Market Roundup - April 2014
April: A month of reckoning?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
In many parts of the country, the weather has taken a slight turn for the better. The economic data released for the first quarter of the year has been viewed as being distorted by the weather. With the start of first-quarter earnings reporting season in April, it’s time to see how businesses really weathered the winter. It will be interesting to see how many executives blame disappointing results on the weather. What will be more interesting is to see how investors respond to the news.
The economy: Time for more uncertainty, not lessBy Brian Jacobsen
Sometimes, the weather can be a convenient excuse for weak data. In corporate finance, academics sometimes say that when bad news hits, executives will take a big-bath approach, announcing even worse information simultaneously as it’s easy to deflect blame—in this case, on the weather. That could be what we see when first-quarter earnings season rolls through.
The early indicators, however, are that the economic slowdown during the winter was, in fact, mainly due to the weather. The Institute for Supply Management’s Purchasing Managers’ Index (PMI) showed a big bounce from February to March. There was a particularly notable increase in the production numbers. Coupled with initial claims for unemployment benefits running at multiyear lows, you have the making for a decent bounceback in the second quarter from the doldrums of the first.
Economic bounceback ahead?Production activity is rebounding, and initial unemployment claims are falling.
Angst about JapanGrowth could be slowing dramatically in Japan. The value-added tax (VAT)—a type of consumption tax—increased from 5% to 8% at the beginning of April and is scheduled to go up to 10% in October 2015, provided the April 2014 increase doesn’t go too badly. The last time the VAT increased was in 1997, and that ushered in a deep economic downturn.
Compared with 1997, conditions today are very different. This time, the Bank of Japan is being much more aggressive with monetary easing. Also, the central government has a $53 billion stimulus plan to offset any economic drag from the tax increase. For an economist, this will be interesting to watch, as it could show whether government spending can offset a tax increase. We’re not optimistic that it can. Its effect on the Japanese economy should be to slow it to the point of temporarily dipping gross domestic product growth into negative territory for the second quarter. But, given that investors have known about this VAT increase for a long time, it shouldn’t really shock markets.
The VAT increase is almost a necessary evil. The Japanese government has an enormous debt load. If the government wants to create inflation and keep government financing costs low, it needs to improve its perceived creditworthiness through more tax revenues.Investors should probably stay enthusiastic about Japanese corporations, even if the Japanese consumer is going to get squeezed a little. The weak yen is helping corporate Japan, and the Japanese government is planning corporate tax cuts.
A busy election month aheadSome of the most unsettling developments in the world are in the political arena. The Russia-Ukraine situation is not resolved. Turkey is in a tense situation with Syria. North Korea and South Korea have launched missiles into each other’s waters. Venezuela is experiencing social unrest. There is no shortage of possible outcomes to worry about.
There is also no shortage of encouraging developments. India’s parliamentary elections kick off in April and conclude in May. Anticorruption and pro-business parties look to be leading. That’s probably why India’s market has done well in March.
Egypt, South Africa, and Turkey are also having presidential elections in May. Those are not likely to be game changers, like India’s, but they are notable. Also of note are the May 22–25 parliamentary elections in the European Union (E.U.). Given the talk about whether the United Kingdom should stay in the E.U., the extent to which Germany is tired of not having its own central bank, and the recent weakness in France’s ruling party, what is typically a perfunctory political process could be important.
Equities: Consolidating, not turningBy John Manley
The market can go only in three directions: up, down, or sideways. The first quarter gave us a taste of all three. January was down more than 5%. February was up enough to get most of the losses back. And now, aside from some last-minute heroics, March was essentially flat. The net result was to leave us only slightly changed from the end of last year. A period of flat trading after a spectacular year like 2013 can have two conflicting explanations. Some would call it a top. We think that it is merely a consolidation.
To us, the positive factors that produced 2013’s return are still in place, if slightly diminished. We believe that the Fed’s monetary policy will remain accommodative, even as quantitative easing ends and interest rates begin to rise. It seems to us that the Fed’s goal is still to encourage, not deflate, the U.S. economy. Thus, tapering should occur and rates should rise only to the degree that they do not have negative consequences for the economy. In other words, bond purchase will not end and lending rates will not increase until the economy has strengthened and no longer needs the help. If we are right, earnings and earnings expectations should rise before interest rates do.
If that sequence occurs against the background of a moderately valued equity market, then stocks should soon resume their upward trajectory. The slope may not equal that of last year, but we suspect it will remain positive. Moreover, we believe that the rotation will continue what has been its oddly normal progression. We continue to believe that growth stocks in the more cyclical area will provide leadership as 2014 progresses and that developed European equities might outperform their American counterparts as that continent continues to recover from recessionary influences.
