STA Weekly Report – The Market Remains Challenged
INSIDE THIS EDITION:
Market Remains Challenged
What Does a Treasury Yield of 3% Mean For Investors?
Weekly Technical Comment
Happy 20th Anniversary Roth IRA – Tax Changes to Disallow Recharacterization
401k Plan Manager
The major indexes eked out small gains in April on the back of strong corporate earnings after being rocked by a bout of volatility earlier in the year. For the month of April, the Dow Jones Industrial Average logged a 0.3% gain, cutting its year-to-date loss to 2.3%. The S&P rose 0.3% in April, but is still down 1% in 2018. The tech-laden Nasdaq rose less than 0.1% on the month, with a year-to-date advance of 2.4%. First-quarter earnings have largely topped expectations, but investors haven’t rewarded beats at the same pace as in recent quarters.
Investors worried that higher inflation could lead central banks to tighten monetary policy faster than anticipated, while concerns about global trade frictions raised alarms about the global economy. The Federal Reserve will draw attention, as policy makers are slated to start a two-day meeting Tuesday. Changes to Fed policy—in addition to interest rates, the U.S. central bank is shrinking the size of its balance sheet—are widely seen as one of the biggest headwinds facing markets.
The U.S. tariffs on aluminum and steel imports are in focus again. President Donald Trump late Monday gave top allies—the European Union, Canada and Mexico—an extension to the tariff exemption to allow more time to negotiate a new pact to avoid the levies. The tariffs of 25% on steel and 10% on aluminum—already in effect against China, Russia, Japan and others—were slated to come into effect on May 1, but have now been pushed back to June 1. The U.S. decision prolongs market uncertainty, which is already affecting business decisions. Trade relations have been a driver of action on stock markets recently, though the spotlight has been on tensions between the U.S. and China.
The U.S. economy grew slower in the 1st quarter of 2018 compared to the previous three quarters, as GDP only advanced 2.3%. Consumer spending was especially disappointing as it only grew 1.1%. This is the weakest growth in nearly five years. For an economy where the consumer makes up about 70% of our GDP, this is disheartening. It is hard to grasp since we had tax cuts which put more funds in consumer pockets.
The regional FED data from Richmond was unexpectedly weak. The report indicated the first negative reading since September of 2016. In addition, we have seen Fed reports from Kansas City, Dallas, New York and Philadelphia show sizable declines lately. These weaker numbers might suggest why GDP growth was not higher and why many economists have lowered expectations for the year.
The market is down 7% from the high in late January, yet our long-term momentum indicators remain favorable. However, we do see our short-term indicators giving warning signals about higher risk in the markets. Until we see both the long and short-term indicators giving similar signals, we would avoid an excessive commitment to equities.
The yield on the benchmark 10-year U.S. Treasury note reached 3% last Tuesday, hitting a multiyear milestone. Since 2011, the 10-year Treasury yield has hit 3% only twice, briefly, in 2013 and again in early 2014, before plunging to a record low in 2016.
Why are yields going up?
Rising yields are driven by multiple factors. The Federal Reserve has signaled its intention to continue raising rates as the U.S. economy strengthens. The Central Bank has been reducing its holdings of Treasury bonds on the balance sheet. The U.S. government plans to issue more Treasury bonds to finance last year’s tax cut and fiscal stimulus. Both measures increase bond supply, which lower bond prices and pushes yields higher. Lastly, inflation is showing signs of picking up, which erodes the real value of bonds’ fixed payments and leads bond investors to demand higher yields.
Why does the yield on the 10-year Treasury matter so much?
The 10-year Treasury yield is a global benchmark for interest rates that influence borrowing costs for consumers, corporations, governments, and economy. For consumers, a higher yield means higher rates for mortgages, auto loans, or student loans. For corporations, a higher yield means that companies must pay more to borrow, which can negatively affect bottom-line earnings. For state and local governments, higher borrowing costs would jeopardize investments in public infrastructure. For federal governments, higher rates mean government must pay more in debt service, which ultimately is a burden carried by taxpayers. For the economy, higher rates tighten financial conditions and slows economic growth.
