Economic data for the week featured more tempered inflation results than expected as seen in last month’s PPI and CPI, lowering the trailing year’s results. Consumer sentiment declined and jobless claims ticked upward a bit due to hurricane-related effects.
Global equity markets suffered a volatile week, with the worst down day stretch seen in over six months. Bonds fared positively, due to cash flows moving to less risky assets. Commodities were mixed to down, as the price of crude oil declined sharply.
(0) The Producer Price Index for September rose +0.2% on both a headline level and ex-food and energy—in keeping with expectations. The overall numbers reflected declines in food and energy prices over the past month of up to a percent, while other segments appeared mixed, such as airline costs, which rose by several percent on the month. Core immediate producer prices rose at the same rate as the headline PPI, while crude materials outside of food/energy fell by nearly -3% for the month. Year-over-year, PPI is up +2.6%, which is a more tempered pace than prior months.
(0) The Consumer Price Index for September rose +0.1% on both a headline and core level, each below expectations calling for a +0.2% increase. For the month, declines were most pronounced in energy, which declined by -0.5% (although still gaining nearly +5% year-over-year), in addition to price declines in non-energy commodity goods. The pace of shelter costs tempered (to just over a +3% trailing 12-mo. rate), only rising by a few tenths on the month, while apparel and medical care prices rose and a substantial decline in used car prices also contributed to the overall mixed results. Year-over-year, headline CPI decelerated to a +2.3% pace—the lowest since February of this year—while core remained stable at +2.2%. After the effects of oil price gains over the past year, these figures remain very close to the Fed’s inflation target.
(-) Import prices rose +0.5% in September, surpassing the median forecast calling for a +0.2% gain, along with August’s number revised higher by a few tenths. However, exempting the +2% gains in the foods/feeds/fuels category and +4% for imported petroleum, the core price index was unchanged as higher industrial supplies prices were offset by lower consumer goods prices, outside of autos. There do not appear to be signs of trade policy impacts thus far, which would be an area of focus in upcoming reports as tariffs go into effect.
(-) The preliminary October Univ. of Michigan consumer sentiment index fell by -1.1 points to 99.0, below the 100.5 reading expected. Consumer assessments of both current conditions as well as future expectations fell, with the latter underperforming the former. Median inflation expectations for the coming year ticked up a tenth to 2.8%, while those for the coming 5-10 years fell by -0.2% to 2.3%—the lowest level in several years.
(-) Initial jobless claims for the Oct. 6 ending week rose by +7k to 214k, which was above expectations of an unchanged 207k level. Continuing claims for the Sep. 29 week rose by +4k to 1,660k, happening to match expectations. Anecdotally, it appears that claims are continuing to stay higher than normal in states affected by the recent hurricane, notably NC and SC, while no doubt this will occur again when the aftermath of Hurricane Michael is taken into account in coming weeks. Other than in those regions, claims levels remain low.
Question of the Week
Where should interest rates be at this point?
This has been pondered countless times over the last decade as the Fed imposed a monetary policy of extreme easing during the depths of the Great Recession, keeping rates near zero in subsequent years, before their the normalization process of raising them more recently. It’s important to keep in mind that the Fed only directly controls one key interest rate—the fed funds target. This is the rate financial institutions use in lending to each other—which serves as an important starting point for market rates on short-term treasury bills, money market funds and bank deposits. Long-term rates, however, while loosely anchored to short rates, are driven much more by future inflation expectations.
While all other non-fed funds rates are market driven, there are some historical patterns that could be helpful in anticipating a ‘fair value’ across the yield curve. It’s perhaps most helpful to look at this from a building block perspective, in which the total nominal interest rate is decomposed by its component parts. Then, the parts are unassembled, estimated and reassembled, to see what a realistic fair value could look like. Although, as with stocks, this exact point is never agreed upon so it exists mainly in theory.
The first building block is the ‘real rate’, which represents the yield earned for an investor taking on the risk and opportunity cost of lending money in the first place. While U.S. treasuries are considered ‘risk-free’ by most investors (at least free from default), that probability, while small, isn’t zero. The real rate also includes compensation for other uncertainties, such as volatility of future inflation and bank policy (and why real rates for emerging market nations tend to stay so high). Longer-term rates also usually contain a ‘term premium’, which is a rate spread that compensates bond owners for taking on the uncertainty of being locked into a longer maturity versus a shorter one. Lastly, expected inflation itself is added in, as bond owners expect to be paid for the loss of purchasing power during the life of their investment.
This gets us to the following relationships. (Note that corporates and other bonds considered as ‘credit’ also contain the building block of a credit spread in addition to these base rates—compensating investors for the risk of default.)
Short-term rate = Real rate + Inflation
Long-term rate = Real rate + Term premium + Inflation
The Fed’s own ‘dot plot’ and Wall Street fed funds rate projections over the next several years fall around a midpoint of 3.0%. Considering the Fed’s inflation target is 2%, this implies a real rate of 1%. Term premium has varied dramatically over time, but the presence of a flattening yield curve implies that it’s trending tighter, which is typical of later in the economic cycle—now just under 1% (since the early 1980’s, it’s ranged from an inverted -1% to a very steep 4%).
