Battered Stocks Stage a Comeback
U.S. stocks jumped last week, with beaten-down commodity names leading the advance. The Dow Jones Industrial Average rose 3.71% to 17,084, the S&P 500 Index climbed 3.23% to 2,014 and the tech-heavy Nasdaq Composite Index added 2.68% to close the week at 4,830. Meanwhile, the yield on the 10-year Treasury rose from 1.99% to 2.09%, as its price correspondingly fell.
The week’s gains were broad-based, extending to other risky assets, such as commodities and high yield bonds. Ironically, the gains and drop in volatility were at odds with the market themes of the past several months. But if the week seemed a bit incongruous, it nonetheless served to bolster the case for two asset classes we favor: high yield bonds and Japanese equities.
Investors Cheer a Trade Deal
Since the summer, trading has been largely driven by negative reaction to growing evidence of a global slowdown. First the fears were centered in China and the broader emerging market (EM) universe. Then, following the release of a disappointing September employment report, investors started to grow anxious that the slowdown in EM would infect the U.S. economy.
Last week, however, virtually every economically sensitive asset advanced despite a slew of evidence confirming everyone’s worst fears: The global economy is indeed decelerating. In the United States, the Institute for Supply Management Services Index report was light. In Europe, German factory orders were soft after being dragged down by weaker Chinese demand. And on a global basis, growth estimates were once again cut by the International Monetary Fund.
Nevertheless, investors looked past the soft data and focused on several positives. First, most investors placed a dovish spin on the minutes from the most recent Federal Reserve (Fed) meeting. They also took solace from some stabilization in the Chinese currency and had generally less angst over emerging markets, which rallied sharply on the week.
But arguably the most important and substantial event was a tentative agreement on the Trans-Pacific Partnership (TPP) trade agreement. After years of tortuous negotiations, trade negotiators agreed to the outlines of the deal. The TPP is an extensive pact that goes well beyond tariff reduction, gradually lowering trade barriers to goods and services (it will introduce more than 18,000 tariff cuts), and setting common standards for trade, investment and labor. The potential impact is significant: The initial 12 countries, including both the U.S. and Japan, comprise 26% of global trade. However, the big winners, given existing tariffs and costs, are Vietnam, Singapore and Malaysia. Expect South Korea and the Philippines to follow once the deal has been signed.
Why did investors react with such enthusiasm to the deal? One reason: In a world in which both fiscal and monetary policy are constrained in many countries, investors were justifiably excited over any development that holds the prospect of boosting global growth, even if over a longer time horizon.
With market volatility temporarily quieted as macro issues stabilize, the focus is now likely to shift back to U.S. earnings. Unfortunately, the outlook is not promising: Analysts are expecting a profit decline in the third quarter, and over the past three months, earnings growth estimates have dropped from -1% to -5%, with expectations also factoring in a decline in revenue. The energy sector is the main culprit, but even outside of that sector earnings are expected to be flat. Absent an unexpected improvement in earnings, or at least more positive guidance for the fourth quarter, the rally in U.S. equities is likely to be contained.