The Daily Prophet: Just When You Thought You Understood Stocks

Connecting the dots in global markets.

It was relatively easy to explain why stocks kept moving higher this year despite the turmoil in Washington and rising geopolitical threats around the world -- North Korea, anyone? The simple reasons were, the economy was gaining strength and corporate earnings were on the rise. But what's harder to rationalize is the mini-selloff that has taken the S&P 500 down as much as 1.52 percent from its record high on Nov. 7 and caused global equities to drop for five straight days.

Although stocks have been long overdue for a pullback, with Bloomberg News reporting that the S&P 500 has now gone a record 12 months without a retreat of 3 percent from a peak, the fundamentals haven't changed. Global growth continues to chug along with few signs of inflation and the earnings outlook remains bright, even if lawmakers and the House and Senate are unable to come up with tax cuts. Since the third-quarter reporting season began a month ago, companies saying earnings will beat analyst estimates have outnumbered those predicting they will miss by a ratio of 1.2-to-1, according to Bloomberg News' Lu Wang. That’s the highest for any similar stretch since 2010, data compiled by Bloomberg show. Over the past month, almost 200 firms provided higher forecasts than analysts' estimates, the first time since 2011 that upward guidance outstripped downward.

Even with the pullback, the S&P 500 is up a healthy 14.6 percent this year, to 2,568.74, and Wall Street's biggest equities bull says there's more to come if you can ride out the current storm. Keith Parker, who was just hired as UBS AG's head of U.S. equity strategy, sees the benchmark rising to 2,900 by the end of next year, which represents a gain of almost 13 percent from current levels, as earnings continue to move higher. But if the Federal Reserve hikes interest rates too much, Parker says there's a chance the S&P 500 drops to 2,200, a decline of about 15 percent.

Perhaps it's that last scenario that has stocks investors spooked. And you can't blame them, judging by what they see happening in the market for U.S. Treasuries, which rallied again Wednesday. The intense media coverage of the relentless flattening in the yield curve is putting everyone a bit on edge. The gap between two- and 10-year Treasury yields shrunk to a new low for the year on Wednesday at 64 basis points, which is down from 136 basis points at the end of last year and the smallest difference since 2007. This move is important because a narrowing yield curve is typically associated with slower economic growth, and a full on inversion is a sign that a recession is on the horizon. Where exactly on the horizon is open for debate. The strategists at Bloomberg Intelligence note that over the last three decades, the lag between a flatter curve and a recession has sometimes been years. Or maybe the flattening has nothing to do with the economic outlook, with the Treasury Department set to issue more short-term debt and the Fed continuing its slow pace of rate hikes. That's a recipe for further flattening over the next several quarters, according to the BI strategist.

The other big concern in markets right is junk bonds. The market has also suffered a swift and sharp selloff in the last week. Investors are now demanding an extra 4.06 percentage points in yield to own U.S. dollar-denominated corporate debt rather than Treasuries, up from the low this year of 3.56 percentage points in Oct. 24. As with stocks, there's really no fundamental reason behind the slump other than investors had become more concerned that yield spreads were too tight. And just like with stocks, the strong performance of the high-yield market has been due to solid economic growth, low inflation, low interest rates and the expansion of central bank balance sheets, according to Deutsche Bank economist Torsten Slok. "None of these factors have changed or are likely to change over the coming months," Slok wrote in a research note. "As a result, this ongoing correction is likely a buying opportunity in credit. The real re-pricing in credit will come once (U.S.) inflation begins to move higher and the ECB begins to signal their exit, and currently we expect both of these negative forces for credit to only appear" in the second quarter of 2018. Along with the note, Slok provided a long-term view of investment-grade and high-yield spread to show the current selloff doesn’t even register as a blip.

Just last week, pundits were touting the comeback in commodities. On Nov. 6, the Bloomberg Commodities Index had reached its highest level since early March. The bulls pointed to the first global synchronized economic recovery in many years along with signs that OPEC was finally getting a handle on oil supply. A week later, the gauge is down 2.5 percent -- including its biggest slide in six months on Tuesday -- and suddenly the market is back to worrying about a slowdown in demand due to weakness in China and concern that maybe OPEC won't be able to eat into a glut in global oil supplies. Nickel, iron ore and oil are all lower, according to Bloomberg News' Heesu Lee and Luzi Ann Javier. The Chinese slowdown is seen hurting metals use. In the oil market, U.S. production is rising and an extension of OPEC-led output curbs to ease a glut suddenly looks uncertain amid Russian hesitation. World wheat and soybean inventories are expected to reach a record. “China focusing on the quality of economic expansion signals the pace of its growth will slow, which is pretty bad for commodities,” Will Yun, a commodities analyst at Hyundai Futures Corp., told Bloomberg News. “Although the market widely believes the supply cuts led by OPEC will extend until next year and Russia will eventually follow Saudi Arabia’s lead, U.S. shale producers will continue to put downward pressure on oil prices.”

If investors really were in "risk-off" mode, one would expect anything having to do with emerging markets to suffer. And while stocks and bonds of developing economies have been week, their currencies have been holding strong. The MSCI Emerging Markets Currency Index is little changed over the last week, even though the MSCI Emerging markets Index of stocks has dropped 2 percent. Eastern European currencies are leading the way, with the Hungarian forint, Czech koruna and Polish zloty all appreciating at least 1.5 percent the last five trading days against the dollar. A lot of the strength is related to stronger economies. Growth in the European Union’s eastern members picked up in the third quarter as rising wages propelled consumer spending, with Czech and Polish growth topping analysts’ predictions. The recovery in the euro area has fueled demand for exports from the EU’s former communist states, while loose fiscal policy and record-low unemployment buoyed consumer spending, according to Bloomberg News' Radoslav Tomek and Andra Timu. That said, not everyone is expected the currency strength to last. "It's only a matter of time before EM currencies weaken, too," the strategists at Brown Brothers Harriman wrote in a research note.

Given the efforts by lawmakers in Washington to cut the amount of mortgage interest that U.S. homeowners can deduct from their overall tax bill, it may seem odd that the shares of home builders have been on a tear. The Bloomberg Americas Home Builders Index has gained 3.22 percent this month, versus a decline of 0.28 percent for the Standard & Poor's 500 Index. We'll find out whether that optimism is warranted on Thursday, when the National Association of Home Builders releases its sentiment index for November. The median estimate of economists surveyed by Bloomberg News is for a slight decline to 67 from 68, but that would just leave it at its average for the year. The economists at Bloomberg Intelligence say reductions in mortgage interest and state and local tax deductions in the proposed House tax bill would disincentivize home buying, particularly in expensive property states including New York, New Jersey and California. Weakening demand from potential buyers would directly impact homebuilders. In a statement responding to the House bill, the National Association of Home Builders harshly criticized the proposal. The prospect of losing sales could significantly weigh on builders' optimism, according to BI.

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