The Federal Reserve Board held interest rates steady, as expected, during a mixed week for the U.S. economy. On the one hand, the U.S. services sector expanded more than expected in October, and initial jobless claims were in line with forecasts. On the other, the Job Openings and Labor Turnover Survey—the JOLTS report—disappointed. Also, crude oil investors were higher than estimated.
Overseas, PMI readings for Europe topped expectations, as did German industrial production. European retail sales were flat, however, and French industrial production fell more than expected. And while UK business investment in the third quarter was weaker than predicted, third-quarter GDP growth in the UK hit its strongest level in two years.
In Asia, signs of weakness from Japan—household spending fell more than expected while bank lending slowed from the previous month. That said, Chinese inflation (at both the consumer and producer levels) were in line with expectations and the country’s import and export results beat estimates.
The U.S. equity market gained ground for the week, with two defensive sectors—health care and real estate—leading the way. Health care got a boost from investors looking for relative stability and from midterm election results that should reduce potential risks in the sector in the near term. Real estate benefited from lower interest rates as well as an overall risk-off market environment. In contrast, energy and communications services lagged. Rising crude oil supplies along with global growth risks weighed on oil prices, hurting energy-related stocks. Weaker earnings and guidance combined with headline risks pushed down communications services stocks.
Most European markets were marginally positive for the week. As in the U.S., defensive-oriented sectors (such as consumer staples) outperformed while cyclicals (such at automobile stocks) underperformed. In Asia, Japanese markets fared better this week than last, with a mix of defensive and cyclical sectors performing well. Emerging markets equities fell, due largely to the strength of the U.S. dollar and the risk of an economic slowdown in China. Some country-specific political and credit risks further weighed on emerging markets.
In the fixed-income markets, longer-duration bonds outperformed shorter-duration securities as interest rates fell. High-yield credit performance was lackluster as investors again sought to mitigate risk. Emerging markets debt underperformed, weighed down by concerns about the Chinese economy and U.S. dollar strength.
GAIN: Active Asset Allocation
Global stocks finished higher during a choppy week for the markets. U.S. large-cap stocks led the way, as small-caps and international equities took a break following their rally the previous week. So far in November, U.S. large-caps are up 2.6% while foreign stocks are up 1.6%.
It is likely that the markets, and the portfolios, will see more significant price swings as we move through November. Meetings between the U.S. and several Asian nations, and the lead-up to a meeting between President Trump and Chinese President Xi, may add noise that creates volatility. We will continue to monitor for improvements in trade relations, and signs of progress should likely benefit our positions in Asia.
The equity portfolios do have some tracking error in them, which we feel is necessary in this current market environment.
Bonds were mostly flat for the week. The Federal Reserve Board kept a key interest rate steady, as expected. The most significant development was the Fed’s statement, which noted that the pace of business fixed investment has moderated from earlier this year and that the unemployment rate has fallen. The market expects the Fed to raise rates once again in December, with more rate hikes to follow in 2019. A modest rise in rates would likely benefit our income portfolios, which have relatively short duration profiles as well as exposure to high-yield securities.
PROTECT: Risk Assist
U.S. equities started the week strong, posting sizable gains following the midterm elections, but fizzled out somewhat by week’s end. Meanwhile, volatility (as measured by the VIX) fell from 20 to closer to 17 as the perceived event risk around the outcomes of the midterms faded. International stocks also rallied early in the week, but ultimately finished down—largely due to concerns about Chinese economic weakness.
SPEND: Real Spend
Global stocks were up approximately 1% last week and domestic stocks gained more than 2%, while bonds were flat—causing the return spread between stocks and bonds to further widen. The one-year spread between global equities and the broad-based bond market is now more than 4%, while the spread between U.S. stocks and bonds is more than 12% over the period.
Rising yields have dampened bond performance for much of 2018, despite pockets of equity market volatility that might typically drive increased demand for bonds. For example, the 10-year U.S. Treasury note has risen by nearly 80 basis points this year alone—one major factor behind the -2.4% year-to-date return for bonds.
Later this week, inflation—as measured by the CPI—for October will be released. Economists overall expect headline CPI growth of 2.5%, year over year—and increase of 0.2%.
Broadly speaking, we are entering a regime not seen since well before the financial crisis. Example: For the first time since 2004, the Federal Funds rate (2.25%) is greater than or equal to core inflation (2.2% during the past 12 months). Our analysis shows that correlations between stocks and bonds often begin to materially increase in these environments—meaning diversification benefits begin to decrease. In such a regime, traditional and passive allocations to stocks and bonds may not be safe as they once were.
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