SEPTEMBER 2018 IN REVIEW
11/09/2018
ECONOMY
ROBUST SEPTEMBER ECONOMIC DATA, AS FED HIKES RATES
Economic Data
Overall, economic reports released in September—mostly reflecting economic activity in August—indicated solid U.S. economic growth without significant inflationary pressures, though wage gains bear monitoring. The Conference Board’s Leading Economic Index (LEI), an aggregate of 10 leading indicators, increased 0.4% in August and 6.4% year over year, signaling low odds of recession in the coming year.
August’s jobs report, released on September 7, reflected robust labor market growth. Nonfarm payrolls rose 201,000 in August, higher than consensus estimates of 190,000 and July’s reading of 157,000. While growth in nonfarm payrolls is tapering off, the slowdown is expected as the economic cycle matures. Meanwhile, the unemployment rate held steady at 3.9%, the lowest level since 2000. The percentage of workers quitting their jobs jumped to a 17-year high. Generally, a high quit rate is viewed positively as it signals employees are confident about finding better job opportunities.
Pricing and wage data showed inflationary pressures remain manageable. Data for the preferred gauge of the Federal Reserve (Fed)—core personal consumption expenditures (PCE) (excluding food and energy)—remained unchanged at 2% growth year over year. This annual reading is in line with the Fed’s implicit annual inflation target, but other headline inflation gauges show inflation remains well below levels reached in previous tightening cycles. The Consumer Price Index (CPI) rose 0.2% month over month, while core CPI rose 0.1% monthly and 2.2% year over year. Headline and core Producer Price Index (PPI) readings fell 0.1% month over month, but have grown 2.3% year over year. Average hourly earnings came in above consensus, rising 0.4% month over month, which tracked to 2.9% annual growth—the highest growth rate of the economic cycle. Labor is typically the largest cost component for companies, and wages can be a harbinger of building inflationary pressures. In spite of the high readings, the 2.9% annual earnings growth remains below the 4% level that has preceded recessions in the past.
Manufacturing reports showed strength, though the impacts of tariffs are becoming visible in the data. The Institute for Supply Management (ISM) Purchasing Managers’ Index (PMI), which has historically been a bellwether for economic growth, jumped to 61.3 in August, its highest level since May 2004.
ISM’s New Orders gauge jumped 8.1%, its strongest monthly growth since August 2014. Domestic orders drove the multi-year high in ISM PMI, while international orders declined month over month. In our view, this shows that U.S. fiscal stimulus continues to outweigh any negative implications of tariffs on manufacturing.
The ISM’s Non-Manufacturing (Services) Index climbed to 58.5, recovering from disappointing July data. NFIB’s Small Business Optimism gauge rose to a record 108.8 last month. Perhaps most encouraging was that the percentage of surveyed firms expecting to increase capital expenditures rose to its highest level since 2007. Capital expenditures are associated with productivity gains per unit of labor, and when worker productivity increases, wage growth tends to follow.
Economic reports reflected a healthy U.S. consumer. The Conference Board’s consumer confidence survey hit an 18-year high, while personal spending rose 0.3% in August, in line with consensus expectations. Consumer spending accounts for about 70% of U.S. gross domestic product, so a healthy consumer is an important support of output.
Housing data continued to be a relative weak spot for the U.S. economy. Existing home sales, which account for 85-90% of home sales, were flat month over month at 5.34 million in August. Housing prices, represented by the S&P CoreLogic Case-Shiller 20-City Composite, rose 5.9%, lower than consensus estimates of 6.2% growth. Housing starts grew 9.2% in August, which was higher than expected, but building permits declined 5.7% month over month, the largest pullback since February 2017.
Fed Raises Key Rate, as Expected:
The Fed announced it would raise the fed funds rate to a range of 2-2.25% following the conclusion of its meeting on September 26, an outcome the markets widely anticipated. In our view, the Fed’s updated rate projections and an important change in its policy statement were the more interesting takeaways.