Per Fed Chair Powell’s recent comments, market participants are concerned the Fed may go beyond ‘normal’ to as a far as 3.5% or higher. As much as anything else, this added chance of an overshoot has enhanced recent interest rate uncertainty. While rates matter not only for bond prices directly, and economic borrowing activity, they are also an important input to valuation models (when rates move up, asset/entity fair values move lower).
There are no shortage of predictions about the future direction of rates. On the more bullish side calling for higher rate levels, economists point to pent-up inflation—notably from strong labor markets and need for higher worker wages, as well as strong monetary stimulus of the last decade and higher oil prices. This is in addition to the inflationary impact from tariffs, should a broader trade war come to pass. Rates should technically rise in keeping with a nation’s rising budget deficits and deteriorating debt-to-GDP ratio, since higher ‘credit risk’ is implied.
On the other hand, the current rate level remains higher than that of all other developed nations that are usually the top competitors for safe assets during periods of equity market volatility, including the U.K., Europe and Japan. This high demand for yield globally has kept U.S. rates down, as has the Fed’s QE bond-buying activity (which is being now unwound). Bearish economists point to a lack of pent-up inflation, due to weaker long-term economic growth forces, such as aging demographics and low productivity, in addition to more widespread deflationary forces that have pushed down the prices of technology and other consumer items. Historically, periods of deflation and lower growth have tended to put a lid on rates, sometimes for extended periods.
|Period ending 10/12/2018||1 Week (%)||YTD (%)|
|BlmbgBarcl U.S. Aggregate||0.44||-2.10|
|U.S. Treasury Yields||3 Mo.||2 Yr.||5 Yr.||10 Yr.||30 Yr.|
In keeping with October’s reputation for enhanced market volatility, markets did not disappoint last week. Equities broke out of a fairly tempered streak by declining by the largest two-day amount since February, by a cumulative -5% loss, before recovering a bit by Friday. Regardless, the declined wiped out half of 2018’s gains thus far, and put small caps into -10% correction territory. Every stock sector was in the red, with defensive segments utilities and consumer staples faring the best with losses under -2%, while heavily cyclical materials and industrials declined well over -6% on the week. Decent early earnings reports in the financial sector seemed to help restore a positive tone by Friday.
While no one cause seemed solely to blame, a combination of higher interest rates and continued U.S.-China tariff concerns seemed to remain an issue as much as any other catalyst, although (ETF-driven) systematic selling activity may have also exacerbated the issue once the price of the S&P fell below its 100-day, then 200-day, moving average. The President described recent interest rate hikes by the Federal Reserve as ‘loco’ and ‘going wild’, which were not taken overly seriously by markets but didn’t help overall sentiment. The overriding concern, however, seems to be the fear that the U.S. (and global) economy is easing from a mid- into a late-cycle environment, which would indicate slowing growth and an eventual recession. The IMF has also updated their world forecast of GDP growth downward, for the first time in over two years, from 3.9% to 3.7%—largely due to fears over escalating trade tensions and stress in emerging markets from rising interest rates.
Foreign stock returns were negative as well for the week, albeit not to the same degree as U.S. equities, helped a bit by a weaker dollar. Interestingly, in contrast to many ‘risk-off’ weeks in the past, emerging markets fared best with the smallest equity losses by segment. Italian stocks fared worse than other developed markets, with continued worries about the nation’s upcoming budget deficit and potential conflict with the EU. In emerging markets, Chinese stocks fared poorly again due to the ongoing trade dispute with the U.S. In response to the controversy and potential negative economic growth effects, the PBOC cut the banking reserve requirement (for the fourth time this year) by 1%, which is effectively a rate cut, injecting the equivalent of about $175 bil. into the economy. Brazil, on the other hand, saw gains as the right-wing protectionist candidate commanded the largest number of votes in the initial presidential election and will proceed to a runoff.
U.S. bonds fared well, ironically, compared to the poor returns of the week prior, due to widespread worries of interest rates rising too far and too fast. Treasuries fared best, outperforming corporate credit as spreads moved wider on the week, which explained the negative performance of high yield. The concept of ‘spread duration’ accounts for the sometimes divergent impacts of one element of duration (term spread of government bonds, in the case of last week—moving lower and pushing bond prices higher) and the offsetting effect of another (credit spread, which is tied a bit more closely to equity risk, which moved higher and pulled down prices). Foreign developed market government bonds fared positively as well, benefitting from flows to lower-risk assets and helped by a weaker dollar. Emerging market local debt performed surprisingly well on the week.
Real estate fared negatively, in keeping with broader equity markets. Asian and European REITs came in slightly better, with a beneficial dollar effect. As expected, more cyclically sensitive REIT groups, such as lodging/hotels lost the most ground, while residential/apartments and malls held up better. While real estate fundamentals remain sound, valuations have been depressed to due such interest rate worries, with a continued wide bifurcation between more popular index components and those with perceived greater structural headwinds, such as retail and regional malls.
Broader commodity indexes lost ground on net, despite a weaker dollar, led by losses in energy—while agriculture and precious metals gained ground during the week. Precious metals, per their historical tendency, served as a profitable crisis asset. Crude oil ended the week -4% lower at over $71/barrel.
Sources: Ryan M. Long, CFA, FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Citigroup, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Marketfield Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, PIMCO, Standard & Poor’s, StockCharts.com, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wall Street Journal, The Washington Post. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.