As good as it gets, or the best is yet to come? Equities traders spent Tuesday waffling between those competing narratives, underscoring the fragile psyche of markets these days. After initially pushing the Standard & Poor’s 500 Index down as much as 0.85 percent in response to what was perceived to be a soft manufacturing report, investors later bid up stocks on optimism that Apple Inc. would report robust earnings (for the most part, it did).
Such is the state of things right now: No one seems quite sure whether the U.S. — or world — economy is strong enough to withstand higher borrowing costs. The result is a lot of intraday volatility that leaves markets without a whole lot of direction or momentum. The S&P 500 rose 0.27 percent in April, its smallest monthly move in either direction since August. LPL Financial Chief Investment Strategist John Lynch notes that the gauge is about 7 percent off its closing high for the year, set on Jan. 26, while estimates for 2018 earnings have risen by about 3 percent since then. The increase in earnings estimates for the next four quarters is even more dramatic, having jumped 6 percent since the January stock-market peak, boosted by strong first-quarter profit growth of 24 percent from a year earlier. In short, higher earnings estimates coupled with lower stock prices have taken about 12 percent off valuations in just the past three months, cutting the S&P 500’s forward price-to-earnings ratio from 18.5 to 16.2, not far from the post-1990 average of 15.4 times, according to Lynch.
“Above-average valuations are justified given our positive outlook for earnings, still-low interest rates by historical standards, and low inflation,” Lynch wrote in a research Tuesday. “When adjusted for interest rates and inflation, stock valuations are near average — and may get cheaper as earnings ramp up throughout 2018.”
Most currency strategists spent the bulk of January and the first half of February slashing their forecasts as the U.S. Dollar Index extended its big slide. Not Morgan Stanley. The firm kept its second-quarter outlook unchanged, predicting the index would rise to 92 by mid-year from its low of 88.253 in February. Today, that call looks pretty prescient as the Dollar Index has staged a strong rebound, reaching 92.448 on Tuesday, a new high for the year. So, what does Morgan Stanley say now? Stick with the dollar because the rally is far from over. “Robust U.S. data, aided by expansionary fiscal policy, contrast with growing concerns about further acceleration in the rest of the world,” the firm’s strategists wrote in a research note Tuesday. Versus individual currencies, they see the dollar appreciating against the yen, euro, and the dollars of Australia and New Zealand. Other strategists are starting to catch up to Morgan Stanley. The median mid-year forecast for the U.S. Dollar Index has jumped to 90.70 from 89.20 at the end of March. The greenback has been the strongest major currency over the past three months, with the Bloomberg Correlated-Weighted Index of the dollar against its peers rising 6.03 percent. That marks a turnaround from last year, when that index plunged 7.25 percent in its biggest drop since 2009.
U.S. Treasury Secretary Steven Mnuchin told Bloomberg TV Monday that he’s unconcerned about the bond market’s ability to absorb all the extra debt the government will be selling to pay for a ballooning budget deficit forecast to reach $804 billion this fiscal year. Here’s hoping he’s right, but so far the early returns aren’t encouraging. The Bloomberg Barclays US Treasury Index fell 1.18 percent in the first three months of the year as the U.S. borrowed a record $488 billion. That was the first quarterly decline in the index since the end of 2016. On average, the Treasury Department pays 2.20 percentage points more in yield than other governments (see chart below), according to ICE Bank of America Merrill Lynch bond indexes. That’s up from 1.71 percentage points at the start of the year. The government will announce its quarterly refunding plans at 8:30 a.m. Wednesday in Washington. Most bond dealers expect two- and three-year note auctions to grow by $1 billion each month during the quarter, with some seeing increases of $2 billion, according to Bloomberg News’ Elizabeth Stanton. Most predict the five- and seven-year auctions will be lifted by $1 billion in May and remain at those levels. The 10- and 30-year auctions are likely to increase by $1 billion apiece. “It’s a very large, robust market — it’s the most liquid market in the world, and there is a lot of supply,” Mnuchin said. “But I think the market can easily handle it.”
One side benefit to a stronger dollar is that it tends to dent demand for commodities. That’s because most commodities are traded in dollars, and the higher it goes, the more expensive they become to buy. The rising greenback was cited as contributing to oil’s biggest decline in three weeks on Tuesday, with futures in New York dropping as much as 2.5 percent. Also contributing to the drop were estimates that crude stockpiles in the U.S. climbed by 1 million barrels last week, according to a Bloomberg survey. If confirmed by government data on Wednesday, it would be the second consecutive weekly gain in inventories, according to Bloomberg News’ Jessica Summers. Oil started May on shaky ground after a 5.6 percent rally last month fueled by conflict between Saudi Arabia and Yemen and the impending May 12 deadline for U.S. President Donald Trump’s decision on whether to reimpose sanctions on Iran. Israeli Prime Minister Benjamin Netanyahu revealed a trove of documents on Monday that he said proved Iran conducted a secret atomic weapons program. While sanctions “will take oil off the market, I don’t think it’s going to be a tremendous amount,” Tariq Zahir, a New York-based commodity fund manager at Tyche Capital Advisors, told Bloomberg News.
EMERGING MARKETS SHUNNED
The love affair between emerging markets and investors is starting to cool. The Institute of International Finance in Washington said Tuesday that non-resident portfolio flows to EM ground to a halt last month. In fact, the organization estimates that those markets suffered about $200 million of outflows. While that isn’t much when compared against the $10 billion or more of monthly inflows that these markets have routinely attracted, it’s notable as the first outflow since November 2016. The MSCI EM Index of stocks has fallen for three straight months, its longest slump since the end of 2015 and beginning of 2016. Likewise, the Bloomberg Barclays EM Local Currency Government Debt Index fell 2.22 percent in April, it’s worst monthly loss since November 2016. EM currencies have also been big losers, with an MSCI index tracking their exchange rates declining 1.65 percent last month. The IIF cites two main reasons for the softness. The first is that the U.S. Federal Reserve is signaling that it might need to step up the pace of rate increases. The second is that global growth is desynchronizing, shifting toward U.S. outperformance. Both drivers are fundamentally positive for the dollar and make life more difficult for EM borrowers, especially those with large external funding needs, according to the IIF.
The Federal Reserve concludes its two-day monetary policy meeting tomorrow, and while there’s no change expected in interest rates, there’s the potential for big market moves. That’s because a growing number of economists, analyst and investors say the Fed could alter the language of its policy statement to suggest policy-makers are leading toward four rate hikes this year, versus the three that are currently expected. That’s known in the market as a “hawkish hold.” The central bank’s preferred measure of inflation rose to its 2 percent target in March from 1.7 percent in February, government data on Monday showed. Outgoing New York Fed President William Dudley told CNBC on April 16 the central bank might have to alter its strategy of gradual rate increases “if inflation were to go above 2 percent by an appreciable margin.”
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