Market Roundup - March 2014
March: Madness or just messiness?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
Weather-tainted economic data continued to steer investors’ attention to bigger-picture issues, such as what’s next for the Fed and ECB, whether Venezuela is going to get much worse before it gets better, and how the conflict in Ukraine will resolve. With enough known unknowns out there, the near-term outlook for the markets may be patterned after the near-past, with bouts of panic and relief. This messiness of markets should be a good opportunity for investors to assess their positions and realign their portfolios toward their longer-term goals.
The economy: Central banks on the brink of big thingsBy Brian Jacobsen
While economic data for February has been affected by unseasonably cold weather, we believe the winter freeze on economic activity should lead to a spring thaw. Because of this, the Fed finds itself in the position of needing to act quickly to revise its forward guidance. When the Fed meets on March 18 and 19, it will likely need to do something about the thresholds it has set for increasing its target for the federal funds rate from zero.
The Fed set the thresholds of 6.5% unemployment and 2.5% projected inflation. The economy is nowhere near the inflation threshold, but its unemployment threshold looms large. The unemployment rate has been dropping faster than most forecasters expected because the labor force participation rate has not increased. This is why the Fed has been trying to shift attention toward other labor market indicators, like the fraction of the labor force that makes up the long-term unemployed (27 weeks or longer) and the number of part-time workers who would rather work full time.
The Fed is likely going to abandon the 6.5% unemployment threshold and focus on the inflation outlook. It may include general and qualitative references to labor market conditions. It may also include references to financial conditions to give the Fed even more flexibility in shaping expectations of when it may raise rates. Although the Fed may continue to cut the size of its asset-purchase program in $10 billion-per-month increments at every meeting, it will be able to provide more monetary stimulus through its forward guidance. That should be a positive for the economy and the markets, but all new policies—even tweaks to policies—can come with volatility.
The ECB must deal with dangerously low inflation to help European equities
The ECB will meet March 6, and it looks like it is poised to cut rates again to deal with inflation that has fallen into what ECB President Mario Draghi has called the “danger zone.” He views inflation below 1.0% as a danger to economic growth, and the latest readings of eurozone inflation are around 0.8%.
Mario Draghi famously said that the ECB would do “whatever it takes to preserve the euro” (July 26, 2012). Well, mission accomplished, as the euro is still here. However, he did not mean that the ECB would do whatever it takes to kick-start growth or increase inflation toward its target of 2.0%. If the euro had an existential crisis, the ECB would likely do whatever is necessary to keep it alive. The euro is not having an existential crisis. It is in a growth and inflation funk, and that doesn’t give the ECB license take drastic measures such as massive asset purchases. Instead, it is likely to rely on traditional tools, such as cutting its main refinancing rate from 0.25% to 0.00% or changing the interest it pays on reserves from 0.00% to a small negative number.
Russia’s imperialism and Venezuela’s turmoil may affect oil prices
Geopolitics are likely to be front and center for the markets in March. Russia’s actions in the Crimean region of Ukraine are likely to lead to diplomatic efforts to keep Ukraine intact. Russia could get its way, as it did in Georgia in 2008. The West’s need of Russia’s assistance in dealing with Syria, Iran, and Venezuela may make it willing—albeit begrudgingly—to allow the Russian empire to slowly expand.
An issue closer to home for the U.S. is the social unrest in Venezuela. The Maduro-headed government is having a hard time keeping oil revenues flowing fast enough to satisfy political promises made to the people. The country is struggling with rapid inflation and shortages of essential items. The popular backing of the socialist government is at risk.
What does this mean for investors? Venezuela is the fourth-largest source of oil for the U.S., behind Canada, Saudi Arabia, and Mexico. Along with the problems in Russia—also a big oil producer—oil prices are likely to stay high and energy stocks are likely to come under pressure. The problems in Russia and Venezuela are not likely to be resolved quickly. We advise particular caution when investing in these regions.
Equities: There is nothing extreme about valuationsBy John Manley
Just as investors got comfortable with being uncomfortable, the stock market found reasons to go back up. It may have been the fairly positive fourth-quarter earnings and sales results that were ignored in January. It may have been the kind words of Chair Yellen, who testified that she was not about to try to shut the economy down at any time in the near future. Or it might have been the sharp drop in bullish sentiment that two or three bad days in January had brought about. Whatever the cause, most of the popular U.S. stock indexes recovered what they had lost in the previous months and moved back to all-time, or new recovery, highs.
In our opinion, the most important fundamentals continue to support a constructive view on the equity market. The Fed should continue to keep rates low, even as it withdraws quantitative stimulus. Earnings expectations should continue to have an upward bias, as the U.S. and developed markets continue their economic recovery. Valuations remain moderate relative to forward earnings expectations. While other more arcane valuation measures appear quite high by historical standards, we believe that forward earnings will remain the metric of choice, at least as long as earnings expectations continue to rise.
We do find events in eastern Europe troubling. The outcome is impossible to foresee and the uncertainty could increase equity volatility. For what it is worth, we would note that the full-scale Russian invasions of Hungary (1956) and Czechoslovakia (1968) did not seem to have a significant, lasting, negative impact on U.S. equity markets.
