Weekly Commentary Overview
- U.S. and European stocks fell sharply last week. Energy-related and retail stocks were the worst performers, with the latter pulled down by growing concerns over holiday sales.
- Last week’s pullback in risk coincided with a bounce in bonds, particularly for longer-term Treasuries as investors dialed back expectations for inflation and a Federal Reserve (Fed) interest rate hike in December.
- As expectations for more quantitative easing (QE) in Europe escalate, European short-term yields are falling even further into negative territory.
- The key takeaway from last week’s turmoil is this: Although U.S. growth remains relatively resilient, global growth continues to slip.
- Among the implications for investor portfolios: Cyclical commodities are likely to perform poorly, long-term interest rates will remain contained, and investors will continue to find themselves stretching for ample sources of income.
- We wouldn’t chase classic yield plays like utilities or staples, but other parts of the yield space look more interesting. For example, preferred stocks appear reasonably valued and offer an attractive yield.
Stocks Tumble as Global Growth Slips
U.S. and European stocks fell sharply last week. In the U.S., the Dow Jones Industrial Average fell 3.71% to 17,245, the S&P 500 Index dropped 3.62% to 2,023, and the tech-heavy Nasdaq Composite Index lost an even harsher 4.27% to close the week at 4,927. Energy-related and retail stocks were the worst performers, with the latter pulled down by growing concerns over holiday sales. The equity selloff also meant that volatility, as measured by the VIX Index, climbed back to 20 for the first time since early October.
Last week’s pullback in risk coincided with a bounce in bonds, particularly for longer-term Treasuries as investors dialed back expectations for inflation and a Federal Reserve (Fed) interest rate hike in December. The yield on the 10-year Treasury slipped from 2.33% to 2.28%, as its price rose. Rates dropped outside the United States as well. As expectations for more quantitative easing (QE) in Europe escalate, European short-term yields are falling even further into negative territory. German two-year bond yields fell below -0.35%, a new record low.
As we head into a new week filled with uncertainty after the horrific terrorist attacks in Paris, a few things are clear: Although U.S. growth remains relatively resilient, global growth continues to slip. And this has several implications for investor portfolios: Cyclical commodities are likely to perform poorly, long-term interest rates will remain contained, and investors will continue to find themselves stretching for ample sources of income.
New Risks Amid Sluggish Growth
Friday's multiple terrorist attacks in Paris reinforce the significant threat that global terrorism represents throughout the world. The magnitude and coordinated nature of the attacks suggests an escalation in the intensity of the terrorist threat. In the short term this may involve a shifting military and intelligence response from the United States, select members of the European Union and other developed countries. From an economic perspective, the fallout from these attacks will likely put some pressure on the French economy as well as the euro. Finally, this will complicate the path to a political solution to the European refugee crisis and harden the case in the U.K. for leaving the European Union.
Meanwhile, despite the recent spate of solid U.S. data, the global economy remains soft. Last week, the Organization for Economic Co-operation and Development cut its estimate of global growth for the second time in three months. The organization now expects growth of 2.9% this year and 3.3% in 2016, the latter down from a previous estimate of 3.6%. Part of the problem is that emerging markets, the engine of growth for much of the past decade, continue to decelerate. Last week provided more evidence of this with a slowdown in China. Exports are now down 3.6% from a year earlier while both inflation and industrial production are decelerating.
These might seem like distant events for U.S. investors, but the sluggish global environment is affecting markets in several ways. To begin, tepid growth is pushing down 2016 earnings estimates, which for the S&P 500 have fallen by two percentage points over the past five weeks. A strong dollar has also been a factor, and should the dollar continue to rise and/or global growth remain sluggish, earnings may have further to fall.
In addition, slow global growth implies most of the world’s central banks will engage in further monetary easing. But easing by Europe, Japan and China may put further upward pressure on the dollar, which is a de facto monetary tightening, even before the Fed begins lifting rates. In turn, a strong dollar is helping to keep a lid on inflation. More evidence of this came last week in the form of a drop in both import and producer prices, with the latter now falling at the fastest pace in years. With realized inflation falling, inflation expectations are once again slipping.
To the extent global growth remains sluggish, yield is likely to remain a valuable commodity.
Implications for Investors
Sluggish global growth and muted inflation have at least two consequences for investors. First, it means we will continue to see pressure on commodities prices, particularly those most exposed to global growth. Last week, commodities were once again hit from several angles. Industrial metals continue to come under pressure as growth in China and the broader global economy decelerate. Oil was singled out for special punishment, with U.S. benchmark WTI crude down roughly 10%, trading back near multi-year lows.
In addition, in an environment in which inflation is modest and yields low, investors are likely to continue to stretch for income. Case in point: utilities stocks, which last week managed to buck the broader selling and post a small gain. While the sector remains expensive, in a low-yield world, investors are more willing to pay a premium for companies with relatively safe dividends.
Still, we wouldn’t chase classic yield plays like utilities or staples, but other parts of the yield space look more interesting. For example, preferred stocks appear reasonably valued and offer an attractive yield. Bottom line: To the extent global growth remains sluggish, yield is likely to remain a valuable commodity.
