A Week of Stock Swings
It was another volatile week, but stocks managed to end this one slightly higher. Evidencing the extent of last week’s gyrations was a powerful swing that sent the Dow Jones Industrial Average from a 250-point loss to a 200-point gain on Friday. For the week overall, the Dow rose 0.97% to 16,472, the S&P 500 Index moved up 1.04% to 1,951 and the tech-heavy Nasdaq Composite Index lagged, adding just 0.45% to close at 4,707. Meanwhile, the yield on the 10-year Treasury fell from 2.16% to 1.99%, as its price correspondingly rose. Despite the flourish in the final week, stocks ended the third quarter with their worst performance since 2011. But the key takeaway is this: Amid scarce evidence of global growth, equity investors are once again beginning to look to central banks for largesse and monetary stimulus to help push stocks higher.Indicators of Financial Stress Widen
After struggling through a particularly bad third quarter, which saw stock declines amounting to a $10 trillion loss in global equity market capitalization, investors were faced with the unpleasant task of digesting another set of soft economic data last week. The U.S. employment report was unambiguously weak, while evidence continues to suggest that the U.S. manufacturing sector is struggling under the weight of a strong dollar and feeble overseas demand.
Growing concerns over the health of the global economy are manifesting in several ways. First, a broad measure of financial stress, the Global Financial Stress Index, recently hit its highest level since the summer of 2012. With investor risk aversion climbing, so-called high-beta, momentum names that are more volatile continue to suffer. For example, at the lows last week, the Nasdaq Biotech Index was down nearly 30% from its July high. Moreover, the returns derived from merger-and-acquisition deals have been falling recently.
As stocks struggled, bond yields tumbled and prices rose. For most of the past few weeks, yields have been grinding lower on the back of a sharp drop in U.S. inflation expectations. At the lows last week, a key measure of inflation, 10-year breakevens, was down below 1.40%, its lowest level since 2009.
The drop in yields accelerated on Friday following the disappointing U.S. labor market report. Not only was the September number roughly 50,000 below expectations, but the August payroll numbers were revised lower as well. In addition, hourly earnings were flat and the labor participation rate fell to its worst level since 1977.
Lowered economic growth expectations are also putting pressure on high yield bonds. Last week, investors removed $1.5 billion from the asset class, the largest weekly outflow since July 1.
Going Forward: Back to Old Tricks
Friday’s sudden turnaround in stocks could be interpreted as foreshadowing yet another shift in the investment regime: a renewed reliance on central banks. Not only did U.S. investors treat a weak jobs report as a sign the Federal Reserve (Fed) will hold off on raising interest rates (giving bonds an excuse to rally), but other countries are following suit. European equities stand to benefit from a weak inflation print, which may prompt further quantitative easing by the European Central Bank. A similar pattern is evident in emerging markets such as India, where last week stocks benefited from an unexpected rate cut from its central bank.
We still don’t believe a U.S. recession is on the horizon, but it is becoming clear that the U.S. is not immune to the global slowdown. Second-half growth is likely to be considerably slower than the nearly 4% we witnessed in the second quarter. The more pessimistic outlook for the economy, which is pushing back expectations for a Fed hike, is also driving short-term yields down. Last week, two-year Treasury yields fell as low as 0.55%, roughly 10 basis points below where they started the year.
Investors may be feeling a bit of “déjà vu all over again,” to quote the recently departed Yogi Berra. As we have seen in recent years, in a world where the Fed keeps rates anchored at zero, stocks benefit, if only because they compare favorably to cash and negligible bond yields. This is an environment in which some old themes, such as income-producing equities, come back into vogue as investors gird for an even longer spell of “low for long” rates.
Russ Koesterich, BlackRock