The most recently released dot plot implies that policymakers expect one more rate hike in 2018 and three more in 2019. The dots also show that members expect the fed funds rate to peak at 3.38% at the end of 2020 before declining into a “longer-term” rate of 3%.
Moreover, the Fed removed the word “accommodative” from its description of its monetary policy in the September 26, 2018, statement, another signal that rates may be approaching a neutral level. According to Fed Chair Jerome Powell, this reflects that policy is moving in line with the Fed’s expectations.
GLOBAL EQUITIES
ANOTHER SOLID MONTH FOR U.S. STOCKS AMID TRADE FEARS U.S.
Stocks rose for the sixth straight month, as the S&P 500 Index returned 0.6% in September, capping off a solid third quarter in which the index rallied more than 7%. Among the major averages, the Dow Industrials fared best during the month with a 2.0% return, outpacing the S&P 500, Nasdaq Composite (-0.7%), and small cap Russell 2000 Index (-2.4%). The Dow’s gain, which led to its first record high since January 2018, is particularly impressive given the Composite’s focus on multinationals that are more impacted by tariffs. The S&P 500 returned 10.6% year to date through September, ahead of the Dow‘s 8.8% return, but behind gains in the Russell 2000 (11.5%) and Nasdaq (17.5%).
A strong U.S. economy was the key driver of the market’s recent gains. GDP grew at a very strong 4.2% annualized pace in the second quarter and is expected to grow a solid 3% in the third, based on Bloomberg consensus forecasts. Manufacturing activity remains robust, business and consumer confidence is high, job growth remains steady, and corporate America continues to deliver earnings growth that is among the strongest in decades. These factors enabled stocks to offset several headwinds, notably trade tensions.
Stocks resiliently sailed through other headwinds, extending the longest bull market ever. Consider that:
• The Fed is expected to raise rates again in December after hiking in September for the eighth time this cycle.
• Long-term interest rates have risen, but the yield curve stayed flat in what some believe may be a sign of future economic weakness.
• The upcoming midterm elections bring policy risk.
• Pockets of stress are still present in emerging markets.
Turning to market leadership, large-cap stocks outperformed their smaller counterparts, as the Russell 2000 Index lost 2.4% in September. Gains in more globally focused large caps likely reflected some renewed optimism that trade deals would be reached with China and our other major trading partners. Rising interest rates, which have tended to favor larger cap companies, may have also played a role. Year to date through September, the Russell 2000 Index returned 11.5%, slightly more than the larger cap S&P 500 and Russell 1000 indexes.
Growth stocks outperformed value for the second straight month in September, though by a slim margin. The Russell 1000 Growth Index returned 0.6%, compared with 0.2% for the Russell 1000 Value Index. The most heavily weighted sectors within growth (technology) and value (financials) both underperformed, but technology performed better in support of growth. The Russell 1000 Growth Index still holds a significant lead over its value counterpart this year, returning 17.1% through the end of September compared with 3.9% for the value index.
Sector performance was mixed during the month, with six up and five down. Interestingly, telecom topped all sectors during its first month after a significant revamp. Renamed and reconstituted as communications services, the sector returned 4.3% in September, outpacing healthcare (2.9%) and energy (2.6%), based on S&P GICS sectors. On the flip side, financials lost 2.2% for the month as banks continue to struggle with the flat yield curve, while rising interest rates weighed on real estate.
International
The international developed equity benchmark, the MSCI EAFE Index, produced a modest September gain of 0.9%, slightly outpacing the S&P 500. A rebound in economic growth in Japan and a weakening yen currency—which helps Japanese exporters—drove much of the gain in the international index, although the U.K. also provided support despite ongoing Brexit uncertainty. On the flip side, German stocks fell during the month as economic growth in the Eurozone slowed and tariffs weighed on the auto sector. The 1% year-to-date loss for the MSCI EAFE Index, which is well behind the S&P 500, has been driven mostly by weakness in the U.K., Germany, and Japan.