Equities experienced a broad-based advance in February
February’s equity advance was fairly broad based, with some drawback at the end. The S&P 500 Index gained 4.6%, while the Dow Jones Industrial Average added 4.3%. The Value Line Indexes ended the month close to these results, with gains of 4.9% for the Value Line Arithmetic Composite Index and 4.5% for the Value Line Geometric Composite Index. Growth slightly outperformed value, with the Russell 3000® Growth Index up 5.1% and the Russell 3000® Value Index up 4.3%. Large-capitalization technology and biotech stocks powered the Nasdaq Composite Index to a 5.1% advance.
Among the sectors, economically sensitive areas generally tended to lead, although there were exceptions. Materials led the pack with a 6.9% gain. Consumer discretionary tied for second with a 6.2% advance. Health care, led by strong fundamentals from the biotech area, posted a similar uptick. However, we are only market-weighted in the above sectors. We believe it is too early in the economic cycle to make major commitments to the commodity space. We are impressed with the fundamentals of health care but not as impressed with the valuations.
We are underweight the three worst-performing sectors. Telecommunication services dropped 1.0% in value, while utilities gained only 3.4%. We believe that the current economic expansion will not be of benefit to these areas. Financials gained 3.1% in February. We continue to worry about the effects of regulation on this sector.
Overseas, developed markets continued to outperform and emerging markets continued to lagOverseas, developed markets continued to outperform as emerging markets were clearly laggards. The FTSE 100 gained 5.0%, but a strong sterling moved that to a 7.0% gain for U.S. dollar investors. Similarly, a strong euro transformed the CAC 40 from a 5.8% dollar return to an 8.4% dollar return. Only Spain (2.0%; 4.4% in dollars) lagged the U.S. in dollar terms. In fact, Ireland and Greece both rose over 11% in local currency terms. We continue to believe that Europe may outperform the U.S. over the course of 2014.
Emerging markets were still weak in February. China gained 1.1%, but the weak yuan lowered that to -0.3% for American investors. India, which we favor, gained 3.0% in local terms but 4.1% in dollar terms. Other markets posted nominal declines. Argentina and Mexico dropped 3.9% and 5.1%, respectively. Brazil’s slight decline in local currency adjusted to a slight gain in dollar terms. We would point out that the emerging markets are far from homogenous and their upturns may occur at different times in the future. Still, we are positively impressed by the degree of negative sentiment that hangs over all of these markets today.
Fixed income: Rates likely to stay low even with less Fed buyingBy James Kochan
Bond market performance thus far in 2014 is reminiscent of the patterns seen in 2011 and 2012. Credit sectors are outperforming and, with one major exception, the weaker credits are outperforming the strongest credits. In addition, the municipal market and the emerging markets are performing well.
The corporate markets have been the best performers so far this year, but, unlike the past two years, the investment-grade market has a slightly better total return than the high-yield market. Within investment grade, the BBB credits performed much better. In February, the total return for the BBB index was almost twice that of the AA index. In high yield, however, the opposite pattern prevailed: The BB and B credits have been performing better than the CCC and weaker credits.
In the municipal market, the A-rated and BBB-rated sectors have posted strong returns thus far this year. In February, a portfolio of A-rated and BBB-rated credits would have produced a 2.1% return versus a 1.0% return for a portfolio of AAA-rated and AA-rated credits. In part, the strong performance of the BBB index was due to a modest recovery in Puerto Rico bonds, and those issues are now out of that index. Thus, the BBB returns should be less volatile in the months ahead. The strong performance of all segments of the municipal market so far in 2014 is partly a response to how cheap that market had become by the end of last year and partly to the seasonal reinvestment demand. From mid-March to mid-April, the seasonals could turn negative as investors raise cash for tax payments. But because municipals are still attractive versus taxables, that seasonal effect might be relatively weak this year.
Geopolitical fears should keep rates low, even if the Fed continues to taperDespite another geopolitical crisis, concerns over the impact of Fed tapering, and some central bank tightening, emerging markets debt staged a solid recovery in February. Prospects of additional easing by the ECB, a rally in the U.S. markets, and the fact that the emerging markets had performed so poorly over the previous 13 months attracted buyers to those dollar-denominated issues.
The longer-maturity Treasuries have posted strong year-to-date returns as weaker economic indicators and unsettled conditions overseas combined to boost domestic and foreign demand. Because both of those developments have, in the past, proved to be transitory, this two-month trend might be unsustainable. At the start of 2014, Treasury yields reflected expectations of continued moderate gross domestic product growth and the tapering of Fed asset purchases. If the experience of the past three years is repeated in 2014, those expectations might again dominate market behavior and yields could return to those early-January levels between now and midyear.
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 lineFor many reasons, we advise caution about the near-term outlook for the economy and markets. With the conflict between Russia and Ukraine and civil unrest in Venezuela, oil prices and energy costs are likely to move higher—or at least stay elevated. History has shown that these types of situations are temporary, and the market tends to move on quickly to new concerns and possibilities. March could be a messy month for markets but a positive one in the long term for investors who keep their wits about them.