Market Roundup - May 2013
May: Look for progress, not perfectionBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
“How can equities be hitting new highs when there are so many problems out there?” is probably the most common question we are asked. We think the answer is pretty simple: It doesn’t take perfection to move the markets, only progress. And though it’s slow, we do have progress in the global economy. Italy was able to cobble together a coalition government, the U.S. was able to post a 2.5% first-quarter gross domestic product (GDP) growth rate, corporate earnings were able to continue growing, and even the labor market continued to add jobs instead of subtract them. This is all progress. No, it’s not perfect, but you can’t expect perfection.
The economyBy Brian Jacobsen
Global manufacturing is growing, but growth is slowing. The big question is whether growth will continue or decline. Left to its own devices, we think the global economy will continue to grow. With central banks remaining accommodative and fiscal policymakers beginning to ease off the austerity talk, we think the odds are in favor of growth.
Slow growth could foretell a continued disconnect between commodity and equity prices. Commodities were bid up on expectations of 8%-plus growth in China, and that growth looks to be slowing to a snail’s pace of 7.5% (hopefully you can sense the sarcasm), indicating that some of the air in the commodity markets might be venting. We could also continue to have low yields on fixed-income securities while valuations in equities rise. Central banks could help depress yields, and corporate profits could continue to grow faster than wages. Sure, these patterns might change some day, but it doesn’t look like this is the year for a change.
The Bank of Japan (BOJ) and the European Central Bank (ECB) seem intent on playing catch-up with the Federal Reserve (Fed). In fairness, the BOJ has tried many of the policies of the Fed in the past but never with a firm commitment. Its announcement that it will try to double Japan’s monetary base (currency plus bank reserves) over the next two years and drive inflation to 2% was met with much fanfare and a weakening yen. The weakening of the yen petered out when the BOJ started hemming and hawing as to whether it would actually hit its inflation target within two years. The BOJ may need to do more than simply meet investors’ expectations about how aggressive it will be if it wants the yen to weaken even more. We think the yen could weaken a bit more, but the big moves are probably behind us.
The ECB has a lot of room to ease monetary policy—inflation is falling and unemployment is rising. The ECB has a single mandate of trying to hit a 2% inflation target, and it really doesn’t look like there’s a near-term risk of overshooting that bogey. The problem that we see is that more easing by the ECB might bolster prices in the markets, mainly keeping fixed-income yields low but also not doing much to encourage economic growth. It’s not as though banks can’t borrow at low-enough rates. In fact, the ECB’s Long-Term Refinancing Operations were being paid back at a faster-than-expected pace. The problem is probably one of lack of lending opportunities for the banks. Not only are they being told to raise more capital, they’re doing it in an environment in which governments and the private sector are cutting back.
Policymakers are beginning to do an about-face on austerity. If this continues, it could bolster investment opportunities in the eurozone, but we need more than a change of tone—we need some real action. This about-face on austerity has been driven, in part, by the recent revelation that too much austerity too quickly creates more problems than it solves. Most economists have recognized this, but policymakers that were in favor of rapid deficit reduction were hanging their hats on research that claimed that once an economy’s debt-to-GDP ratio hit 90%—a type of tipping point for debt—it was all downhill from there. Thanks to spreadsheet errors, data exclusion, and other technical details, it turns out that the tipping point may not exist after all. The data do support the thesis that debt can be a drag on growth, but they do not support the notion that rapid debt reduction is a panacea.
In the U.S., investors seem fixated on the Fed. While fundamentals support advancing equity prices (profit growth, anyone?), day-to-day market movements seem driven by questions about when the Fed may slow its asset purchase program. We don’t think the Fed wants to mess much with the mortgage market, especially considering home sales tend to pick up during the spring, summer, and early fall. And it is not likely to shift from monetary easing to tightening. It could spend a long time in the middle: still easing, but not as much, and then into a passive stage between easing and tightening.
Because the weather has been nice and we’ve been thinking about barbecue, we believe the Fed will follow a barbecue recipe for monetary policy. Just as pork should be cooked low and slow, the Fed will likely stick to a low and slow monetary policy of keeping rates low and slowly tapering its asset purchases. Abrupt moves in monetary policy can create jarring effects in the markets. Because everyone seems to be waiting anxiously to see what the Fed will do next, we think it will move at a snail’s pace once it starts to taper, perhaps in the third quarter of 2013.
