The combination of higher interest rates and mixed company earnings kept stocks under pressure, with a notable exception: emerging markets (EMs), which have been demonstrating relative strength of late
A Lackluster Week for Stocks—and Bonds
Last week was characterized by poor performance from both stocks and bonds. The latter saw a dramatic rise in yields as prices fell in both the U.S., where the yield on the 10-year Treasury rose from 1.91% to 2.11%, and to an even greater degree in Europe. As for stocks, the Dow Jones Industrial Average lost 0.31% to end the week at 18,024, the S&P 500 Index slipped 0.42% to 2,108, and the Nasdaq Composite Index fell 1.71% to 5,005.
The combination of higher interest rates and mixed company earnings kept stocks under pressure, with a notable exception: emerging markets (EMs), which have been demonstrating relative strength of late. We believe EM equities should have some representation in most investors’ portfolios.
Bonds Sell Off Despite Mixed Data
Last week’s market moves occurred against a backdrop of generally mixed economic data. There was a bit of good news in the form of strengthening wages, with the Employment Cost Index rising by 2.6% year-over-year, the strongest change since 2008. However, most measures of growth continued to disappoint: First quarter gross domestic product growth came in at just 0.2%, when economists had been looking for a 1% gain, and personal income growth was also flat in March.
Perhaps most troubling, the April ISM manufacturing survey failed to bounce as expected. This is a worrisome sign given that most economists and investors expect the first quarter economic weakness to be reversed in the second quarter as the impact of a harsh winter and the West Coast port strike fade.
Typically, mixed economic data would trigger a bond rally as investors engage in a “flight to quality.” So it was somewhat surprising that investors sold bonds last week, driving yields higher. The trend was most evident in Europe, where German government bond yields, for example, rose to over 0.35%, five times the low from just two weeks ago.
U.S. yields rose as well, but the move here at home was driven by higher inflation expectations. In particular, 10-year inflation expectations have risen by roughly 0.40% from their January low and are now at their highest point since October.
This is still below 2014 levels, but higher oil prices, improved European growth and some evidence of stabilizing inflation in Europe appear to have left investors less concerned about the prospect of deflation. In addition, the U.S. dollar’s rally has at least temporarily stalled. While the Dollar Index remains up 5% year-to-date, it is down 5% from its March high.
Resilience in Emerging Markets
The combination of rising yields and a mixed earnings picture pushed stocks lower last week. Despite improving sentiment over Greece and a decent start to the European earnings season, European equities lost over 2%, while Japan was lower by more than 3%. U.S. losses were more modest, but stocks continue to struggle with earnings. While Apple and Merck both produced solid results, the overall earnings outlook has been cloudier. Roughly three-quarters of S&P 500 companies have beaten earnings estimates, but more than half have missed top-line estimates, mostly due to the dollar’s strength in the first quarter.
Last week’s losses were particularly severe for rate-sensitive stocks such as utilities, which lost over 1.5% on the week. As we’ve been discussing for some time, with valuations stretched, it will not take much of a yield rise to put downward pressure on the more rate-sensitive parts of the market.
In contrast, one area demonstrating some resiliency is emerging markets. EMs are up roughly 10% year-to-date in dollar terms. In addition to the rally in Chinese equities, there has been some reversal from markets that trailed in 2014—notably Russia and Brazil. Better relative performance and still reasonable valuations (EM trades at a 30% discount to developed markets, based on price-to-book) have led to some change in investor behavior, with $600 million flowing into broad EM exchange-traded products last week.
EM equities are likely to experience more volatility this fall as we get closer to a rate hike by the Federal Reserve. However, we still believe most investors should include EM equities in their portfolios.
Russ Koesterich – Global Chief Investment Strategist – BlackRock