Market Roundup - March 2013
March: Lions, lambs, and chickensBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
With the Italian election and the run-up to the sequester in the U.S., February was a politically noisy month. Ben Bernanke, chairman of the Federal Reserve (Fed), gave reassuring words to the markets during his testimony before Congress. Despite all that excitement, March could be an even more interesting month. People say that when it comes to the weather, March goes in like a lion and out like a lamb—a saying that could also apply to the markets. Depending on how events unfold, it could be more of a lion throughout the month, especially as U.S. politicians are likely to play chicken with the federal budget.
The economyBy Brian Jacobsen
In February, Italians went to the polls to elect representatives to the lower and upper houses of parliament. The center-left coalition, headed by Pier Luigi Bersani, won a plurality of seats in the lower house, but the center-right coalition, headed by former Prime Minister Silvio Berlusconi, won a plurality in the upper-house. Beppe Grillo, head of the opposition Five Star Movement, made a notable showing. Because the Five Star Movement has refused to join forces with either Bersani’s or Berlusconi’s coalition, it looks like President Napolitano may have to call for a new election. Alternatively, and quite likely, Bersani and Berlusconi will need to form a grand coalition. This grand coalition wouldn’t likely be able to make much progress in terms of further reforms, but it would prevent Italian policies from backsliding.
U.S. politics were equally indecisive. The sequester—the $85 billion in reduced budgetary authority for defense and discretionary nondefense accounts—wasn’t averted…yet. The reduction in spending authority—which isn’t the same thing as a reduction in spending—may result in a decline of approximately $45 billion for the affected programs and agencies. It’s not nothing, but we don’t think the near- or long-term effects will be earth-shattering for the economy or the markets. Considering that the sequester could be undone with a budget agreement, we see no reason to change our economic forecasts because of it.
The budget agreement could be the real challenge. Because a federal budget hasn’t been passed since 2009, programs and agencies have been funded through six-month continuing resolutions. The latest one expires March 27. An agreement could undo the sequester, but it’s also possible that Congress and the president won’t come to an agreement. In that case, the federal government would be shut down. A government shutdown wouldn’t actually stop the government from functioning. Essential services (defense, safety, health, and tax) would continue. Nonessential services, such as the national parks, would close. A short shutdown wouldn’t have much of an effect on the economy. A protracted shutdown could drag on growth. It could also be a drag on politicians’ popularity. Voters may have blamed President Bill Clinton for the 1995–1996 government shutdown—but Clinton’s popularity soared afterward. How the budget debate turns out may depend more on polling numbers than economics. One thing is quite likely: If they don’t get their way, politicians will sound like Chicken Little, claiming that the sky is falling.
Offsetting some of the political problems, the Fed and other central bankers seem ready to help investors. In testimony before the House and the Senate, Chairman Bernanke basically said that the economic recovery continues to be moderate but uneven. The labor market is improving only gradually, while inflation is staying low. Low inflation is likely due to slow wage growth relative to productivity growth (also called unit labor cost) and tepid growth in private-sector credit. The chairman also effectively silenced the Fed members who believe the Fed should stop its asset purchase program. These members have been leading investors to expect an early end to quantitative easing. But according to Chairman Bernanke, the benefits of additional asset purchases—keeping housing affordable, driving down the cost of financing automobiles and durable goods, and helping corporate cash flows through cheap credit—outweigh the costs of more asset purchases, which would create credit market distortions and concerns about future inflation.
For those who are worried about what might happen if the Fed loses money on its portfolio of securities, it’s important to note that part of the Fed’s legislative mandate is to keep “long-term interest rates moderate.” In other words, the Fed has three mandates, not two: maximum employment, stable prices, and moderate long-term interest rates. That means the Fed has political cover to keep intervening in markets to make sure it doesn’t lose money on its portfolio. Even if it does lose money on its portfolio, the Fed could absorb the losses without compromising its ability to conduct monetary policy by creating a deferred asset on its balance sheet.
