Peaky Bonds and Bearish Stocks

The US economy has maintained strong growth with unemployment levels still at a 17 year low measured at 4.1% with real annual GDP growth for the final quarter of FY17 measured at a rate of 2.6%. The performance of the US economy and stock market has resulted in gains for other economies contributing to the global GDP growth rate of 3.7%. The growth in US GDP has been driven by numerous factors, including residential and non –residential expenditure, federal government spending and exports.

US treasury yields have risen above 2.7%, reaching a peak not seen since 2015. In fact, Global bond markets are enjoying rallies due to a hawkish stance by the European Central Bank President Mario Draghi who claims that global economic conditions will improve and markets around the world will recover. The ECB stated that a reduction in stimulus spending throughout major banks worldwide would take place due to a recovering global economy. This indicates that the world has moved a fair distance from the austerity status quo of the Recession era: this was evident in German 10-year bonds which rose to a value of 0.625% not seen since early 2016.

The catalyst for a long lived stock market rally has been the difference between the income generated via investing in equities and the income generated via investment in fixed income securities. As Treasury yields rise they will lower the yield generated by equities indices relative to fixed income indices resulting in greater resistance or pressure that must be broken for stock markets to rise. Numerous economists warn that US Treasury yields could rise even higher, to a target of 3.00% which could place the majority of US equities in danger.

One can argue that such negative effects on equity markets have already been seen through the decline in US stock market indices, Dow Jones dropped by 0.4%, S&P 500 decreased by 0.36% and the NASDAQ 100 dropped by 0.29% on the back of rate hike expectations. Furthermore the CBOE Volatility Index (VIX) has increased from its record low of 9 points to 13.21 points, indicative of increasing investor uncertainty.

The effects of an optimistic ECB as well as US Treasury yields rising to three year highs were also felt in the Chinese economy where the Hang Seng dropped by 0.56% and the Shanghai SSE Composite 300 fell by -0.97%; the only optimistic stock market index the Asian region was the South Korean KOSPI which increased due to strong performance by Samsung a major Korean retailer of electronics and a competitor to Apple rising by 0.87%.

The US tax reform policies implemented by President Donald Trump via a $1.3 trillion dollar tax cut have resulted in a decrease from the previous corporate tax rate of 35% to a value of 21%. The benefits of this tax reform legislation are an increase in excess of $4,000 dollars for the average American household income, while major technology giant, Apple, has announced that $245 billion of its profits will stimulate the American economy with a total amount of $350 billion projected to nourish the US economy over the next 5 years.

The US dollar has dropped below its peak in early to mid-January of 92.5 US cents v. DXY (a weighted basket of foreign currencies) to a value of 89.0 US cents as a result of investor confidence weakening due to President Trump’s aggressively isolationist and discriminatory rhetoric particularly regarding immigration from second and third world countries. Other potential reasons for the declining US dollar are increased bullish growth in global markets which result in increased financial competition according to IMF analysts; the US dollar has not dipped below its 90 cent threshold since December 2014.

The US Composite Purchasing Managers Index (PMI) was measured at 53.8 points a decrease from 54.1 points in December 2017, the manufacturing PMI was measured at 55.5 points increasing over December 2017 with non-manufacturing PMI measured at 55.9 points decreasing from Dec 2017 and business confidence measured at 59.7 points a marked increase over Dec 2017. Industrial production was measured at 3.6% increasing by 0.1% accompanying a manufacturing production rate of 2.4% which decreased by 0.1% relative to Dec 2017 with consumer confidence measured at 94.4 points and economic optimism measured at 55.1 points an increase over Dec 2017.

The US under Trump’s America First isolationist doctrine has not ratified the Trans Pacific Partnership Agreement which aims to balance or negate excessive Chinese economic and geopolitical influence in the Asia-Pacific region. The possible hints of a trade conflict between the US as well as rival economies such as China and even the European Union could exacerbate the effects of high bond yields resulting in market volatility.

The U.S Treasury Secretary, Steve Mnuchin has stated that a slightly bearish US dollar is excellent for US exports as well as investment in the US economy; US exports had increased by 5.5% in the last year. Further impetus for the US economy include the introduction of new Federal reserve Chairman, Jerome Powell who will step in to replace Janet Yellen as she steps down in the final days of January passing on excellent economic conditions. The US economy looks set to be cultivated by an experienced, hawkish and thorough chairman. It remains to be seen what Powell’s stance regarding increasing Treasury yield rates will be with regards to stock market performance.

The benefits for numerous businesses as well as middle class individuals from Trump’s reforms have yet to be completely felt and will likely result in sustained growth for the American economy. The President himself has stated that the US economy and dollar will remain strong and such performance would greatly boost an economic rally however investors should keep an eye on US inflation as well as broader global economic performance relative to the US which could result in a decreasing US dollar and could affect the economy more than yield rate increases

US Treasury yields will play a crucial role in the health of equities within the US as well as globally where a combination of factors such as a high unemployment rate, an uncertain fluctuating US dollar, increasing government debt as well as four possible Federal Reserve inflation rate hikes along with an increasingly likely 10 year Treasury yield of 3.00% will define whether the US economy rises or falls.

By Miguel Alzona

 

This content has been written and published by KOSEC – Kodari Securities.

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