Rising Rates Reintroduce Concerns

Monday, May 21, 2018 – Trade, Treasury, Trump. Three Ts that have caused a mixed week for investors, as trading was scattered amid a flurry of both positive and negative headlines. The 10-year Treasury yield reached 3.11%, its highest level since 2011 and headlines regarding trade negotiations were also in the spotlight. The good news is that rates are rising for the right reasons. Inflation expectations have been set with the confidence of continued gradual rate hikes, led by a lift in wage growth, reflecting a healthier economy and full employment. But government borrowing costs are continuing to grind upwards, putting pressure on U.S. stock indexes: Dow Jones -0.1%; S&P 500 -0.2%; Nasdaq -0.4%.

However, unlikely interest rates have reached a level that will begin choking off economic growth. In prior stock market peaks back to 1987, the 10-year yield averaged 6.5% at the market’s peak. That being said, rising interest rates are the most credible threat to the economic cycle and while we are not there yet, this expansion will ultimately end as Fed rate hikes and longer-term rates reach restrictively high levels.

Looking ahead, geopolitical tensions will provide some ongoing underlying support to oil, which will help limit crude prices from returning near that triple-digit mark. It must be noted that crude prices have risen to a three-and-a-half-year high, driven by concerns over potential sanctions limiting Iranian supply along with production cuts in the Middle. At over $78 per barrel of Brent Crude, oil prices have risen sharply but remain well off of the $100 mark for the next few years. On the upside, higher crude prices are will provide a boost to energy-sector profits and have thus contributed to the recent stock market rebound.

Turning to emerging market equities, an asset class that has struggled somewhat in 2018 after a very strong performance last year. The main culprit, a rise of the U.S. dollar, because emerging market companies have a load of debt denominated in US dollars. The dollar index has risen nearly 4% over the past month, rising to a five-month high last week. At the same time, roughly 40% of S&P 500 profits come from international markets. However going forward, we expect to see outperformance in emerging markets as the dollar’s rise tampers off.

Watching for any key stocks making big moves last week along with the ETF Global Behavioral 25 and ETF Global Quant Movers, we saw big movement in Global Markets, specifically Europe and Latin America, as well as a blowout in utilities. Key funds included Utilities Sector SPDR Fund (XLU), iShares Edge MSCI Multifactor Utilities ETF (UTLF), First Trust Latin America AlphaDEX Fund (FLN), and Shares MSCI Italy Capped ETF (EWI). We do expect the prospective focus to be on interest rates, trade negotiation and corporate cash flow, which will be a driving force for volatility for the remainder of the year. Sorting this week’s ETFG Quant scores based on momentum, you’d see essentially nothing but hedged equity funds. Investors should prepare by rebalancing their portfolios with a mix of stocks and bonds based on their risk comfort.

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