After a rough August, emerging markets (EM) stabilized in September as currencies firmed. The MSCI EM Index was still down, losing 0.5% for the month, adding to a difficult year that has seen the asset class lose 7.5% year to date amid U.S. dollar strength and pockets of stress. Turkey, Russia, and Brazil were September’s top EM performers, while Russia, Taiwan, Thailand, and Mexico have been among the best performing EM countries this year. Recession has led to substantial year-to-date losses—over 20%—in South Africa, while weakness in China and South Korea has also weighed on the broad EM index in 2018.
FIXED INCOME
TREASURY YIELDS SURGE AMID STRONGER WAGE GROWTH, TRADE TENSIONS
Rates across the Treasury curve rose in September. The 10-year Treasury yield climbed 20 basis points (bps) in the month, reaching a high of 3.10% on September 25. Longer-term yields benefitted from data showing an acceleration in wage growth in August and a renewed appetite for risk at the end of last month. On September 18, the 10-year yield jumped the most since May after the United States threatened to raise the rate on $200 billion in tariffs if no trade deal is reached by the end of the year, encouraging investors that a U.S.-China trade agreement would be reached by then. The curve flattened further, as the spread between the 2-year and 10-year yields fell to 24 basis points (0.24%) through the end of the month.
The move higher in rates last month weighed on high-quality fixed income. Treasuries dropped 0.9%, their biggest slide since January, while the Bloomberg Barclays Aggregate Bond Index slid 0.6% in the month. Mortgage-backed securities
fell 0.6%, and investment-grade corporates decreased 0.3%. Economically sensitive, lower credit quality sectors were boosted by strong equity market performance. High yield climbed 0.6% in September for a fourth straight monthly gain, while bank loans climbed 0.7%. Emerging-market (EM) debt rose 1.3%, rebounding after currency turmoil and trade tensions weighed on EM debt in August. Unhedged foreign bonds were the worst performer, declining 1.1% as pronounced dollar strength was a headwind on returns.
ALTERNATIVES
CONVERTIBLE ARB HOLDS UP WELL AS RATES INCREASE
Overall, alternative investment performance was disappointing in September, with only the HFRX Convertible Arbitrage Index (+0.3%) and HFRX Distressed Securities Index (+0.2%) delivering noteworthy gains at the subcategory level. With interest rates backing up over the course of the month, convertible arbitrage’s limited duration profile held up well, while the interest received on cash from short positioning also increased alongside broader market rates. Gains in the distressed space were more idiosyncratic in nature and not specific to any one sector. Positive performance in Puerto Rican–related debt continued to add value for the managers who maintain those positions.
On the macro front, the HFRX Systematic Diversified CTA Index gave back much of the previous month’s positive performance as the index fell 0.6% and has now declined 2.4% for the year. Losses were concentrated in equity and bond allocations, as short equity positioning in select developed European and emerging markets weighed on performance. Additionally, long holdings across intermediate and longer-dated U.S. Treasuries led to losses. Long positioning across the energy complex helped offset these losses to a small extent as crude and heating oil futures contracts increased in value.
As measured by the 1.6% loss in the HFRX Equity Hedge Index, long/short equity managers delivered disappointing returns even as most global developed equity markets rallied. A sell-off in momentum-related securities weighed on the long books of many strategies, while price increases in short holdings also detracted from overall performance. Year to date, the HFRX has now declined 0.9%, with a majority of the relative weakness originating during the past two months.
REAL ASSETS
WEAKNESS IN REAL ESTATE, INFRASTRUCTURE HIGHLIGHT CHALLENGING MONTH
Most liquid real asset categories fell during September, with U.S. real estate investment trusts (REITs) suffering the largest decline. Commodities were the lone bright spot, with a solid gain for the month.
Master Limited Partnerships
Master limited partnerships (MLP) broke a two-month winning streak, as the Alerian MLP Index lost 1.6% in September. The month’s losses brought the year-to-date return to 5.9%. Higher oil and natural gas prices and solid energy production trends were not enough for the group to offset the rise in interest rates that has historically weighed on MLPs. The group was also likely negatively impacted by policy risk related to a proposition on the November 6 ballot in Colorado that would tighten industry regulations, along with some—though manageable—disruption from hurricane Florence.
