Market Roundup - February 2014
February: Will it be short, but intense?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
January didn’t start the year well, but the markets have 11 more months to redeem themselves. We think February’s movements might mimic January’s, with short and intense movements. U.S. economic data is likely to be muddled with the continued adverse weather, and turmoil in the emerging markets is unlikely to settle down over the next few weeks. With U.S. debt ceiling talks coming to a head on February 7, perhaps the only redeeming feature of February—besides its shortness—will be that corporate earnings continue to grow.
The economy: Emerging markets aren’t likely to stay downBy Brian Jacobsen
Despite saying that tapering isn’t on a preset course, the Fed gave every indication that it will continue to cut its monthly asset purchases by $10 billion every time it meets. Neither weak December payrolls and durable goods order numbers nor turmoil in the emerging markets could induce the Fed to veer from its course. In all fairness, U.S. economic data was likely affected by weird weather in December, and emerging markets problems are somewhat of their own making. But, the Fed would have had little to lose by pausing the taper for a bit.
Alas, there can be a vast distance between what we think should happen and what we think will happen. Recent Fed policy is an example of that. However, the Fed’s commitment to tapering should assuage investor fears about an overreaction to any temporary pickup in inflation data. Fed policy may be the one constant in an ever-changing world.
Not all emerging markets are alike; many are healthy and getting healthierIn our “Outlook 2014,” we warned about growing problems in select emerging markets, calling out Argentina and Venezuela as possible basket cases. Well, Turkey and South Africa can be added to that list. Their currencies came under fire, and central banks from Brazil to India intervened, raising rates to stem inflation and capital flows. The initial reaction was positive but temporary. Why temporary? Probably because investors doubt the governments’ commitments to keeping rates high. This course risks slowing growth at the price of lowering inflation—not a desirable outcome in an election year in places like South Africa, India, Turkey, Brazil, and Indonesia. We are more confident that the central bank of India, compared with the other central banks, will set policy independently of the electoral calendar. Some emerging markets may be volatile, but we believe attractive areas include India, Mexico, China, and emerging Europe.
U.S. growth is likely picking upWhile some emerging markets may appear to be precariously balanced, ready to tip into too-high inflation or too-low growth, the U.S. is showing signs of strengthening growth with continued low inflation. Economic growth in the U.S. picked up in the second half of 2013. Some of the growth could be given back, as changes in inventories contributed 1.67 percentage points to third-quarter gross domestic product (GDP) growth and 0.42 percentage points to fourth-quarter GDP growth.
In 2011, real GDP grew 1.8%. In 2012, it grew 2.8%. In 2013, 1.9%. This might not look like a favorable pattern—and it isn’t impressive when compared with previous recoveries—but it at least looks sustainable. There are no signs of overinvestment in housing or inventories, which typically precede recessions. With consumption spending—globally, not just domestically—hanging in there, businesses should continue to slowly expand and invest in property, plants, and equipment. Gross investments in equipment and intellectual property have surpassed their 2007 levels, but after adjusting for depreciation, they ended 2012 at 18.3% and 12.3% below their 2007 levels. In other words, despite the pickup in investment, the aging production base still has a long way to go.
While short-term noise may prevail in the economic data—or in the market movements—we think investors should keep their eyes on the longer-term opportunities.
Equities: January wasn’t as bad as it feltBy John Manley
In some ways, January was not nearly as bad as it felt. In others, it was worse. The actual declines posted by most of the popular equity indexes and averages were generally modest by historical standards, especially in view of the strong advances in the prior month and year. However, the timing was awful, coming in the normally seasonally strong first month of the year. The legend on Wall Street is that January is a bit like the camel’s nose under the tent: It may not be a big deal in itself, but there is usually a lot more behind it.
While we do not subscribe to the notion that a down January is an indication of what we’ll see over the rest of the year, we would have preferred more evidence that a lot of money on the outside of the equity market is trying to get in. We do not see excessive valuations, a tightening Fed, or crumbling earnings momentum. In the past, these have been the hallmarks of major declines. We do sense a lack of the raw fear that, we believe, has weighed on the psyches of investors since 2009. We suspect that sagging equity prices have gone a long way toward restoring the dread that fueled the rally of the past five years.
We continue to believe that the developing economies are recovering their economic momentumStrength in developing economies around the world can, in our opinion, still be translated into surprisingly good earnings growth. We maintain our bias toward large, high-quality equities with exposure to midcycle growth. We are wary of a systemic dip in corporate profitability or a significant abatement in central bank stimulus. So far, we have seen neither.
January was not a happy month for equity investors but it was not a tremendously painful one, either. While the narrowly focused, large-capitalization and high-profile Dow Jones Industrial Average fell 5.2%, these results somewhat overstated the damage done to most domestic equity measures. The S&P 500 Index dropped 3.5%, and the technology-heavy Nasdaq Composite slid only 1.7%. Smaller stocks, on balance, lost less than larger ones. The equally weighted Value Line Arithmetic Composite Index and the Value Line Geometric Composite Index declined 2.9% and 3.2%, respectively. The Russell 3000® Growth Index held up better than the Russell 3000® Value Index. They declined 2.8% and 3.6%, respectively.
Sector performance differed greatly. Safe and noncyclical were the places to be. The utilities sector led the pack with a healthy 3.0% gain, while health care added 0.9%. To us, the utilities sector seems likely to be at an earnings momentum disadvantage this year. However, we do acknowledge that the area’s relative price/earnings ratio seems modest by historical standards. Health care, on the other hand, no longer seems to be the value it was two years ago. While not excessive, valuations seem high by historical standards, and we are market weighted.
