Weekly Commentary Overview

  • Equities rose last week, with U.S. markets finally showing some signs of strength. The increasing prospect that the Fed's path toward higher interest rates will be gentle, as well as continued merger-and-acquisition (M&A) activity, have helped stocks.
  • However, U.S. investors are still facing soft earnings growth and expensive valuations.
  • While we certainly would not abandon U.S. stocks, we would suggest tilting toward sectors and geographies offering relative value.
  • In particular, we believe investors should consider Asian equities and large, integrated oil companies, which are rallying despite the volatility in oil prices.

U.S. Stocks Exhibit Some Vigor

Equities rose last week, with U.S. markets finally showing some signs of strength. The S&P 500 Index rose 1.74% to 2,102, the Dow Jones Industrial Average grew 1.58% to 18,057, while the Nasdaq Composite Index climbed 2.23% to close the week at 4,996. As for bonds, the yield on the 10-year Treasury rose from 1.84% to 1.95% as its price correspondingly fell.

The increasing prospect that the Federal Reserve’s (Fed’s) path toward higher interest rates will be gentle, as well as continued merger-and-acquisition (M&A) activity, have helped stocks. However, U.S. investors are still facing soft earnings growth and expensive valuations. While we certainly would not abandon U.S. stocks, we would suggest tilting toward sectors and geographies offering relative value. In particular, we believe investors should consider Asian equities and large, integrated oil companies, which are rallying despite the volatility in oil prices.

The Fed and M&A Trump Soft Earnings

The U.S. earnings season got off to a shaky start last week with a sell-off in Alcoa. While the company beat estimates, its share price fell on news of a glut of capacity in the aluminum industry.

However, stocks benefited from soothing comments from New York Fed President William Dudley, who suggested that the pace of interest rate increases is likely to be “shallow.” Diminished Fed fears have helped to push short-term interest rates back down. Last week, the two-year Treasury note traded below 0.50% for the first time since early February. While yields bounced off of those levels and ended the week at around 0.55, two-year yields are still 20 basis points (0.20%) below their March peak.

As for longer-term bonds, despite some increase, the yield on the 10-year Treasury is still 25 basis points (0.25%) below where it started the year. As discussed in previous commentaries, foreign buying is helping to suppress long-term rates. In February, for example, Japanese investors bought their largest amount of Treasuries in seven months.

One positive side effect of the extraordinary low interest rates is a continuation, even acceleration, in merger activity. Last week Federal Express agreed to buy Dutch carrier TNT for $4.8 billion, and Royal Dutch Shell offered to buy BG Group for approximately $70 billion.

In this environment, we would still favor equities over other assets, but focus on pockets of value. One such area is Asian equities, both developed markets like Japan, as well as emerging markets. We are also seeing some opportunities in the energy sector.

Finding Value in the Face of Continued Headwinds

Despite last week’s strength, U.S. stocks still face two lingering issues: weak earnings and expensive valuations. Bottom-up estimates for S&P 500 company earnings have come down 8% over the past three months. At the same time, the S&P 500 is trading at roughly 18.5 times trailing earnings, the highest since late 2009 when corporate earnings were still depressed.

In this environment, we would still favor equities over other assets, but focus on pockets of value. One such area is Asian equities, both developed markets like Japan, as well as emerging markets. Japan continues to benefit from reasonable valuations, an accommodative central bank and increased equity buying by pension funds. Not only has the market dramatically outperformed its international peers year-to-date—up around 14%—but a stable yen has meant that returns have not been significantly eroded by a cheapening currency. We are also seeing the rally in China’s A-Shares (traded in Shanghai, but difficult for non-Chinese investors to access) extend to other markets, including the more accessible China H-Shares (traded in Hong Kong), India and South Korea.

We are also seeing some opportunities in the energy sector. We’d remain cautious on the physical commodity: Oil experienced another wild ride last week, buffeted between signs of weaker U.S. production and still-surging inventories (crude supply grew at a 14-year record rate for a single week, with inventories hitting new highs). Physical crude oil price volatility is now roughly five times the level it was last summer.

However, integrated oil company stocks appear to be bottoming. A basket of global energy companies is up roughly 8% from the March lows. Investors seem to be reacting to the relative value in the space. Stocks in this group are trading with an attractive average yield of nearly 4% and a reasonable price (just 1.5 times book value). Given our outlook for stabilization in oil by year’s end, current prices may represent good long-term value.

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Market Perspectives

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