U.S. Economy Stays Strong as the Fed Holds Steady

HI_Market Notes - US economy strong as Fed holds steady - 862018

The Federal Reserve Board last week left a key short-term interest rate unchanged, as expected. But the Fed also explicitly stated that economic activity has been strong—suggesting to some investors that the Fed could resume its rate hikes in the near future. Other data points signaling economic strength included continued low unemployment and better-than-expected U.S. pending home sales in June. That said, ISM services sector data and nonfarm payrolls were weaker than anticipated.

In stark contrast, Eurozone GDP slowed more than expected during the second quarter (while inflation edged higher than was forecast). The difference in GDP growth between the U.S. and Europe is now at its widest since the second half of 2014. Manufacturing PMIs across the region were mostly lackluster—although France showed some signs of strength by beating estimates. In addition, UK construction PMI beat expectations.

In Asia, the Bank of Japan stated it would increase by two-fold the range in which it allows the yield on the 10-year Japanese government bond to move. This announcement, along with dovish forward rate guidance, created the biggest swings in local bond yields in two years. Elsewhere, China PMIs came in below forecasts while Australian retail sales were better than expected.

In the U.S. equity market, the real estate and healthcare sectors benefited from strong second-quarter financial results and future guidance. These sectors also outperformed as investors shifted toward more defensive areas of the market in the wake of rising tensions over U.S.-China tariffs. The trade and tariff issues also hurt cyclical sectors such as energy and industrials, which could see negative economic results if a U.S.-China trade war heats up.

Trade war worries also hurt European equity markets, as did fiscal risks in Italy that returned to the forefront last week. Emerging markets underperformed due to elevated tariff risks and because the U.S. imposed sanctions against Turkey and Russia. However, Latin American markets showed resilience and generally outperformed.

In the fixed-income markets, high-yield and shorter-duration debt instruments generally outperformed longer-duration securities. Emerging markets debt underperformed as the majority of emerging markets currencies depreciated. An exception: the Brazilian real had another strong week, mitigating some of the downward pressure on emerging markets.

GAIN: Active Asset Allocation
Economic data last week showed continued strength in the U.S. economy—which means the Fed remains on track to raise a key short-term interest rate at its next meeting in September. This has raised some concerns about the possibility of an inverted yield curve, in which yields on short-term securities are higher than rates on longer-term issues. An inverted yield curve isn’t the end of the world for equity markets, but it does tend to slow economic activity.

Domestic equities gained nearly 1% while foreign equities lost roughly 1% for the week. Strong performance from growth stocks—both large-cap and small-cap—re-emerged following a week in which growth/momentum stocks experienced more volatility than the broader market. We are seeing some slowing in the real estate market, but (outside of a few specific sub-sectors) we don’t see a large bubble.

It was a relatively flat week for bonds, Although the yield on the 10-year U.S. Treasury note closed above 3% for the first time since late May, it quickly came back down to end the week where it started. Our barbell position in longer-duration Treasuries was down slightly for the week.

PROTECT: Risk Assist
Global trade-related concerns led to a choppy week in the financial markets. At one point, volatility expectations (as measured by the VIX) spiked to above 14, but later fell back to just above 12.

We updated our volatility forecasts for the coming month, which generally call for lower overall volatility.

SPEND: Real Spend
It was a generally flat week for both global equities and the U.S. broad-based bond markets, with the one-year return spread between the asset classes currently at just over 12%. The spread between global equities and the broad-based U.S. bond market is even wider, at more than 18%.

The Real Spend equity portfolios currently have a 70% allocation to domestic equities, while the Real Spend fixed-income portfolios have overweight allocations to preferred stocks and high yield bonds. As a reminder, the allocations generally follow the longer-term views from our asset allocation process.

Yield-focused investors saw a split week: Most fixed-income yield plays were flat, while equity-based yield investments were up strongly. For example, emerging markets debt was down 75 basis points while REITs were up more than 3% and master limited partnerships gained more than 5%.

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