The Daily Prophet: Stock Bulls Are Left to Ponder 'What's Next?'

Connecting the dots in global markets.

The Standard & Poor's Smallcap 600 Index surged Thursday, continuing a remarkable turnaround for smaller companies in recent months and underscoring a growing conundrum for the broader market as a whole: what now?

The S&P Smallcap gauge has more than reversed its decline of 3.10 percent this year through late August to gain 15.5 percent since then, trouncing the 10.8 percent surge in the S&P 500 Index of large-cap stocks in the same period. In many ways, the fact that small-cap stocks have finally joined the rally in large-cap shares answers the question of whether the passage of the Republican tax plan is priced in equity values. It is. But with valuations topping 22.5 times for the S&P 500, there needs to be something for investors to look forward to if stocks are to at least maintain their current levels. To the strategists at Bloomberg Intelligence, that means tax reform needs to stimulate economic growth. That's especially true for small-cap stocks, which aren't as exposed to the global economic recovery as large-cap ones.

Besides valuations, there are other metrics showing that the margin for error is slim. A recent survey by the National Association of Active Investment Managers found that even the most pessimistic mutual fund overseers are fully invested in stocks, with exposure to equities at the highest level in data going back to 2006, according to Bloomberg News' Lu Wang and Elena Popina.

For all the hoopla over the passage of the Republican tax bill, no one really knows what the measure will mean for the economy outside of boosting corporate earnings. The bond market, though, seems to be forming a consensus: faster inflation. The $1.3 trillion market for Treasury Inflation-Protected Securities, which offer investors a hedge against rising consumer prices, just saw its biggest monthly inflow of cash since March, amounting to $1.4 billion, according to Liz Capo McCormick and Matthew Boesler. Demand at a $14 billion auction of five-year TIPS on Thursday was so strong that Wall Street dealers were left with a record low share. The sale took place as the inflation outlook implied by the securities is the closest to the Federal Reserve’s 2 percent target that it’s been since April. “TIPS are like a call option on rising inflation, and they have become attractive,” said Thomas Atteberry, a money manager at First Pacific Advisors who helps manages the firm’s $6.1 billion of fixed-income assets, told Bloomberg News. “The tax changes will at the margin have an impact on people’s thinking that inflation will be somewhat higher.” At the TIPS auction, bids exceeded the amount offered by the most since 2012, leaving dealers with a paltry 16.5 percent of the issue.

Those who think the world economy is largely devoid of inflation should take a look at Canada. The local dollar surged along with yields on the country’s government bonds as faster-than-forecast inflation and retail sales growth spurred wagers for more imminent monetary tightening. The loonie rose as much as 1.1 percent against the U.S. dollar, outperforming all other major currencies Thursday, according to Bloomberg News' Maciej Onoszko. Rates rose across Canada's bond curve, with two-year yields increasing to the highest since 2011. While the Bank of Canada has tightened monetary policy twice this year, traders had dialed back their expectations for rate increases as policy makers emphasized caution -- including over the future of the North American Free Trade Agreement. Yet inflation’s jump above the bank’s 2 percent target and a surge in retail sales to the highest since January may push the bank to act faster than anticipated. “This data is strong across the board and will support the aggressive pricing for BOC tightening,” Alvise Marino, a foreign-exchange strategist at Credit Suisse, told Bloomberg News.

India's government bonds are sliding at the fastest pace in almost two decades, and the selloff isn’t showing signs of easing. Yields on benchmark 10-year notes have surged 78 basis points, to 7.22 percent, since the end of July. Some of the 15 respondents in a Bloomberg survey see them rising to as high as 7.50 percent, as a potentially wider fiscal deficit risks more debt sales by the government and elevated oil prices threaten to fan rising inflation, according to Bloomberg News' Kartik Goyal. If that wasn’t enough, this week brought another headwind. A slim poll victory for Prime Minister Narendra Modi’s ruling Bharatiya Janata Party in his home state of Gujarat stoked speculation that his administration will resort to populist measures to woo voters ahead of the 2019 general election. “The uncertainty surrounding government borrowings is hanging like a sword over the bond market,” Vijay Sharma, executive vice president for fixed income at PNB Gilts in New Delhi, told Bloomberg News.

It has become conventional wisdom that politics don’t matter to markets, except when they do. Mexico peso traders are realizing this is one of those times. The peso led losses among the world’s major currencies Thursday after a former deputy in the ruling party in Mexico was arrested as part of a graft inquiry. The peso hovered around its lowest level since March as political uncertainty continued to weigh on the most-traded currency in emerging markets, according to Bloomberg News' Justin Villamil. A deepening graft investigation involving Alejandro Gutierrez, a former deputy of President Enrique Pena Nieto could imperil his party’s chances in the July elections. An ongoing scandal could also bolster the prospects of leftist rival Andres Manuel Lopez Obrador. "The news of this arrest scares investors," Jesus Lopez, a strategist at Banco Base in Monterrey, Mexico, told Bloomberg News. The peso is also the worst-performing major currency this month, falling 4.34 percent against the dollar.

Thinking of skipping work Friday to get a jump on the next week's holidays? If you're in the markets, you might want to rethink those plans. The last day of the week will bring a slew of economic data, with reports on personal incomes and spending, inflation, durable goods orders, new home sales and consumer confidence. And that's just in the U.S. There's some pretty important data on tap in the U.K., Germany, Italy, Canada, Brazil and Mexico as well. Analyst are forecasting that the U.S. data will reinforce the idea of an economy that is gaining strength, with both incomes and spending expected to come in a bit better than average with little evidence that inflation is accelerating. In other words, happy holidays!

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