Market Roundup - December 2013
To taper or not to taper: That is not the questionBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
Since the market gyrations of May 2013, when it was evident that the Federal Reserve (Fed) was going to slow the pace of its asset purchase program, and September 2013, when it was clear that the taper wouldn’t start yet, investors have been eager to know when the taper will begin. Will it be December, or will it be January? Or maybe March? We think the real question is: Does it matter? What’s an extra $85 billion a month for one or three months to the asset markets? Considering that yields on Treasury securities bottomed in May 2013, peaked in September 2013, and then didn’t revert to their old lows, we think that whether the taper begins today or tomorrow won’t really matter.
The economyBy Brian Jacobsen
Consumer confidence and consumer sentiment were both dinged by the partial government shutdown in October, but even in the face of the political cinema, hiring and business activity advanced. Consumer, business, and investor sentiment all trudged higher in November. A vague but free-market-oriented reform plan coming out of China’s Third Plenum has stoked confidence in China’s growth, while a temporary—albeit an admittedly controversial—deal with Iran over its nuclear program also helped markets and optimism in November.
Headlines in December will likely be dominated by three issues: Will the Fed taper? Will the budget committee members in D.C. get a deal done? What’s going on in the East China Sea?
On December 18, the Federal Open Market Committee (FOMC) will have its meeting, and if we see decent payroll numbers on December 6, it’s possible that it will decide to slow the pace of its monthly asset purchases. This taper, as it is referred to, isn’t likely to affect the equity or fixed-income markets materially. Yes, it might cause some volatility before or after the policy announcement, but it’s not likely to have a lasting effect. Yields in the fixed-income market have already reacted to the inevitability of a taper. Whether it happens sooner or later probably doesn’t matter. If the Fed does taper, it will likely try to communicate to the world that it intends to keep its target for the federal funds rate exceptionally low for an even longer period of time than it originally intended. This forward guidance on when the federal funds rate may change is viewed by members of the Fed as a better way to communicate its policy intentions than its activity around asset purchases. Indeed, this is why we think any onset of tapering will create a pattern in the fixed-income markets more like the one that occurred in 2004, when fixed-income markets took monetary policy tightening in stride, than in 1994, when the markets stumbled and tumbled as the FOMC bumbled its communications with the investing community.
One of the products of the deal struck in October to end the partial government shutdown and to suspend the debt ceiling was the formation of a budget committee tasked to come up with a budget deal by December 13. We think it’s unlikely that the two sides will come together with a deal. Instead, we think they’ll give it the new college try (try it, see that it’s hard, and quit; unlike the old college try, which involved sticking with it until the work is done) and emerge with two competing budget plans to serve as platforms for the 2014 midterm elections. Just as the market pretty much ignored the partial government shutdown, the markets will likely ignore a failure of the budget committee.
The next two deadlines that people may fixate on are the January 15 and February 7 deadlines for funding the federal government and suspending the debt ceiling, respectively. While the Republican Party has recouped some of its popularity since the early October drama, we don’t think it will risk another government shutdown in January. Taking another drubbing in the popularity polls isn’t likely going to serve the party well going into campaign season for the November elections. Thus, we may see another six-month deal to fund the government at the levels built into current law, which means a slight reduction in federal government spending for the first six months of 2014.
The February 7 deadline isn’t really a deadline to default. The U.S. Treasury has the ability, absent a deal to raise the debt ceiling more or to suspend it, to use extraordinary measures to ride along the debt ceiling for a few months. Even if the debt ceiling isn’t raised on February 7, it probably doesn’t really have to be raised until late spring or early summer.
The really big issue we are watching for December—in addition to our expanding waistlines from the early onset of holiday parties—is the renewed tension in the East China Sea, with China on one side and Japan, Korea, and the U.S. on the other.
China created an Air Defense Identification Zone (ADIZ) around islands in the East China Sea that Japan says belong to Japan but China claims as its own. We have written about these disputed islands before (early concerns about rising nationalism from our emerging markets team is here, and a pessimistic take from an outside expert is here).
