It was a solid week for almost all markets. The global equity indexes pushed higher around the world with the S&P gaining +1.0% for the week while the small-cap Russell 2000 added +1.8%. Europe and Japan also performed well. The European indexes added +1.5% for the week while Japan was up +3.2% (both in dollar terms). Emerging markets lagged, with Brazil losing -2.4%.
Bond yields dipped meaningfully after Friday’s weekly employment report. The yield on the 10-year Treasury closed at 2.16%, the lowest level since the election last November (as you can see below).
Intermediate-term Treasury bonds added +0.6% while long-term Treasury bonds jumped +1.7%. It is also notable that short-term yields didn’t change much this week. This means that we’ve seen a notable flattening in the yield curve (difference between 10-year and 2-year yields). The spread has fallen from a higher of almost 140bps to 88 bps on Friday, as you can see below. A flatter curve is often time interpreted as a sign of less investor enthusiasm for the economy and/or lower inflation expectations.
A flatter yield curve is also bad news for the banks. Banks typically borrow short and lend long. A flatter curve means their margins could come under pressure. Bank stocks were down -0.7% this week in an otherwise up tape.
Finally, the other sector red for the week was the oil sector. Crude closed down -4.0% and energy stocks were hit for -2.3%. Crude prices are now down -8.5% YTD and energy stocks are off -13.6%.
Home Prices and Inventory
One of the most noted economic reports this week was the S&P/Case-Shiller release. It showed that home prices continue to percolate, with the latest number showing nationwide appreciation of +5.8% year-over-year in April, as you can see below.
There were large regional divergences in prices as you might expect. Seattle (+12.3%), Portland (+9.2), and Dallas (+8.6%) reported the highest year-over-year gains among the 20 cities.
While inventory levels in the Bay Area have picked up, nationwide inventory levels are very low. As you can see below, single family homes available for sale throughout the country are basically at historic lows.
So while price appreciation could very well level off in the months to come, it is awfully hard to make the case for a crash in home prices in the foreseeable future.
Payroll Gains Disappoint – Earnings Do Not
The other main economic report for the week was Friday’s jobs report. It basically was a let-down. Nonfarm payrolls increased by a lower-than-expected 138k in May (chart below), and the details of the report were similarly weak (prior months were revised lower by -66k)
The headline unemployment number did dip lower by 0.1% to 4.3%, but this is because the labor force participation rate declined 0.2% to 62.7%.
Friday’s weak report was the catalyst for the push lower in bond yields. The yield on the 10-year dipped 0.06% on Friday and the dollar sold off across the board. But we shouldn’t make too much of this single report. Second quarter GDP growth expectations have kicked higher in the last few day and now stand at +4.0% (economists’ consensus expectations are at +3.1%).
Furthermore, the equity rally is being underpinned by decent earnings numbers. First quarter earnings were up roughly +15% in the first quarter, and expectations are for more of the same in the second quarter (chart below).
It is a similar story overseas. Research firm, Bank Credit Analyst, forecasts European profit growth accelerating to well over 10% in the quarters to come while Japan could see growth of 20% (charts below).
The earnings backdrop is the key reason global equities have been able to push higher despite the ever increasing odds of political gridlock the last couple months.
What Does this Mean for the Fed??
So what does the jobs report mean for Fed policy? Not much this month. Certainly the modest job growth number comes on the heels of another soft inflation report. The Fed follows the Core Personal Consumption Expenditures index, and the April number fell well short of the Fed’s 2% goal, as you can see below.
The Fed is clearly falling short on inflation target, and policy makers are starting to talk more and more about this. This doesn’t change the likelihood of a hike on June 14th in our view. The odds of a hike are running at basically a sure thing, even after Friday’s jobs report (blue line below). However, the statement that comes out that day may note the shortfall in inflation and open the door for a pause.
This means it is quite possible that the odds of a September hike back off on the days and weeks to come. Goldman already thinks a September hike is off the table:
“We now expect the committee to announce a tapering of maturity reinvestments in September, and we now expect the third hike of 2017 to occur at the December meeting (we previously expected a hike in September and a balance sheet in announcement in December). This change reflects recent detailed discussion of the balance sheet among committee members, as well as our view that the committee will prefer to wait for clarity on the outlook before implementing a third hike this year – particularly given signs of slowing job growth and the recent drop in core inflation.”
Is Another Shocking Vote Possible?
The U.K. holds a general election on Thursday less than two years after the last general election in May 2015 and less than a year after the fateful Brexit vote. This latest election was thought to be a non-event as the government enjoyed a commanding lead over Labour of 20pts+ in the opinion polls when Theresa May announced the snap vote. The intervening six weeks must be feeling like an eternity for the PM as she has seen the Conservative lead atrophy to only 8pts based upon on the five most recent polls (chart below).
As The Economist notes:
“Written off by the pollsters and dismissed by his opponents when Theresa May called the election in April, Mr Corbyn and his Labour Party have seen a surge in their support in the past two weeks. The Conservatives’ average lead has fallen from nearly 19 points in April to six. It amounts to one of the steepest swoons in four decades of elections.”
The bookies in the U.K. take a different view. They peg the odds of a conservative victory at 80%, as you can see below.
But it is hard to place much faith in the bookies this time around. They missed both the 2015 election and the Brexit vote (as well as Trump). This naturally has the pundits on edge. At the moment, a conservative win still looks possible, but who can really be sure. But a close election is good for one person; Labour leader Jeremy Corbyn. Even if he loses he wins in two ways. First, and most important to him, he will likely keep his job.
Second, if the Tory majority in parliament is trimmed or they end up with a hung parliament, the PM is put in an awfully difficult, and possibly embarrassing, position. The Economist again:
“If his poll numbers hold up, he is likely to deny Mrs May the landslide that she must have hoped for when she called the election. A slimmer majority would embolden Tories who disagree with her brand of Conservatism—and there are plenty of them—to grumble more loudly. Opposition to her Brexit plan may be stronger, from both Remainers and her own hardline Eurosceptics.”
Quite a turnaround for the Labour leader considering that a week ago few thought he’d have a job come Friday morning. As former British Prime Minister Harold Wilson is thought to have said, “a week is a long time in politics.”
Have a good weekend.
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