Highlights
• A sharp rise in bond yields triggered the start of a corrective phase for stocks. We think yields are likely to continue rising, which could put additional pressure on equity markets.
• For equities, we expect more volatility over the short-term, a continuation of the bull market over the medium term and generally lackluster returns over the long term.
Last week, investors shifted the focus from worrying about missing out on the ongoing rally to concerns that equities were overbought. There were a number of issues for investors to ponder, including an ongoing complicated political backdrop, earnings reports and economic news. The main focus, however, was on sharply rising bond yields, which rattled equity markets and caused a notable decline. The S&P 500 Index fell 3.8 percent for the week.1 Despite the magnitude of the decline, the drop was orderly and only took market values back to levels of a couple of weeks ago.1 Losses were broad-based, with relative outperformers including banks, airlines and telecommunications companies.1
Weekly Top Themes
1. January’s employment report pointed to improving growth and rising inflation. New jobs growth came in at a higher-than-expected 200,000, while unemployment was unchanged.2 The biggest news was that average hourly earnings were up 0.3 percent for the month and 2.9 percent year-over-year, which is the largest increase since 2009. 2 The tightness of the labor market appears to finally be creating wage acceleration.
2. Earnings continue to come in strong. With 42 percent of S&P 500 companies reporting, 81 percent have exceeded estimates, the highest in seven years.3 At the same time, 75 percent have increased their fiscal year 2018 earnings-per-share projections).3
3. U.S. political confusion remains a market risk. President Trump’s State of the Union address was noted for its calm tone, but no new policies were outlined in any detail. Investor attention is focused on this week’s expiration of the current continuing budget resolution and the likelihood of further showdowns.
Bond yields are likely to continue to rise unevenly. The 10-year Treasury yield advanced 17 basis points last week alone, and is up 42 basis points since the start of the year.1 In our view, nearly all key indicators point to a high likelihood of continued increases: Treasury supply is growing due to rising deficits, climbing inflation, improving economic growth, tightening monetary policy and rising global rates. We could see a pause in the advance and/or a near-term decline, but the long-term direction for rates appears to be up.
Stocks appear fairly valued, but we expect market sloppiness to continue. Equity markets still enjoy a strong fundamental backdrop of solid global growth and strong earnings. Monetary policy and inflation are shifting but do not yet represent headwinds. The problem for stocks right now is that interest rates appear to have risen too high, too quickly. With the S&P 500 Index around 2,800, we think equities are fairly valued given earnings prospects. This means we believe prices can continue to advance, but volatility will be higher than in recent years.