Equity fatigue continues with headwinds from bond sell-off, Doll says

U.S. equities finished lower for the second straight week as the S&P 500 declined 2.04%, narrowly escaping its worst week of the year. A specific catalyst behind the pullback was not identified by us or market analysts. Media reports focused on the tapering debate, shareholder activism and the emergence of the Eurozone from a record long recession. Increased violence in Egypt did not appear to be a major factor in the decline; however, crude oil prices gained almost 2% for the week and precious metals rallied. U.S. bond yields backed up again, which depressed equities in the U.S. but did not impact the rest of the world. Emerging market equities were up 0.78% for the week.
Given the U.S. Treasury yield rise of more than 100 basis points since the start of the year despite lower inflation, lower growth and accelerated quantitative (QE) buying around the world, a possible explanation includes an imminent end of easy money that is forcing unwinding of fixed income holdings. Obviously this asset class has been the primary beneficiary of loose global monetary policy over the last five years.
Initial unemployment claims dropped to a new low for the expansion, decreasing 15,000 to 320,000. Over the last three months, unemployment has moved largely sideways. As claims decline, this increases the odds increase that the Fed will taper QE in September, and second half economic growth may improve somewhat.
Growth in business capital expenditures normally exceeds overall GDP growth by a wide margin during the early years of business cycle recoveries. That has not been the case during this cycle. We expect acceleration in business spending in the coming year due to loosening credit standards, strong corporate balance sheets, high expected return on investment and reduced uncertainty from fiscal cliff policy.
The first half of 2013 revealed declining trends in employment growth, personal income growth and real retail sales growth. The deceleration in these three data series was concerning and more indicative of recessionary than recovery activity. Since the end of June, the data has shown improvement, particularly in retail sales. Progress in these areas will support the consensus view that the economy is going to be stronger in the second half of the year. We are encouraged but not convinced. We would like to see a rebound in employment because both rising employment and income will be needed to sustain the upturn in retail sales. If U.S. growth begins to gradually accelerate, this should lift third and fourth quarter GDP growth.
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The Big Picture
We believe equities are in pause mode while waiting for faster GDP and earnings growth, actual Fed tapering and/or lower oil prices. In the meantime, the equity rally is fraying somewhat with the S&P 500 simply marking time for several weeks as evidence of fatigue has set in for buyers. In absence of further valuation expansion, attention will turn to profits. We see that the anti-reflationary combination of rising oil prices, higher Treasury yields and U.S. dollar strength has intensified the drag on corporate profitability this summer. Implications for the fixed income market should calm. We think equities are moderately high risk investments from a short-term perspective because conditions appear overbought and prices have already discounted somewhat better corporate earnings
The investment backdrop appears to be experiencing a number of major transitions as safe havens such as government bonds, gold and bond proxies have fallen out of favor based on declining values. We see this as affirmation of economic activity around the world and a potential demise of the central bank liquidity boom. The good news is that there is opportunity for nominal and real GDP growth with low inflation. Much depends on the level of bond yields, the robustness of earnings and investor sentiment. We anticipate equity valuations should move higher as earnings climb, implying healthy returns. Bumps will occur when technical conditions are overbought, with equities rising faster than earnings, and/or when bond yields rise too rapidly. We believe the underlying trends remain favorable.

Bob Doll is chief equity strategist and senior portfolio manager at Nuveen Asset Management LLC. This commentary originally appeared on the firm’s website.