In regard to barbecue: As John Manley has pointed out, we like all types. This includes New York-style barbecue, which is burgers on the grill with friends from Brooklyn, the Bronx, and Queens.
EquitiesBy John Manley
Despite several setbacks, the equity market continued its slow, grinding advance in April and closed near all-time highs on several indexes. In a pattern that we believe is somewhat typical of a bull market, stocks suffered sharp but shallow retreats that soon were erased by small but persistent gains. First-quarter earnings results were not spectacular but neither were they disappointing. Like many other factors affecting equity prices, earnings were good enough not to offset the bullish effect of positive monetary pressure.
We continue to believe that, as is generally the case, the actions of the Fed continue to be the dominant influence on the capital markets. In the past six months, the Fed has vocally and vigorously pumped liquidity into the economy in order to stimulate its growth. That liquidity has moved through the equity market and had tended to push it higher. In our opinion, this effect has been augmented and amplified by the growing perception among investors that a risk-free investment with little or no return is, in reality, not risk-free at all. We do not view this year’s market action as a sign that investors now perceive a diminished risk in equities. Rather, we think it has reevaluated the dual risks of being in or out of risk-based assets and has decided that it’s better to be in. As one of my colleagues has stated, investors are making moves to avert the risk of going broke safely.
While the potential of an equity market correction always exists, we still see a lot of investors waiting on the sidelines for it to happen. With valuations at reasonable levels, we suspect that stocks will generally maintain an upward bias as long as the Fed continues to try to stimulate the economy—and no proof surfaces that its efforts are or will be in vain.
The S&P 500 Index finished April about 1.9% above where it began the month. This was in line with the 1.9% return posted by the Dow Jones Industrial Average but above the 0.9% gain of the Value Line (Arithmetic) Average and the 0.5% gain of the Value Line (Geometric) Average. It would appear that the market’s gain was concentrated among the large-capitalization, high-quality stocks, which we continue to favor. The Nasdaq Composite Index gained 1.9%, but this probably was a result of the poor performance of information technology stocks early in the month.
Growth seemed to do a bit better than value, with the Russell 3000® Growth Index edging the Russell 3000® Value Index with a 1.9% versus 1.4% gain in the month, respectively. However, year-to-date value has beaten growth by about 200 basis points (bps; 100 bps equals 1.00%).
Among the groups and sectors, the reach for yield by investors was obvious. The two best-performing sectors in April were both high-yielding names. The best performer was telecommunication services, with an almost 7% advance, followed by utilities, with a 5.9% gain. Other high performers were also in noncyclical areas. Health care gained 2.9% and consumer staples gained 3.1%. In fact, since the beginning of the year, these four sectors have dominated trading, and all have posted double-digit advances. It is interesting to us that these sectors have traditionally been known as early-cycle stocks, having been associated with the early phases of rising equity markets. They are believed by some to catch the early phases of Fed stimulus before it has had a chance to move the more cyclical elements of the market.
Some cyclical sectors of the market actually posted slight declines in April. The energy sector declined 0.9% in the period, while industrials dropped 0.8%. The international markets were a mixed bag, but the tone seemed to be a bit better in developed markets. The Nikkei average continued to soar in reaction to strong monetary stimulus and thus gained 11.8% (7.9% if adjusted for the weak yen). Both Italy and Greece posted strong gains that were enhanced by the advance of the euro. The emerging markets continued to see pressure, with Russia down 3.2% and Mexico off 4.1%. China and Brazil also declined, but India posted a 3.5% gain.
Overall, we would still focus on the U.S. in the short term. However, we are intrigued by indications that worsening European economic numbers may soon lead to a less austere form of austerity.
Fixed incomeBy James Kochan
The Treasury market rallied in April, enough to bring the year-to-date returns into positive territory but not enough to catch up with the returns from the corporate or municipal markets. Treasury yields declined 10 to 20 bps in response to weaker economic data in the U.S. and overseas. As a result, April’s year-to-date total returns for the 10-year and longer maturities—which were negative for the first quarter—were in the 1.4% to 1.6% range. Treasury Inflation-Protected Securities (TIPS) also performed well enough in April to pull the year-to-date return to 0.4% from a first-quarter return of -0.6%. Because of low yields and relatively small inflation adjustments, TIPS returns continued to significantly lag returns on the nominal notes and bonds, despite April’s rally.