In March, both the S&P 500 Index and the Dow Jones Industrial Average eked out fractional gains. Smaller stocks also posted slightly positive gains, with a rise of 0.33% and 0.06% in the Value Line Arithmetic Composite Index and the Value Line Geometric Composite Index, respectively. The Nasdaq Composite declined slightly in the period. We still have a mild preference toward larger-capitalization names. Growth lagged value, as investors sought safer havens. The Russell 3000® Growth Index fell 1% as the Russell 3000® Value Index rose by a little over 2%. We believe that growth should regain the edge as stocks resume an upward slope.
Within the sectors, the performance trends were not harshly pronounced. A better bond market helped some of the higher-yielding sectors, and cyclical areas drooped. The high-yielding telecommunication services sector led the pack with a 4.8% gain. Utilities also fared well, with a 3.4% rise. Because of their bond-like characteristics, we continue to recommend underweighting these areas. Financials, buoyed by generally positive stress-test results, gained 3.2%. Given mediocre valuations and a questionable regulatory environment, we would be very selective here.
On the other hand, the energy sector, which we favor, gained 2.4% in the period. Although we do not see strong pricing power in this area, we believe that the large integrateds and service companies can benefit from the move toward energy self-sufficiency in the U.S. If anything, Russia’s incursion into Crimea and the resultant concerns about western European gas supplies highlight the potential benefits to the Western democracies of greater domestic energy production.
The cyclical sectors—industrials, information technology, and materials—were flat to slightly up. While the first sector no longer has attractive valuations, we believe that fundamentals remain encouraging. Technology does look cheap to us and should benefit from a recovery in Western Europe. We believe that it is far too early to invest in the materials sector.
Overseas, the results were mixed. Italy gained about 6% in March. On the other hand, Russia declined more than 3%, as capital moved away in anticipation of the impact of announced and potential sanctions. Other foreign markets show slight gains or losses in trendless trading. We believe that Western European markets could outperform if early signs of recovery pan out. While the emerging markets present their own challenges, we wonder how sentiment could further deteriorate from the skeptical levels of today.
Fixed income: A decent start to the yearBy James Kochan
It was a good quarter for most segments of the bond markets, but almost all of the gains occurred in January and February. March was decidedly lackluster.
The municipal market produced the best return for the quarter, largely because it had the poorest performance in 2013. Yields in the 10-year maturity segment declined 50 basis points (bps; 100 bps equals 1.00%) throughout January and February before increasing slightly in March. As has been typical when the market has performed well, the weaker credits recorded the best returns. The quarterly return for the BBB credits was 400 bps better than the return for the AAA credits. A portfolio of A/BBB credits would have outperformed a portfolio of AAA/AA credits by approximately 250 bps. Even after the first-quarter rally, yields on 10-year AAA municipals were only slightly below the yields on 10-year Treasuries, and yields on A-rated municipals were only slightly less than yields on A-rated corporates.
In a marked departure from the experience of the past four years, first-quarter returns in the investment-grade corporate market were approximately equal to those from the high-yield market. The primary reason is that the weakest high-yield credits—rated CCC and lower—did not outperform. They had been recording much greater total returns than the BB and B segments, but this past quarter, they underperformed the BB credits by approximately 10 bps. In the investment-grade sector, the weaker credits continued to perform best. The BBB segment outperformed the AA segment by 100 bps.
The reduction in Fed purchases of MBS took a small toll on the mortgage market in the quarter. Spreads to Treasuries widened approximately 10 bps. While the Fed also reduced its purchases of Treasuries, the Treasury market was aided by somewhat better foreign purchases as the Ukraine crisis unfolded. The MBS market has not benefited from purchases by foreign investors.
Prices of dollar-denominated emerging markets debt recovered strongly in January and then stalled in February and March. The result was a quarterly performance that was better than it was in the fourth quarter but not equal to the returns from the domestic high-yield market. International investment-grade bonds performed slightly better than the domestic taxable markets, due in part to improvements in the peripheral European markets. Those markets have recovered to the point where yield differentials versus U.S. Treasuries are far less than they were a year ago.
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 lineSome investors are concerned about latent inflationary pressures. They argue that there isn’t a lot of slack in the economy, as short-term unemployment has more impact than long-term unemployment on triggering inflation. We think this view is oversimplified, as it misses the importance of the growth of credit in triggering inflation. As credit creation is still growing slowly, pressure on prices from credit growth is minimal.
For those who are concerned about slack in the economy because it may determine when the Fed starts hiking rates, the coming months should make two issues more clear: First, we will see how much the economy bounces back from the winter slowdown. And second, we will discover whether the economy actually has less slack than the unemployment rate lets on. These two results are related, as a bounceback with little slack could turn inflation numbers higher, whereas a bounceback with a decent amount of slack will keep inflation low. We think we’ll have the bounceback with little inflationary pressure. That should create an environment that is favorable for investors who are sticking with their strategic asset allocation.
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.