The equity markets are off to an excellent start this year, in a continuation of 2017. Large caps continued to outperform small caps, despite the tax cuts, the weaker dollar, and global growth likely the cause. Tech and healthcare continued their momentum from last year. Tech and the market were able to perform, with Apple, the largest market cap company, down for the year, writes Ketu Desai.
As rates continued to climb upwards, the clear underperformers were rate-sensitive sectors such as utilities, real estate, and telecom. The move in rates, combined with investors taking profit/rebalancing, caused minor losses toward the end of the month for the broader index. According to JPM, $125 billion in rebalancing came from pension funds towards the end of the month. Oil also rallied during the month, which caused some inflation concerns, and those concerns were one of the reasons for the rally in gold.
The economic and earnings data that came out during the month continued to be favorable. Consumer spending, which accounts for roughly 70% of GDP, was alive and well in the fourth quarter, increasing 3.8%–the fastest growth rate since the first quarter of 2015. Moreover, business spending also increased, with spending on equipment increasing 11.4%–the strongest since the third quarter of 2014. It appears that with tax reform, we may be in the midst of a new capital expenditures cycle, which could help further drive the economy. Many economists believe that first quarter growth will be 3%, a very early read from the Atlanta Fed indicates north of 4% growth. At the same time, inflation data continued to come in muted, core PCE was up only 1.5%. With stronger growth and limited wage pressure, corporate earnings have been strong, approximately 80% of S&P companies have beat revenue and earnings estimates, according to Factset. They are also beating revenue estimates by a wider margin, 1.1%, which is nearly double the historical average. The dollar, which got weaker during the month, also served as a tailwind for domestic companies. The dollar I think will be an important story, as it has wide ranging implications across asset classes.
For equities, the dollar’s decline will continue help multinational/large cap companies outperform this year. UBS expects that the dollar weakness should add another 1% to earnings. The dollar’s decline, I think was also a factor in the continued dovish tone from the ECB and BoJ this month. For instance, the ECB’s inflation outlook is based on a 1.17 EURUSD, and with the Euro now stronger, it will dampen inflation pressure, and reduce ECB urgency to become hawkish. The latest Eurozone inflation number, actually fell to 1.3%. A similar argument can be made for the BoJ. If these central banks remain dovish, and the fundamentals continue as they have, it will continue to favor risk assets.
Towards the end of the month, we saw the US 10YR breach 2.7%, and those were the worst couple of days of the year for equities. It was a reminder that if rates move up quickly, it will hurt the equity market, especially, high-yield stocks, high multiple stocks, growth stocks, momentum stocks, and emerging markets. The question is at what level do rates become a serious issue. For the first time since 2008, the two-year yields more than the dividend yield of the S&P.
If one uses the equity risk premium to judge the relative attractiveness of bonds versus equites, it is not until approximately 3.5% on the 10YR do bonds start to look as or more attractive, at current equity multiples. It is quite possible that the market reacts before such levels due the velocity of the move, inflation, economic fundamentals, policy shifts, or sentiment. As we saw this month, where top performing sectors outperformed rate-sensitive sectors by nearly 15%, rates are going to create equity market dispersion.
Looking forward, the market will continue to focus on earnings, economic data, and news out of Washington.
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