How fast and how much further will bond yields rise?
Most economists surveyed by Bloomberg see a gradual increase of interest rates. The consensus forecasts put the 10-year Treasury yield at 3.14% by end of this year and 3.49% by end of 2019.
How do rising yields affect bond investors?
First, coupon payments are the largest component of a bond’s total return. So, higher yields are good news for bond investors over the long run. However, higher yields also lower bond prices. So, bond investors should expect a total return of the coupon minus the decrease in bond price for their bond portfolio going forward.
How do rising yields affect stock investors?
Despite the yield on 10-year US Treasuries topping 3%, the difference between the yields on the 10-year and 2-year notes has narrowed to less than 0.5 percentage point. This indicates a flattening yield curve which makes investors anxious because as the market moves closer to an inverted yield curve, it could signal an eventual economic recession and a market downturn.
Source: The Wall Street Journal
However, historical market data shows that stocks tend to perform well when the yield curve is relatively flat. Since 1976, when the spread between the 2-year and 10-year Treasury yields falls between 0% and 0.49%, the S&P 500 has rallied 13%, on average, in the following 12 months. So, it may be too early for investors to completely sit on the sideline, at least from historical perspective.
A flattening yield curve also provides a good reminder to investors that they should proactively examine and manage risks in their investment portfolio.
Key Trendlines Are Being Tested
After a few weeks of a failed equity market bounce, we’re seeing many of the same trendlines being tested once again. This week we see a number of key trendline tests from across the financial market spectrum. And since the resolution of such trendline tests may well determine the direction of the most important markets in the world, we feel these charts in our weekly technical comment is warranted.
We find many equity indices involved in tests of important uptrends. To wit:
The S&P 500 is testing its post-2016 up trendline, and 200-day average…again…
and the Dow Jones Transportation Average is testing its post-2016 up trendline, and 200-day average…again.
Dollar Index Hits New 2018 High
Chart 3 shows the PowerShares Dollar Index (UUP) rising today to the highest level since last December. It’s also climbed back above its 200-day moving average and a falling trendline extending back to the start of 2017. The UUP may now be headed up for a test of its November peak. The rising dollar carries a lot of intermarket implications. The most obvious implication is that a rising dollar tends to hurt commodity prices, and precious metals in particular. Not surprisingly, precious metals are leading the commodity pullback. Energy and industrial metals are also losing ground. A rising dollar can also be negative for U.S. large cap stocks. That’s because a stronger dollar makes their exports more expensive. The dollar is getting a boost from the rising spread between Treasury and European bond yields.
A Closer Look at 2018
Chart 4 gives a closer look at Chart 3 since the start of this year. The inverse correlation between the two lines is seen more clearly. The Dollar Index (UUP) hit bottom at the start of February when the large cap/small cap ratio first peaked. Since the start of that month, the $SML outperformed the $SPX by nearly 5 percent. The red line started falling more sharply near the end of February after the UUP hit bottom for a second time. Since the start of March, small caps have gained 2.3% while large caps have lost -2.9%. The rising dollar has had a lot to do with that.
Weekly Snapshot of Global Asset Prices
If you have any questions, please feel free to email me at firstname.lastname@example.org.
STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Mike Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)
Happy 20th Anniversary Roth IRA – Tax Changes to Disallow Recharacterization
By: Scott Bishop
Most people know that 2018 starts a year with a brand new tax law (some of the highlights can be found in this linked summary). However FEW know that it is the 20th anniversary of the Roth IRA…I started my first personal Roth IRA in 1998! I was talking about this anniversary with team as part of Ed Slott’s Elite IRA Advisor GroupSM. The Slott team had a lot of thoughts to share.
The year 1998 seems like a long time ago. In January 1998, Bill Clinton was in the White House and about to be impeached. The Unabomber was in the news and the Spice Girls were winning music awards. January 1, 1998 also brought us the launch of Roth IRA. However, unlike other ‘90’s memories, the Roth IRA is still going, stronger than ever. You may already be reaping the tax benefits of your own Roth IRA. Or, maybe you’ve hesitated to open one. The 20th anniversary may be the time for you to take the plunge…
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