate tax cut bumping up
earnings per share by 12%, according to one estimate. A solid earnings
recovery, regardless of the source, would provide much needed
support to a rally more “multiple”- than earnings-driven since profits
last peaked in the 2014’s third quarter. Last year’s valuation-driven
gains drew first on lower interest rates associated with weak U.S.
growth and “Brexit”-related increases in U.S. securities demand by
foreigners, then on the improved earnings outlook following the
Trump election victory.
Up and modestly down movements left the benchmark S&P 500 with
a fairly narrow gain on the week, across just seven of 11 sectors and
only 82 of the 143 industry groups. More telling were sector rankings,
influenced heavily by rising yields on the growing probability of
As impressive as the stock market’s string of weekly gains was the
abrupt change in market expectations for the next rate increase. The
shift was best captured in the Fed funds futures market, where the
probability of an Ides-of-March 15 rate increase jumped from 40%
to 94% in the space of a week. Prompting the change: the positive
spin to recent data here, gathering signs of economic recovery and
reflation abroad, and the positive spin to the president’s speech—all
cemented by transparent, uniformly “hawkish” warnings of an early
rate increase by the Fed. The bond market’s muted response—the
benchmark 10-year Treasury yield up from a week-ago low, but to just
a two-week high of 2.48%—may have been due to skepticism over the
economy’s current strength and outlook, plus more likely subdued
inflation expectations and stepped-up foreign demand for U.S. securities signaled by the dollar’s trade-weighted rise to an early-January
high. The policy-sensitive two-year yield led the rise, as it typically
does in the run-up to a Fed rate change, climbing to its highest reading
since yields were collapsing at the end of the 2008-09 recession.
Fairly muted increases in bond yields increase the odds of a typical
stock rally through the early stages of an interest-rate “up cycle,” on
adequate economic and earnings growth. Still, the Fed may be walking a fine line as it balances interest-rate “normalization” with the risks
to a notoriously weak, “stop-go” recovery/expansion. “Real,” or inflation-adjusted interest rates (one measure of the “bite” to monetary
policy on economic activity) still are below expected levels for current
growth and the CPI’s “core” inflation—at little more than 0.2% on the
10-year Treasury note, just a fraction of its long-term norm. Moreover,
the economy is in a better place than it has been since the closing
stages of the economic growth cycle a decade ago. Balance-sheet
rebuilding largely is complete, and credit intensity of spending still is
on an upward trend. Most importantly, the turn from “disinflation” to
re-inflation—underscored by increasingly broad-based price pressures
lifting inflation toward the Fed’s 2% target—holds the promise of
improved business “pricing power” (and top-line earnings growth)
plus stronger wage gains. However, the Fed’s actions already are
rekindling “deflationary“ head winds from dollar increases associated
with the modest rise in interest rates and their effect on commodity
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Market comment
prices, foreigners’ dollar debt burdens, and, more generally, global
“liquidity” conditions in the run-up to potentially unsettling European
elections aggravating the effect on global funds flows.
On the edge. Investors fixated on a full data calendar in the latest
week, recognizing its importance in shaping the Fed’s mid-March
interest-rate decision and in bridging a period of uncertainty until a
stimulus program’s dimensions are clearer. A multi-faceted view of the
economy from mixed releases featured high-profile strengths laced
with soft spots raising questions about the strength of this aging
growth cycle. February purchasing-manager indexes (PMIs) signaled
strong, well-balanced growth from its manufacturing and dominant,
labor-intensive non-manufacturing sectors. Non-manufacturing’s
“boom”-like orders combined with an increase in the employment
component to a level that, with a drop in weekly jobless claims to a
44-year low, bode well for next Friday’s jobs report. Strong domestic
spending and an overseas growth recovery lifted the manufacturing
PMI to its best reading in 2.5 years, countering international competitiveness at a 14-year low. Added support came from late-cycle
business investment, overcoming a January decline in equipment
orders to post its strongest three-month growth in 2.5 years, and from
a jump in February consumer confidence to a near-17-year high.
Still, bright spots in the data failed to prevent a second straight decline
in the Citigroup Economic Surprise Index to a still-healthy level and
another sub-2%, real-time growth estimate for the January-March
period. A second decline in inflation-adjusted consumer spending in
the past three months left November-January growth at its weakest
in nearly a year. A first look at February spending from auto sales,
though encouraging, continued to show signs of strain in increasingly
aggressive financial incentives needed to stoke sales. Prospects for
an early rebound in spending are clouded by weakening growth in
household inflation-adjusted incomes, or “purchasing power,” on
still-moderate wage gains and rising inflation, cutting year-to-year
growth to a three-year low in January and leaving inflation-adjusted
weekly earnings down for the first time since December 2013. Added
concern has come from weakening loan growth, capped by the weakest
yearly growth in banks’ loan balances since June 2014.
Dominating a reasonably full economic calendar in the coming
week will be Friday’s all-important employment report for February,
capable of making or breaking the chances for an Ides of March rate
increase by the Federal Reserve. Meeting the consensus, 180,000 jobs
gain and a dip in the unemployment rate to 4.7% is almost certain to
cement the Fed’s vote for a mid-March rate increase. Investors will be
marking time ahead of the end-of-week jobs report scrutinizing largely
second-tier data on manufacturing orders, consumer credit and the
trade balance—all for January—along with the February ADP survey
of private-sector jobs (a harbinger of the official numbers Friday),
fourth-quarter labor productivity, February export and import prices,
along with the fourth-quarter Financial Accounts of the U.S. (a.k.a.
the Flow of Funds report) due out Thursday. Also on tap will be a $56
billion sale of three-, 10-, and 30-year Treasury securities Tuesday
through Thursday.
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