Market Update: Thursday, May 17, 2018

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Daily Insights

  • How much do interest rates matter for EM equity investors? Over short-term periods, like what we are experiencing now, rising interest rates tend to cause higher volatility for emerging market (EM) stocks. However, over intermediate and longer periods of time, EM stocks have tended to do well as rates rise and correlations between EM stocks and the 10-year yield have been positive over most of the past 30 years. Note that EM stocks performed relatively well during the most recent Federal Reserve (Fed) rate hike cycle in the mid-2000s (June 2004 to June 2006), outpacing the S&P 500 Index when the fed funds rate rose from 1% to 5%; EM also performed well from January 1999 through July 2000 when the fed funds rate rose from 4.3% to 6.9%. The EM crisis periods of the mid-1990s were an exception and comparable given EM economies’ much stronger financial positions today broadly.

  • Japan’s streak of positive GDP growth quarters comes to an end. After eight straight quarters of growth, the longest streak in nearly 30 years, Japan’s gross domestic product (GDP) contracted in the first quarter, by an annualized rate of 0.6% quarter over quarter. Though the contraction is likely temporary and not the start of a new recession, it does add to the case for the doubters of Abenomics. Though we believe growth will likely bounce back in the second quarter, trade risk has ratcheted higher after Japan indicated it will pursue retaliatory tariffs on the U.S. after the country was not granted an exemption for the recently announced steel and aluminum tariffs.

  • 10-year Treasury yield breaks 3.1%. We continue to target below-benchmark fixed income duration in portfolios, with an emphasis on investment-grade corporate bonds targeting the intermediate part of the curve along with bank loans. We remain comfortable with the upper end of our year-end 10-year yield forecast of 3.25%, though the odds of three more Fed rate hikes this year have increased (fed fund futures are now pricing in a nearly 60% probability of four total 2018 rate hikes). We expect the U.S. yield premium versus the rest of the developed world, and contained–but moderately rising–inflation to keep yields from moving significantly higher. Stocks have historically shown the ability to move higher in a rising rate environment.

  • Flurry of trade headlines offer little clarity. A NAFTA deal is unlikely to be reached in time to be completed ahead of Mexican elections in July. Meanwhile, apparently China trade hawk Peter Navarro will participate in U.S.-China trade talks this week after reports he would be excluded. Bottom line is trade policy risk remains high and will likely contribute to elevated stock market volatility in the near term.

  • Jobless claims modestly higher than expected. New applications for unemployment benefits were reported at 222,000 this morning, slightly above economists’ expectations of 215,000. Nevertheless, claims remain near 40-year lows, and with the jobless rate at 3.9%, we believe the labor market is robust and gradually tightening.

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Thursday

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  • Germany: PPI (Apr)

 

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