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Overview

  • Stocks advanced last week, led by the U.S. and Europe, both thanks to and in spite of economic news.
  • The gains came amid positive economic data in the U.S., but the opposite in Europe.
  • The buoyant investor sentiment seeped over to the more-aggressive segments of the fixed income markets, such as U.S. high yield.
  • It is not stocks, but "safe havens" such as gold and shorter-duration U.S. Treasuries, that may be the most vulnerable in the near term as rates ready to normalize.

Stocks Soar ...

Stocks rallied last week on better U.S. economic data and optimism for further monetary accommodation in Europe. The Dow Jones Industrial Average added 2.03% to close the week at 17,001, the S&P 500 Index rose 1.71% to 1,988 and the Nasdaq Composite Index advanced 1.65% to 4,539. Meanwhile, the yield on the 10-year Treasury rose from 2.35% to 2.41%, as its price correspondingly fell.

The stock market continues to wrestle with a series of counterforces, and for now, low rates and an improving U.S. economy are trumping full valuations and lingering geopolitical risks, allowing stocks to move higher. In fact, it is not stocks, but some of the safe haven assets — notably gold and short- to intermediate-duration U.S. Treasuries — that may be the most vulnerable in the near term as a period of interest rate normalization approaches.

... Both Thanks to and in Spite of Economic News

As markets have stabilized over the past couple of weeks, investors appear to be recommitting to equities. We saw $17.9 billion flow into equity funds last week amid a rally that was led by U.S. and European stocks.

Ironically, last week’s gains were driven by tangible evidence of an economic acceleration in the United States and the exact opposite in Europe. In the U.S., most of last week’s data confirmed that the second half of the year should be stronger than the first. Housing starts surged in July to a better-than-expected 1.1 million, helped by a drop in mortgage rates (30-year conventional mortgage rates are down 0.40% from the start of the year). At the same time, existing home sales rose to a 10-month high. Additionally, in a further sign of improvement in the labor market, continuing jobless claims fell to the lowest level in more than seven years.

In contrast, European equities — which narrowly outperformed the United States — rose despite slowing euro-area manufacturing. Investors, it seems, put a positive spin on further weakness, hoping it might lead to more aggressive action by the European Central Bank (ECB). It’s another example of the “bad news is good news” phenomenon we remarked on last week.

"Traditional “safe haven” assets such as shorter-term U.S. Treasuries and gold may, in fact, be more vulnerable than stocks in the near term."

The buoyant investor sentiment appeared to seep over to the more-aggressive segments of the fixed income markets, such as U.S. high yield. As we discussed several weeks ago, high yield is no longer cheap, but we believe strong fundamentals and low default rates justify current valuations. This is arguably one reason why sentiment seems to have turned, with flows going back into the asset class and spreads once again tightening relative to Treasuries.

Interest Rate Normalization in the Offing

U.S. and U.K. inflation came in at or below expectations last week. Still, both the U.S. Federal Reserve (Fed) and the Bank of England appear ready to start normalizing interest rates soon. While the Fed is still noting the slack in the labor market, recently released minutes and comments from the central bank’s Jackson Hole Symposium suggest that a period of rate normalization is approaching. We expect this process of normalization to begin in the first half of 2015, but rates are still likely to remain relatively low.

How should investors position for a rate hike? While longer-term interest rates have remained stable, the prospect for an early Fed tightening is exerting downward pressure on the prices of shorter-maturity Treasury bonds — particularly those with two- to five-year maturities — and pushing yields higher. We continue to suggest investors exercise caution in these maturities, as we expect they will prove the most vulnerable if the Fed accelerates the timetable of the first rate hike.

Also Sensitive to Rising Rates? Commodities

In addition to short-maturity bonds, another asset class that is proving vulnerable to rising rates is commodities. The prospect for tighter monetary conditions is driving the dollar higher and putting downward pressure on many commodities.

Stronger economic data and the prospect for tighter monetary conditions pushed the dollar to its highest level since last September. Along with a stronger dollar, the potential for higher real (i.e., inflation-adjusted) rates and a declining geopolitical risk premium have pushed the gold price down 5% from its July high. Other commodities have suffered as well: Most agricultural commodities are down between 5% and 10% year-to-date, and oil prices have slid on less angst over Iraq and the Middle East.

All of this suggests to us that traditional “safe haven” assets such as shorter-term U.S. Treasuries and gold may, in fact, be more vulnerable than stocks in the near term. Although not cheap, stocks have the tailwinds of still-low rates and improving economic conditions at their back.

3 To-Dos for Bond Buyers


In this week’s video, Jeff Rosenberg discusses why this year is an inflection point in monetary policy and reveals three things bond buyers should be doing now.

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