Investment Insights: What is the 800-pound hawk in financial markets?

Wade Balliet
Posted by Wade Balliet
Investment Strategy

This weekly report presents insights from our Global Investment Management team.

Federal Reserve building at duskMarket anxiety over rates rekindled yesterday as 10-year Treasury prices dropped and yields climbed over the psychological threshold of 3%, closing at 3.07% – its highest level since 2011. The move may have been spurred by better than expected manufacturing and steady retail sales data, which translates into questions of whether a persistent improvement in economic data may pressure the Fed’s rate path.

Investors have continued to grapple with the double-edged sword of a strengthening economy, but also the accompanying higher interest rates that can weigh on stock values. Even with signals of an improving economy, U.S. stock markets ended down on Tuesday; the S&P 500 Index declined 0.68%. Potential moves from the Fed, rising yields, and a relatively elevated level of volatility have combined into a risk aversion that crosses beyond financial markets.

The Fed delivered fairly status quo comments in the minutes from its May meeting, but it seems to have left investors wanting more. Monetary policy officials had acknowledged rising inflation, but did not comment on financial market stability or the possibility of an economic slowdown. Projections from the Fed indicated an almost even split between those that were expecting a total of three or four rate hikes in 2018. Fed funds futures market probability indicates that three additional rate hikes this year just moved above a 50% probability, according to Bloomberg; a hike in June is very widely expected by the markets and is currently at a 100% probability based on the same data. While the Fed may be attempting to clearly telegraph its next moves, it seems that investors are expecting a showdown between a more hawkish Fed and the stock markets in the coming months. That may be no competition – the Fed is the real 800-pound gorilla – or hawk – in the room.

The first earnings season of the year officially ended yesterday, despite the fact that 43 companies within the S&P 500 still have yet to report, and the results are clear. As we have discussed over the past few months, companies seem to have been benefiting from strengthening economic recovery, high consumer confidence, and tax reform. Out of the companies that have reported so far, they have managed to grow profits by over 23% since last quarter and beat earnings expectations by an average of 7.25%, based on Bloomberg aggregation data. The recovery in oil prices may have also been a large part of the overall extraordinary earnings growth as the energy sector grew by the largest amount – over 93% – followed by information technology at around 30% growth. However, even with these stellar numbers, U.S. stock markets have been mostly sideways this year. We believe this only underscores the importance of rates and the Fed in the current financial market dynamic.

The Global Investment Management team has been holding firm on our equity positioning based on market fundamentals, and also on our views of monetary policy. The upward move seen in longer term yields over the past few months may be a harbinger of further normalization in rates, but based on current market data, we believe the sharp fluctuations will be mostly transitory. We have recently made changes in our strategies to include floating rate bonds in lieu of more traditional short-term fixed rate corporate bonds, as we believe the floating component will add protection and value if rates continue higher. For now, we expect a continued flattening and some upward movement across the yield curve.

Chart showing various market returns as of 5/15/18

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Investing involves risk, including the possible loss of principal and fluctuation in value. Economic and market forecasts reflect subjective judgments and assumptions, and unexpected events may occur. Therefore, there can be no assurance that developments will transpire as forecasted. The information in this newsletter is for informational purposes only and is not intended to be investment advice or a recommendation. Nothing in this newsletter should be interpreted to state or imply that past results are an indication of future performance.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

International securities involve additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

 

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