After the March 19–20 Federal Open Market Committee (FOMC) meeting, the FOMC will release its updated summary of economic projections. The projections will likely become the most important economic data releases for investors. If the FOMC accelerates its schedule for dropping the unemployment rate below 6.5%, or if inflation exceeds 2.5%, investors will likely react by selling Treasuries, thereby increasing yields. Whether this scenario would help or hurt stocks depends on how the projections change. If they change because unemployment is expected to fall faster, stocks will benefit. If they change because inflation is beginning to pick up, stocks will suffer. Based on the Fed’s statements and our forecasts, we might not need to worry about changes to the projections until the June meeting.
EquitiesBy John Manley
February may be short on days but, this year; it was not short on excitement. One day, the release of the most recent FOMC minutes raised what we believe to be premature fears of an early end to quantitative easing. Less than a week later, the market stumbled again—this time in reaction to what appeared to be a hung election in Italy and fears of an abatement of that nation’s fiscal austerity commitment. But even with the approach of the sequester, U.S. stocks had an almost unremitting upward bias. We believe that the Fed’s policy of positive monetary pressure is exerting a positive influence on equities and should continue to do so in the absence of any severe disappointment or shock. Moreover, we sense that individual investors who, since 2009, had banished equities to the periphery of their investment horizon are now actively reconsidering this decision. While any of a number of issues that overhang the market could produce a 5% correction at any time, we believe that such a correction is somewhat anticipated and that anticipation may short circuit any pullback.
In the U.S. marketplace, the S&P 500 Index managed a 1.4% gain despite the setbacks. The larger-capitalization, higher-quality Dow Jones Industrial Average outperformed this with a 1.8% advance. The equally weighted Value Line Composite Indexes lagged with 0.7% (arithmetic) and 0.3% (geometric) gains. Growth slightly lagged value as the Russell 3000 Growth returned 1.2% and the Russell 3000 Value returned 1.4%.
Among the groups and sectors, there was a clear bias against cyclicality. The consumer staples sector, with a 3.2% gain, was the clear winner in the month. Also outperforming was the telecommunication services sector (up 2.6%) and utilities (up 2.2%). We are neutral on all of these sectors, but, in our opinion, the staples offer the best longer-term growth potential (offset, to a degree, by rather full valuations). The only cyclical sector to outperform was the industrials sector, which gained 2.5%. This may be due to improvements in some of the early indicators of domestic manufacturing activity.
The only negative return was posted by the materials sector. The drop of 1.5% reflects our opinion that, at the very best, it is too early to make a major commitment to commodities. A strong dollar may have had an influence in the short run but, longer term, we are far from certain that China can reemerge as the dominant force it was in the past. The energy sector, where we would focus on integrated large-capitalization companies, also lagged, with a meager 0.4% advance. Health care, another of our favorites, lagged slightly, with a 1.3% gain. We would focus here on large-capitalization pharmaceutical and device companies that should be able to profit from an increase in tax-payer-funded health care spending.
The international markets, on balance, lagged the U.S. In Europe, the best performers were the peripherals, which have suffered fiscal contractions in recent years. Ireland gained 5.9%, and Greece advanced 2.2%. Among the larger economies, only the Financial Times Stock Exchange 100 Index, a market-cap-weighted index of stocks traded on the London Stock Exchange, and Switzerland were higher, up 1.8% and 3.4%, respectively. As might be expected because of electoral issues, the worst-performing market was Italy, with an 8.7% decline. While the news there was not positive last month, we are reasonably hopeful that the situation is not as bad as the markets have painted it.The emerging markets were an unhappy group. The stocks of Brazil, Russia, India, and China—the BRIC countries—fell like bricks, with Argentina the worst performer. The equity market there suffered a 12% drop on fears of a deliberate default on some government paper. That the issue may be political makes it no less serious in our opinion. Russia and India suffered from concerns about economic growth and fell 5.4% and 5.2%, respectively. Brazil declined 3.9% during the month, as political uncertainty exacerbated economic issues. China’s -0.8% decline seemed modest in comparison, but it is worrisome that its market, like Russia’s and Brazil’s, remained down year to date.
Fixed incomeBy James Kochan
Bond market returns were uniformly positive in February but, in many sectors, not strong enough to overcome poor January results. Consequently, Treasuries and the sectors that respond most directly to movements in Treasury yields still have negative year-to-date returns.
