Stocks Notch a Positive Week
U.S. stocks rebounded last week, despite surrendering some gains on Friday following a confrontation on the Ukrainian border. Overall, the Dow Jones Industrial Average gained 0.66% to close the week at 16,663, the S&P 500 Index rose 1.22% to 1,955 and the Nasdaq Composite Index advanced 2.15% to 4,465. Meanwhile, the yield on the 10-year Treasury dropped from 2.41% to 2.35%, as its price correspondingly rose.
Interestingly, the stock market advance was largely driven by investors treating bad news as good news, perhaps hoping for either a continuation or increase in monetary stimulus. Ultimately though, relative value is the order of the day, and has become a key differentiator of performance. Against this backdrop, Japan and emerging markets in Asia maintain particular appeal.
The Power of Perception
Last week’s stock gains can be partly attributed to a perception that geopolitical risks in Ukraine and the Middle East were abating—at least until Friday when the border tension in Ukraine delivered a dose of reality.
However, investors also bid up stocks on the back of generally weak economic data, including another soft U.S. retail sales number, stagnating growth in the eurozone and slowing loan growth in China. The common theme in all of these instances was optimism for either more aggressive monetary and/or fiscal stimulus or, at the very least, a continuation of already easy monetary policy. One specific case in point: U.S. stocks rose sharply on Wednesday amid weak U.S. retail sales. Investors, it seems, thought the news might reduce the odds of an early Federal Reserve rate hike.
Low Rates Help Stocks Shine
Also helping to support stocks is the fact that interest rates have been grinding lower, contrary to all expectations. The drop in rates can be partially explained by the still-uneven nature of the U.S. recovery. While the broad economy is improving, there are persistent pockets of weakness, such as household spending. Retail sales unexpectedly stalled in July and have notched average monthly gains of just 0.3%, below the post-crisis average. While the consumer should be benefiting from a more robust labor market, the lack of income growth remains a significant headwind.
But beyond the challenges facing the U.S. economy, rates are also being suppressed by softness in other countries. Ongoing economic weakness and the lingering threat of deflation have pushed down European bond yields; German Bund yields traded below 1% last week, an all-time low. With lower European yields making the United States more attractive in comparison, Europe’s slowdown is contributing to the persistence of low rates in the U.S. In turn, low rates are helping to support stocks, as investors have little choice but to search for return, and even income, in other asset classes.
Relative Value at Work
Against this backdrop, investor behavior points to a continued search for value. Last week, money continued to flow into emerging markets and U.S. large caps; we also saw a reversal back into high yield. At the same time, assets are leaving other market segments with more aggressive valuations. One example: U.S. small caps, assets we’ve been cautious on for some time, continue to experience outflows. Last week, $1.2 billion came out of U.S. small-cap exchange traded funds, bringing the total outflows since March to $10 billion.
In contrast, Japanese stocks rallied 3.5% last week, despite a sharp contraction in second-quarter gross domestic product. The rally is partly explained by a proposed asset allocation change on the part of the GPIF—Japan’s largest pension fund—in favor of domestic equities. But there is another factor at work as well: While Japan is still facing several headwinds, much of the bad news is already reflected in market pricing. At 1.4 times book value, Japanese stocks are roughly 50% cheaper than those in the United States. So despite lingering economic headwinds, relatively cheap valuations have been attracting buyers, a trend we would expect to continue.