REITs & Global Listed Infrastructure
Domestic REITs lagged all other major real asset categories, including international REITs, during September as the MSCI U.S. REIT index lost 2.6%. Year to date, domestic REITs have lagged the S&P 500 Index by about eight percentage points but have outpaced international REITs, global infrastructure, and commodities. Rising interest rates and the market’s preference for more cyclical sectors are the primary reasons for U.S. REIT underperformance. Within the REIT sector, industrial and office REITs outperformed while healthcare and data center REITs lagged.
The S&P Global Infrastructure Index fell 1.0% during September, bringing its year-to-date decline to 4.6%, including dividends. Performance within the utility sector was the most noteworthy detractor, as the rise in interest rates weighed on returns. Year to date, the S&P Global Infrastructure Index now trails the global equity benchmark MSCI ACWI Index by more than eight percentage points.
Commodities
Commodities broke a three-month losing streak in September. The Bloomberg Commodity Index rose 1.9%, with gains in energy and industrial metals prices offsetting losses in precious metals. Crude oil prices surged higher amid the anticipation of tightening global supply, primarily from impending Iran sanctions. Copper edged higher during the month, likely aided by reports of new Chinese economic support measures, while precious metals fell, hurt by sustained U.S. dollar strength. U.S. trade negotiations fueled intra-month volatility in agriculture prices. Corn and soybeans rose slightly during the month, while wheat prices dropped. The Bloomberg Commodity Index was down 2.0% year to date through the end of September.
Investing in real estate/REITs involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.
IMPORTANT DISCLOSURES
Trust and fiduciary services are provided by Zions Bancorporation, N.A. through Its Wealth & Fiduciary Services Group. Investments are not Insured by the FDIC or any federal or state government agency, are not deposits of or other obligations of, or guaranteed by, Zions Bancorporation, N.A. or its affiliates, and may be subject to investment risks, including the possible loss of principal value or amount invested. Amegy Bank, California Bank & Trust, The Commerce Bank of Oregon, The Commerce Bank of Washington, National Bank of Arizona, Nevada State Bank, Vectra Bank Colorado, Zions Bank are divisions of ZB, NA.
This information is not meant as a guide to investing, or as a source of specific investment recommendations, and Wealth & Fiduciary Services (WFS) make no implied or express recommendations concerning the manner in which any client’s accounts should or would be handled, as appropriate investment decisions depend upon the client’s investment objectives. The information is general in nature and is not intended to be, and should not be construed as, legal or tax advice. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
This document is prepared by LPL Research and WFS. In addition, the information is subject to change and, although based upon information that WFS, considers reliable, is not guaranteed as to accuracy or completeness. WFS makes no warranties with regard to the information or results obtained by its use and disclaims any liability arising out of your use of, or reliance on, the information. The economic forecasts set forth in the presentation may not develop as predicted.
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Stock and Pooled Investment Risks
Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market. The prices of small and mid-cap stocks are generally more volatile than large cap stocks. Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.
Investing in foreign and emerging markets securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.
Bond and Debt Security Risks
The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the
advertised yield.
Mortgage-backed securities are subject to credit, default, prepayment, extension, market and interest rate risk.
Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
INDEX DEFINITIONS
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry.
The Russell 1000 Index measures the performance of the large cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market.
The Russell 2000 Index measures the performance of the small cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index.
The Russell 3000 Growth Index measures the performance of the broad growth segment of the U.S. equity universe. It includes those Russell 3000 companies with higher price-to-book ratios and higher forecasted growth values.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
The Morgan Stanley Capital International Europe, Australia, Far East (MSCI EAFE) Index is a capitalization-weighted index that tracks the total return of common stocks in 21 developed-market countries within Europe, Australia and the Far East.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
The HFRX Equity Hedge Index is designed to be representative of the overall composition of the equity hedge segment of the hedge fund universe. Equity Hedge strategies maintain positions both long and short in primarily equity and equity derivative securities.