China has a history of territorial disputes in the waters surrounding China—all of which have known reserves of oil or natural gas—but declaring an ADIZ is an escalation of these disputes. The U.S., as an ally of Japan, immediately responded by flying two unarmed B-52 bombers through the zone in defiance of China’s orders. Whether this escalates into something much bigger or fizzles into nothing will depend on discussions between the U.S. and China, which will likely take place in the first week of December.
Despite the growing economic heft of China, it still doesn’t have the military capabilities of the U.S., so an outright conflict would be self-defeating and humiliating for the Chinese. This is why we think the probability of a conflict is vanishingly small. The issue will likely strain the already tense relationship between Japan and China and could backfire on the Chinese, as its recent action could further arguments in Japan for building a stronger military presence.
It is entirely possible that this episode actually reflects a rift within the Chinese leadership and that the military—the People’s Liberation Army (PLA)—is behaving semi-autonomously, diverging from the political leadership. If this is the case, it will be an early test of Xi Jinping’s ability to corral the PLA into acting in concert with the reform plans of the Communist Party of China rather than nationalistically.What this says to us is that while a few big headlines are likely in store for December, none of them should raise the hackles of investors.
EquitiesBy John Manley
In November, the equity market continued to rise for much the same reasons that it rose in the prior 12 months: Fed policy has remained accommodative and it seemed to imply that this easy stance would remain in place even after quantitative easing was taken off the table. Reported earnings continued to positively surprise in most areas, and consensus forward earnings expectations also continued to rise. Valuations on these forward earnings-per-share expectations expanded but remained modest to moderate by historical standards. After a year of pop-up threats, sharp and shallow corrections, and quick resolutions, investors seemed to be tired of worrying. At least superficially, the most obvious threat to equities was the growing belief that we have nothing to fear but the lack of fear itself.
While the equities markets, as measured by the S&P 500 Index, had a near 30% gain in the first 11 months of the year, December could be a tricky month as some investors look to lock in gains and others try to play catch-up. However, looking into next year, I don’t see any reason to believe that the forces at work this year will go away. Profitability is high by historical standards and so are many alternative valuation measures (for example, price to sales). These measurements are well publicized but could still cause problems at some point down the road. However, in my opinion, that point will come only after earnings have begun to fail or flutter or the Fed has become much more restrictive. Given the fact that we have not seen the economic surge that preceded most peaks in earnings or price in the past, I suspect that the current horizon is clear.
As mentioned above, November was a good month for stocks. The S&P 500 Index gained 3.0% but was among the weakest of the domestic equity indexes. The Nasdaq and the Dow Jones Industrial Average both gained 3.8%. Smaller stocks slightly outperformed the Value Line Composite Indexes, gaining 3.5% (Arithmetic) and 3.1% (Geometric), respectively. Growth and value were a tossup, with the Russell 3000® Growth Index and the Russell 3000® Value Index both advancing 2.9%.
The best-performing sectors were somewhat eclectic. Health care led with a 4.7% rise, as market participants observed the first unsteady steps of the Affordable Care Act rollout. While we had been strong proponents of this area for some time, higher relative valuations and a 40% gain year to date have moved us to a more neutral stance recently.
Financials were a close second, with a 4.6% rise. While we are impressed with the sector’s fundamentals in a period of Fed accommodation, we have underweighted it due to concerns about current and future regulatory issues. Two sectors we do like, industrials and information technology, both outperformed the S&P 500 Index in November. The former gained 3.6% and the latter 4.0%. We continue to believe that infrastructure spending in the energy area domestically and a drive to upgrade corporate efficiencies and profitability around the world will continue to push earnings and prices higher.
We are underweight the only two sectors to decline in price last month. The telecommunication services sector dropped 2.5% and the utilities sector slipped 1.9%. We see high valuation and lack of earnings catalysts here. Also, with their generally high yield and low growth profiles, we find these areas to be too bond-like for our taste.
Internationally, equity markets results were mixed in November. All developed markets except Germany (up 4.1% locally, 4.3% in dollar terms) underperformed the U.S. The FTSE 100 Index dropped 0.8%, but a rise in the pound sterling made that a 1.1% gain in dollar terms. Italy’s political issues moved its market 1.6% lower and Spain slipped 0.2%. Both markets were helped in dollar terms by a slightly higher euro.