At the other end of the spectrum, energy was the worst-performing sector, with a 6.3% decline in January. While we do not expect significant increases in hydrocarbon prices, we do find the large-capitalization components of this sector to be of high quality and attractively valued. Materials dropped 4.6% last month. We think it is far too early to position a portfolio for a commodity price increase and would only market weight the area. We are also market weighted in the consumer staples area. That sector, which seems far from cheap to us, fell to -5.1% on concerns about the exposure of a number of its companies to the emerging markets.
Most cyclical areas felt downward pressure as the year began. Consumer discretionary stocks fell 5.9% after a strong 2013. We are market weighted. The industrials sector, which we do favor, slipped 4.5% after a spectacular 2013. The area is no longer cheap, but we continue to see the potential for earnings acceleration. One area that was a positive surprise was information technology, which outperformed with only a 2.5% drop. We are impressed by the sector’s valuation and earnings potential.
Overseas, developed markets did far better than emerging markets. The FTSE’s 3.5% drop matched the S&P 500 Index, but France and Germany outperformed, with declines of 3.0% and 2.6%, respectively. Spain, Italy, Ireland, and (even) Greece posted gains in local currency but saw those increases eroded by weakness in the euro.
All of the major emerging markets underperformed the S&P 500 Index in dollar terms. India fell only 3.1% in local terms, but weakness in the rupee reduced that to a 4.3% loss for dollar-based investors. Russia declined almost 10% in the period, and Argentina saw an 11.6% gain in its equity market translate into a 9.3% loss in dollar terms. Finally, the Japanese yen rose in value, but the Japanese equity market still produced a -5.7% return for American investors.
Fixed income: The Treasury market may have fully adjusted to the eventual end of Fed asset purchasesBy James Kochan
It has been fashionable to refer to the January sell-off in equities as a result of the risk-off trade, but the pattern of bond market returns suggests a more complex investment process. To be sure, the Treasury market rebounded strongly from a poor fourth quarter, led by the longest maturities. In addition, the high-yield corporate market had a rare month of underperformance, but that is to be expected when equities perform poorly. Within high yield, however, the riskiest credits—rated CCC and lower—outperformed the stronger credits, suggesting that not all investors are more risk-averse.
Other markets that might have been expected to suffer from a risk-off psychology performed better than Treasuries. Investment-grade corporates outperformed Treasuries, and the BBB credits outperformed the AA credits. The municipal market recorded the best returns of any market in January, in part because it was unusually cheap versus the taxable markets as the year began. Within that market, investors showed a decided preference for the weaker credits. The BBB index recorded a return that was twice the return from the AAA credits.
The mortgage market underperformed slightly in January, as spreads to Treasuries widened by approximately 10 bps. A reduction in Fed purchases might have contributed to the underperformance, but the investment habits of foreign investors might have been just as important. For those investors, the risk-off trade is to buy Treasuries, not mortgage-backed securities. And with spreads to Treasuries still narrow by past standards, domestic investors have not been enthusiastic toward the mortgage market.
In emerging markets debt, selectivity is more important than everAfter performing in line with domestic high yield during 2011 and 2012, dollar-denominated emerging markets debt performed poorly in 2013. Because of that poor performance, the sector was expected to outperform in 2014. Instead, fears of capital outflows have hurt the currencies and bonds in a host of these countries. The dollar-denominated index underperformed domestic high yield by almost a percentage point in January. The sector now offers considerable relative value, but selectivity has become even more important than in the past.
International investment-grade bonds performed relatively well in January, despite the strength of the dollar. Rallies in several of the weakest European markets helped, as did the higher yields from the A-rated and BBB-rated companies and sovereigns. Well-diversified international bond portfolios have been adding incremental value for the past two years despite a great deal of volatility in the eurozone.
The Treasury market may have fully adjusted to the eventual end of Fed asset purchasesFed tapering was supposed to push Treasury yields higher, and those yields did rise late last year in anticipation of the start of tapering in January. Since January 1, however, the yield on the benchmark 10-year note has declined 35 bps. Even the announcement last week of another reduction in asset purchases had no negative impact. Perhaps, at a yield around 3% on the 10-year note, the market had fully adjusted to the eventual end of Fed asset purchases. If so, when this most recent bout of turmoil overseas ends, it would not be surprising to see that yield move back to around 3%.
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 equities, whether growth or value.
EquitiesGlobal equities still look attractive from a valuation perspective. There are risks, as the economic recovery is still middling at best. But pessimism is already priced into stocks, especially European and emerging markets equities. Commodity-oriented emerging markets could get cheaper, while manufacturing-oriented emerging markets could continue to recover.
Value versus growthChoosing 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 blend value and growth characteristics.
Large caps versus small capsLarge-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.
Based on our economic outlook, we believe interest rates are likely to remain low for the balance of the year and next year. This presents an opportunity for investors to take on additional duration and credit risk, but we prefer more credit risk to more duration risk. Provided the economy doesn’t 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*
Neutral positioning is the percentage of market capitalization meeting the classification criteria of a broad market index
Neutral positioning is 50%
The bottom line
It’s tempting to think that the rest of the year will look the same as January did. We think that would be a mistake. In fact, we think January presented a good opportunity for investors to dip back into riskier assets rather than to abandon them. We have been of the opinion since the third quarter of 2013 that investors would have a number of opportunities when the equity market pulled back to take advantage of more attractive entry points. February and March may continue to present those opportunities.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.