Eye on the Markets - 2018


Equity Markets, Sector Rotation and the Latest Economic Data

By Ketu Desai

November was a strong month for the market, however, the month got off to a slow start, and there was dispersion among asset classes and within the sectors of the equity market. In this article, we will discuss the equity markets, sector rotation, the latest economic data, emerging markets and fixed income markets.

The equity market rally accelerated in November, particularly the last couple of days of the month, with tax reform/cuts being the key driver. The difference, according to analyst estimates for earnings growth in 2018, is 8 percent without tax cuts vs 11 percent - 15 percent with the tax cuts. As Washington moves closer to tax reform, investors repositioned to companies that will benefit the most from tax reform. Investors dumped tech, and moved into value sectors including retail, financials, and small caps. While the market has been calm at the index level, beneath the surface sector rotation has been one of the key themes this year.

For an investor with a longer-term horizon, the rotations proved to be a good buying opportunity. We are also in a period of the year where buying and selling can happen for non-fundamental reasons, as we are in between earnings cycles. This is especially true for sectors such as tech.

We witnessed similar dips towards the end of June and September, only to have strong performance in July and October, when they reported earnings. It will be interesting to see if this trend continues, or if this rotation has legs. For a strong 2018, the market will need tech to participate as it is over 20 percent of the market.

In domestic economic data, last quarter's GDP growth rate was revised up to 3.3 percent. Business and investment spending was up 10.4 percent, post-crisis, this element has not been a significant portion of our growth. Another encouraging sign has been the growth of productivity, which could help growth in 2018. It is on track to rise 1.3 percent in 2017, and be north of 1 percent next year, after averaging 0.6 percent for the past six years. While growth numbers were strong, inflation continued to be muted, core PCE rose an annualized 1.4 percent, providing support to a goldilocks economy.

Emerging markets underperformed this month. The Chinese market especially exhibited volatility, and in particular the Chinese tech sector. Further, deleveraging, some weaker than expected economic data, and rising yields were also factors. The Chinese 10-year is up nearly 40 bps since the end of September.

The fixed income market domestically also experienced noteworthy moves. High-yield bonds experienced a selloff that saw investors pull $3.5 billion from high-yield funds. The high-yield spread moved out 50 bps at the peak, during the month. Most of the move was contained to a couple of sectors. The yield curve also continued to flatten, as the spread between the 10-year Treasury and the 2-year, breached 60 basis points.

Many are concerned that if the Fed continues its path to raise interest rates that the yield curve may become inverted. Often an inverted yield curve is a sign of a pending recession. Quantitative easing is certainly having an impact on the shape of the yield curve. While the Fed has withdrawn from quantitative easing, other central banks around the world are continuing, and our long-end looks relatively attractive for non-domestic investors.

Further, inflation numbers continue to be muted, which is having an impact on the yields. For these reasons, at this point it is not concerning that the curve has flattened, however, if the Fed does get aggressive next year with policy, it is worth taking seriously the message the bond market is sending.

Looking forward, the market will focus on a Fed meeting that will likely bring another rate hike. Investors will also look to economic data to ensure that the economy remains strong. The key driver for the next leg up for the rest of this year will be tax reform/cuts.