Japan was a study in contrasts. The equity market soared 9.3%, but a weak yen trimmed that to 4.8% in dollar terms. China’s market added 3.7% in the month, as signs of economic stability increased slightly. However, India slipped back 1.8% after a strong showing in the prior two months.
Resource equity markets sagged, with New Zealand down 2.7% and Australia off 0.9%. The sole exception was Argentina’s 10.7% gain. However, that spectacular showing was due more to the prospect of regime change than any current fundamental improvement, in our opinion.
Fixed incomeBy James Kochan
Perhaps the September–October relief rally was overdone. The bond markets were relieved when, in mid-September, the FOMC decided to keep its asset purchase unchanged. The yield on the 10-year Treasury dropped from around 3.00% to 2.50% by late October, then increased to nearly 2.75% in November. As usual, the longest-duration Treasuries were the poorest performers. The combination of longer durations and a relatively small inflation adjustment has produced a year-to-date return of -7.90% for the Treasury Inflation-Protected Securities sector, considerably weaker than returns on comparable notes and bonds.
The municipal market showed some signs of stabilizing in November, but it continues to show weak year-to-date returns. For the first time in six months, returns from BBB credits were only moderately weaker than returns from the stronger credits, and the longer maturities did not perform worse than the intermediate maturities. For the year to date, however, The BBB sector has a return of -6.8% versus a return of -1.3% for the AAA sector. As a result, spreads between the BBB and AAA yields are near an all-time high. The generous incremental yields on the weaker credits should help restore the performance edge to the A/BBB sectors in the months ahead.
Because the high-yield mutual funds and exchange-traded funds have seen steady inflows, that market recorded positive returns in November and is on track to produce coupon-like returns for 2013. The weakest credits outperformed again in November, but the differentials versus the B and BB sectors have been shrinking in recent months. In the investment-grade corporate sector, returns across the quality spectrum were fairly uniform last month, but year-to-date returns still favor the BBB credits.
The mortgage market is on track to produce a negative return for the full year, which would be the first annual negative return since 1994. That market has been buffeted by worries that the Fed might scale back its mortgage-backed securities (MBS) purchases, but the primary reason for the negative returns has been the narrow MBS-to-Treasury yield spreads. With spreads unusually narrow due to the start of Fed purchases late last year, MBS yields have increased almost in step with Treasury yields. While the mortgage market has outperformed the Treasury market, it has not been the steady, positive performer that it has been in earlier periods of moderately rising Treasury yields.
The final weeks of 2013 could be tumultuous for the bond markets. New-issue calendars in the corporate and municipal markets are often fairly heavy during the first weeks of December, just when many dealers and portfolio managers are looking to close the books for the year. This year, the FOMC announcement scheduled for December 18 could add to the volatility. While the odds of meaningful policy changes are probably slim, they might not prevent the markets from reacting to each economic indicator as if it might or might not advance the onset of Fed tapering. Investors would be wise to ignore the short-term swings in market sentiment and focus on those sectors that offer the best relative values. By almost any metric, that would currently be the A/BBB segments of the municipal market.
Table 1: Year-to-date bond market total returns (%)
Asset allocationBy Brian Jacobsen
Investment horizonsFor 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.
Fixed incomeBased 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 for equities 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 strategic positioning represents our guidance for investors with a time frame of three years or longer. The tactical positioning in the pie charts below represents our guidance for investors with a time horizon of less than one quarter.
The bottom line
The latter part of 2013 looks a lot like the early part, with the apparent consensus being that stocks must fall. The argument seems to be that the price rises must fall, just as a ball thrown in the air must. Metaphors, like treating the market like a ball or the economy as an engine, can be useful to a point but deceptive beyond that point. Wisdom is knowing when you’ve crossed the line from usefulness to deceptiveness. Stocks don’t simply stop rising because they have risen in the past. Nor do they keep rising because they have risen in the past. It takes something—call it a friction or a force or an event—to push them lower. Bad earnings, bad prospects for growth, or a collective souring of mood can push things lower, not rising prices on their own. There are some headlines that could create waves in the markets in December, but we don’t think those waves are a prelude to a tsunami.