U.S. bond yields are the highest in seven years, the dollar is strengthening, emerging markets are wobbling and oil is up to US$80 a barrel. Yet there is an unlikely oasis of calm out there: stocks.
There are many possible reasons for this, including: U.S. tax cuts boosting earnings expectations and share buybacks, exchange rate moves, a sense a 3 per cent Treasury yield was already priced in and a belief that the turmoil in the emerging world is and will remain isolated to certain countries.
Since the 10-year U.S. yield and dollar really began to take off in mid-April, increasing the pressure already bearing down on emerging markets, the world’s major equity indiEXes have held steady or rallied.
There is a question mark over how long stocks can remain immune from this tightening of global financial conditions, bubbling inflationary pressures and geopolitical tension. But, for now at least, investors aren’t interested in the answer.
Investors poured US$11.9-billion into global equity funds in the latest week, mostly into U.S. funds, according to BAML. That’s the biggest inflow in two months and the fourth weekly inflow in a row.
Exchange rate moves have been a boon to Japanese, euro and Britishstocks. Since April 17, when the U.S. dollar, U.S. bond and emerging market moves cranked up a gear, the yen has fallen 3.5 per cent, the euro’s down 4.5 per cent and sterling is off 5.5 per cent.
In that time the Nikkei has gained 5 per cent, the euro STOXX 50 is up 2.8 per cent and the FTSE 100 is up 7.5 per cent. Euro zone stocks have also coped with yet another bout of messy Italian politics, which hit bonds hard, while Britishstocks have ignored deteriorating economic data and growing confusion at the Bank of England.
Based solely on exchange rate differentials, these markets might have been expected to rise as much as they have. But Wall Street and Asia ex-Japan, which are most exposed to higher U.S. yields and stronger dollar, are up too. Albeit just.
The VIX index of implied volatility, still considered the benchmark measure of investor fear surrounding U.S stocks, has drifted to 13 per cent, its lowest since just before the ’volmageddon’ spike in early February.
Wall Street got a shot in the arm from first quarter earnings. They rose 26 per cent from the same period a year ago, in part thanks to the dollar’s biggest annual decline last year since 2003.
U.S. President Donald Trump’s tax cuts, which were finally pushed through in December, have also boosted future earnings expectations and unleashed a wave of share buybacks and corporate merger and acquisition activity.
U.S. stock repurchases in Q1 were US$137-billion, the strongest quarter in two years. Apple announced a US$100-billion buyback plan earlier this month, giving credence to research firm TrimTabs’s view that buybacks in 2018 will “smash totals from all other previous years.”
In recent weeks, T-Mobile and Sprint agreed to a US$26-billion all-stock merger and Marathon Petroleum agreed to buy rival Andeavor for more than US$23-billion in the largest-ever tie-up between U.S. oil refiners.
It’s not just U.S. Mergers and acquisitions activity that’s taking off. According to Deals Intelligence, a Thomson Reuters company, global M&A so far this year has reached US$1.85-trillion, up 67 per cent on the same period last year. Cross-border M&A has doubled to US$836-billion.
If buybacks and merger-mania are sweeping across developed markets, the same cannot be said of emerging markets. Argentina and Turkey, which boast two of the largest current account deficits in the world, have been hit particularly hard by the dollar and U.S. yields.
There are country-specific factors at play there, such as Turkish President Tayyip Erdogan exerting his influence over monetary policy. But investors are generally betting, for now at least, that these two crises will remain localized.
And while the 10-year Treasury yield’s break higher to a seven-year high of 3.12 per cent is eye-catching, it hasn’t taken anyone by surprise. Or at least it shouldn’t have.
Last September, the 10-year yield was close to 2 per cent. Bonds then embarked on a near-uninterrupted slide and the yield nudged 2.95 per cent in February, so the break above 3 per cent when it finally came a few weeks ago would hardly have spooked equity investors.
These are reasons why stocks have held up so far, but there’s no guarantee they will remain supportive. The pain from increasing dollar strength and higher U.S. yields could spread through corporate America. Emerging market turmoil could deepen. The positive affect from the tax cuts will fade.
Any one of these could alter investor sentiment toward stocks. And quickly.