The mortgage market also recovered somewhat in April but continued to lag the Treasury market. Unusually narrow spreads to Treasuries and heightened prepayment risk limited the ability of the mortgage-backed securities market to perform well as Treasury yields declined.
Investors were apparently quite comfortable to continue accepting a degree of credit risk. The corporate bond markets continued to outperform all other markets throughout the month. In the investment-grade arena, the BBB credits have returned 2.2% thus far in 2013, versus returns of 1.3% and 1.4% for the AA- and A-rated sectors, respectively. Bank paper outperformed strongly in 2012, but now that spreads are close to their precrisis averages, that sector is performing in line with the rest of the investment-grade market.
The high-yield corporate market continues to defy the laws of gravity. As of April 30, the 4.8% year-to-date return this year was almost as strong as the 6% return for the first four months of 2012. And once again, the CCC and weaker credits were the strongest performers. That index is up 7.6% this year versus returns of 3.8% and 4.6% for the BB and B sectors, respectively. Concerns that the high-yield market would be the most vulnerable to the great rotation into equities have thus far been unfounded.
The municipal market performed well in April, a month in which investors usually sell municipal bonds or fund shares to make tax payments. Mutual funds continued to experience net outflows through most of April and new-issue calendars were relatively full, but municipal yields declined in step with Treasury yields during the month. Extending the pattern seen over the past three years, the A/BBB sectors outperformed the AAA/AA sectors again in April. Thus far this year, the A/BBB sectors’ average return is 2.3% versus 1.4% for the AAA/AA sectors.
For bonds in general, 2013 returns are following the same patterns seen in 2012. The credit sectors have been performing well, while returns from Treasuries and those sectors most closely associated with Treasuries, such as mortgages and TIPS, have been returning significantly less. In a low-yield environment, sectors that still offer reasonable or somewhat generous spreads to Treasuries—such as BBB and high-yield corporates and A/BBB municipals—would be expected to continue to produce the stronger total returns.
Table 1: Year-to-date 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 may still be rewarded by looking at higher-yielding fixed-income investments as well as growth-oriented equities. While there could be a spring swoon (or is it a summer swoon?), we don’t expect that any loss will be deep.
Global equities still look attractive from a valuation perspective. The BOJ and ECB are likely to pick up the monetary easing baton from the Fed so looking for companies with global exposure remains our preferred strategy. Emerging markets could continue to underperform, thanks to political risks and questions about how rapidly these economies can grow. Emerging markets is a term that should be thought of as a plural noun, not a singular noun. We see more growth opportunities in places like Mexico and emerging Europe than in Brazil, Russia, India, and China—the BRIC emerging markets.
Value versus growth
Choosing between value and growth is like choosing between walking to the store and breathing. Why not both? We think pessimism about the future—of which there is plenty—has contributed to mispriced growth opportunities that nicely blend value and growth characteristics.
Large caps versus small caps
Large-cap companies are probably better positioned for global growth than small-cap companies. That doesn’t mean small- and mid-cap companies should be ignored. However, we think it’s more important to be discerning about the economic exposure of a company rather than judge it solely on its size.
Fixed incomeBased on our economic outlook, we believe interest rates are likely to remain low for the balance of the 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 table*Understanding the table
The shading on each chart could be thought of as a temperature control in a car. The blue bar represents our recommended tactical positioning for investors with a time horizon of less than one quarter. The green bar represents our recommended strategic positioning for investors with a time frame of three years or longer. The light gray line represents the neutral weight. For equities, this is the percentage of market capitalization meeting the classification criteria of a broad market index. Because the fixed-income market tends to be dominated by sovereign debt, we chose to represent the neutral weight as 50%.
The bottom lineForeign central banks, like the BOJ and the ECB, are likely to ease more, while the Fed is unlikely—over the next few months—to ease less. Inflation is low, and growth is slow. That hardly argues for monetary policy tightening. Fiscal policy is also shifting from less debt now to more growth now. These are strong forces to push asset prices higher. We think adding risk to a portfolio could pay off over the long term.