Yields on 5-year and longer Treasuries fell 10 basis points (bps; 100 bps equals 1.00%) in February but remained in the narrow ranges in place since November. A yield above 2% on the 10-year note appears to have attracted buyers, especially in light of unsettled market conditions in Europe. This rally could be due, in part, to elections in Italy, which have rattled the euro markets somewhat.
Returns from mortgages and investment-grade corporate bonds have become unusually sensitive to movements in Treasury yields. Because spreads to Treasuries in those two markets are now relatively narrow, they have lost much of their cushion against rising (or falling) Treasury yields. This is especially true in the mortgage market, where spreads are approximately one-half of those prevailing before the Fed began buying $40 billion in mortgage-backed securities (MBS) a month. Investment-grade corporate spreads are not that out of line, but they are approximately 25 bps narrower than what might be considered typical for this stage of an interest-rate cycle. As a result, yields increased along with Treasury yields in January and fell in February.
In the high-yield corporate market, where spreads to Treasuries are not unusually narrow, total returns were stronger in January than in February. Yields rose slightly in February, which was perhaps a reflection of some buyers’ resistance to the low yields of January. As is typical during a month of modest returns, the CCC- and lower-rated credits did not outperform the B-rated issues in February. Year to date, however, returns from high yield are strong, and the CCC index return is 3.6% versus 1.8% for the B index and 1.2% for the BB index.Almost all of the total return from municipals in February came from coupon income, as prices were essentially unchanged. Because of wide quality spreads, the A and BBB credits continued to outperform the high grades. Over the past two months, returns from the A/BBB sectors have been double those from the AAA/AA sectors. Ratios to Treasury yields remained generous, which kept the municipal market somewhat insulated from swings in Treasury yields. For example, the ratio of 10-year A-rated municipal yields to Treasury yields is now 1.5, far above the 0.80–0.90 range that prevailed in the decades before 2008.
Table 1: Bond market total returns (%)
Asset allocationBy Brian Jacobsen
For investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Short-term, over the next three months, we think investors can still be rewarded by looking at higher-yielding fixed-income investments as well as growth-oriented equities.
From a valuation perspective, we think there are still opportunities, especially in a globally diversified equity portfolio, but there are reasons to stay agile and manage downside risks. Eurozone and Japanese equities have performed relatively well, thanks to Mario Draghi’s pledge to do whatever it takes to keep the eurozone together and Shinzo Abe’s pledge to increase the Bank of Japan’s inflation target. Time will tell if the Draghi/Abe dyad will succeed, but investors have responded to it positively thus far. We think investor sentiment is still sour but improving, which should be positive for these areas.
Value versus growth
The global economy is likely to grow 3.5% to 4% in real terms for 2013. It’s not stellar growth, but it’s still growth. We think investors are on high alert for the next crisis, meaning that even mediocre economic results could be surprisingly positive. Against this backdrop, we prefer looking for mispriced growth opportunities globally across the value spectrum and value opportunities in the growth spectrum. We believe many opportunities exist in technology, broadly defined as the way inputs are converted into outputs in a more efficient way, which argues, we believe, for investing in business-facing businesses rather than consumer-facing businesses.
Large caps versus small caps
While we still think large-cap companies are better positioned for global growth than small-cap companies, we also believe that small- and mid-cap companies should not be ignored. It’s more important to be discerning about a company’s economic exposure than to base your judgment on its size.
Fixed incomeBased on our economic outlook, we believe interest rates are likely to remain low for the next year. This presents an opportunity for investors to take on additional duration and credit risk, but we prefer more credit risk rather than more duration risk. Provided the economy does not dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues would.
Asset allocation summary table1
The bottom lineInvestors are chomping at the bit to jump into equities, which we think is capping their downside. When everyone is waiting for a pullback, the pullbacks that occur tend to be shallow and short. Fixed-income downside—short term—seems also to be capped, thanks to the likely intervention of central banks. We think the political risks of March argue for Treasury yields staying low but volatile. March is supposed to come in like a lion and go out like a lamb. Instead, we could hear lots of roaring from politicians throughout March, keeping investors sheepish.