Stocks Strong as Volatility Falls Sharply

HI Market Notes header 5142018

Another mixed week on the global economic front. On the positive side in the U.S., wholesale inventories, initial jobless claims and the University of Michigan’s consumer sentiment index were better than expected. However, two measures of inflation—the consumer price index and the producer price index—disappointed.

Overseas, we saw positive developments in: Brazilian retail sales; industrial production in Italy, Mexico and Germany; and manufacturing production in the UK. But industrial production in India and France, as well as factory orders in Germany, were below expectations.

The U.S. equity market saw shares of energy companies benefiting from rising oil prices. Healthcare companies also outperformed as President Trump clarified his position on addressing prescription drug prices. However, interest-rate sensitive sectors such as utilities underperformed as rates rose for the week.

Internationally, emerging markets–especially those in Asia—outperformed, as tensions eased on the Korean Peninsula and trade tensions with China moderated. European equities underperformed due to uncertainties surrounding economic growth and future central bank actions.

In the fixed-income markets, corporate credits outperformed in the wake of strong equity market results. Emerging markets bonds once again underperformed as fixed-income investors continued to reduce their risk exposure.

GAIN: Active Asset Allocation
Global stocks posted strong returns last week, led by U.S. equities. Year-to-date, stocks are outpacing bonds by more than 4%. The rally in stocks coincides with declining levels of volatility as earnings season wraps up.

We have maintained a global equity allocation in the portfolios throughout the year, though we continue to evaluate our emerging markets positions. Domestic stock markets have begun to outperform on a risk-adjusted basis (and, more recently, on an absolute basis). China has held up well despite its volatility, but other emerging markets are falling behind the pack. Meanwhile, several underlying trends in growth stocks, small-cap stocks and the healthcare sector are attractive.

Bonds were mostly flat for the week, with corporate debt outperforming Treasuries. The stock market rally, coupled with falling equity market volatility, helped high-yield bonds and other corporate credits. That said, credit spreads are fairly tight, which could lead to more risk if investors get nervous.

PROTECT: Risk Assist
Investors’ expectations for volatility in everything from equities to interest rates to commodity prices plummeted last week. Example: The CBOE Volatility Index (or VIX, which measures expected future stock market volatility) fell to below 13 to close at its lowest level since late January. Volatility eased due to factors such as the winding down of first-quarter earnings season and a reduction in geopolitical tensions between the U.S. and North Korea.

The Risk Assist portfolios continue to be modestly de-risked (approximately 10% to 20%). Broadly speaking, global equities would have to rally 4% to 5% to trigger re-risking in the portfolios (and would have to fall 5% to 6% to de-risk further).

SPEND: Real Spend
Global stocks outpaced the broad bond market by more than 2% last week, with bonds ending the week flat as short-term yields rose slightly (causing the yield curve to flatten). So far this year, global stocks are up more than 2% (despite bouts of increased volatility) while bonds are down nearly 2.3%. The return spread between the two asset classes over the past 12 months stands at 16% in stocks’ favor, with bond returns flat during that time (and down 2% in real terms).

Inflation data for April was released last week, with the headline CPI inflation number coming in at 2.5% on a year-over-year basis. The closely watched core CPI (which strips out food and energy components) was 2.1% year-over-year—very slightly lower than expectations, and right in line with the Federal Reserve’s 2% inflation target. What’s more, the Fed has recently suggested that it is willing to tolerate temporary inflation levels that are slightly higher than its target. Market expectations for inflation going forward barely budged last week.

Much of the yield-focused areas of the market were uneventful last week, with most fixed-income yield plays posting fairly flat returns. One exception was a small gain in the corporate bond sector. REITs followed equity markets higher (up more than 1% for the week) while master limited partnerships were volatile but ended the week up 2% due to rising oil prices.

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