• A generally positive tone to earnings season supported stocks last week, but investors finally showed signs of fatigue.
  • Earnings have generally beat expectations in the U.S. and Europe. Still, last week saw aggressive selling of risky assets.
  • Outflows have been particularly pronounced for high yield bonds.
  • More volatility is possible in the near term for high yield, but we would hold course with the asset class.

Stocks Retreat After Hitting a New Record

Stocks initially pushed higher last week, with equities in the United States hitting a new record before retreating on Friday. For the week, the Dow Jones Industrial Average slipped -0.10% to 16,969, the S&P 500 Index edged up 0.12% to 1,978 and the tech-heavy Nasdaq Composite Index climbed 0.39% to 4,449. Meanwhile, the yield on the 10-year Treasury dipped slightly from 2.48% to 2.46%, as its price correspondingly rose.

A generally positive tone to earnings season supported stocks last week, but investors finally showed some signs of fatigue, or at least general nervousness, over what has become fairly lofty stock prices. Last week saw aggressive selling of risky assets, including U.S. equities and high yield bonds. On the latter, we would expect more volatility in the near term, but for long-term, income-oriented investors, high yield still represents a good source of income.

Earnings Season Lends Support

A decent second-quarter earnings season lent support to stocks. In the United States, roughly 80% of companies reporting earnings have beaten analysts’ profit estimates, while 69% exceeded sales projections. Profits at S&P 500 companies appear to be on a pace to rise 6.2% in the second quarter, with sales gaining 3.3%, both comfortably ahead of analyst estimates. Last week witnessed strong earnings from key companies including Microsoft, Facebook and AT&T.

Even Europe, where earnings have disappointed the last few quarters, is showing some improvement. A healthy 65% of European companies have beat expectations, versus a historical average of 62%.

A Surprising Sell-Off

Still, what is interesting is that despite the genuinely positive tone to earnings, investors appear to be selling the rally. We saw $4.2 billion exit global exchange traded products last week, representing the first weekly outflow since late May. Selling was particularly aggressive for U.S. large caps, which lost $6.8 billion, while European equities lost $600 million in their third straight week of outflows. Emerging markets defied the trend. A shift in investor sentiment made it one of the few segments to experience inflows.

High Yield Hit Hard

Outflows were particularly pronounced for U.S. high yield bonds.

High yield is often thought of as the most “equity-like” segment of the bond market. Still, we find the recent outflows somewhat surprising. The interest rate environment has remained remarkably stable, with the yield on the 10-year U.S. Treasury stuck around 2.50%. Investors have continued to buy bonds amid persistent geopolitical unrest and a stable inflation environment. Indeed, last week provided more evidence that inflation is not an imminent threat. U.S. consumer inflation was in line with expectations, up 2.1% year-over-year, while core inflation actually surprised to the downside with a 0.1% increase. This put the year-over-year number at 1.9%. Despite recent fears over higher prices, for now, core inflation remains well anchored at its10-year average.

"High yield is often thought of as the most “equity-like” segment of the bond market. Still, we find the recent outflows somewhat surprising."

Even with the lack of volatility in rates and a generally positive tone to the bond market, high yield flows have turned negative. Over the past two weeks, $4 billion has come out of high yield mutual funds and exchange traded funds (ETFs). We saw $1 billion leave high yield ETFs last week alone. The recent selling has pushed yields up around 0.40% from their June lows.

High yield has seen significant inflows over the past several years, a result of investors’ quest for yield in a low interest rate environment. Given that, more outflows and volatility are certainly possible in the near term. However, for investors with a longer time horizon, we would hold course. We still believe the supply/demand balance is favorable and that high yield continues to offer attractive yields relative to the alternatives.

The Short End of Short Duration

In this week's video, Jeff Rosenberg discusses the implications of rising interest rates and the importance of shortening your duration but not owning short duration.

2014 Outlook

The List: What to Know, and Do, in the Second Half of 2014

The first half of 2014 was not without a few surprises. What’s in store for the remainder of the year? Find out what every investor needs to know.

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