Market Roundup - August 2014
August: False dawns and dusksBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
Fed Chair Yellen pointed out in her semiannual report to Congress that the U.S. economy has encountered a number of false dawns—when a hoped-for acceleration in growth has failed to materialize—during this recovery. That’s one reason—maybe the main reason—she is hesitant to raise rates. After an abysmal first-quarter gross domestic product (GDP) report, her hesitation seems justified. But investors seem to be thinking it is dusk time for bonds and stocks: Interest rates must rise and valuations must fall. Not so fast. That type of thinking hasn’t worked too well over the past few years, and we believe it likely won’t work well for the next few.
The economy: Low interest rates may continueBy Brian Jacobsen
The second quarter of 2014 can be nothing but better than the grim first quarter. According to the Bureau of Economic Analysis, the economy shrank 2.9% in the first quarter on an annualized basis. New-home sales for the second quarter look to be weaker than that, so housing is unlikely to help boost the economy. Consumer spending was slightly better in the second quarter than the first quarter, by perhaps 2%. Government spending is relatively flat. Imports may grow a bit faster than exports, thanks to slightly higher oil prices. That leaves investment spending by businesses to help the economy crawl out of the hole of the first quarter. Various indicators, like the new-orders component of purchasing manager indexes, are pointing to a future pickup in investment spending, but it’s unclear whether actual spending—rather than just the orders—will occur in the second or third quarter. This could set the stage for a disappointing second-quarter GDP number as well.
Thankfully, despite the possibly disappointing economic data, corporate earnings are anything but disappointing. Cash flows are increasing and businesses are beating analysts’ expectations, not only for profit growth but for sales growth as well. The divergence between the economy’s weakness and corporate earnings strength likely will continue to confound the investing public.
With continued strong corporate profits, a premature tightening of monetary policy by the Fed could be the party spoiler, but that seems highly unlikely. In its semiannual report to Congress, the Fed worried about excesses in the leveraged loan market (which they have been warning about for the past few years) and valuations in small-cap biotech and social media stocks (which they have been warning about for the past few months). Now—not to be too critical of the Fed—it’s not exactly in the business of valuing securities. Using a price/earnings (P/E) ratio to value speculative growth stocks is a fool’s errand. We believe companies need to be evaluated on the basis of what they can do over the next 12 years, not the next 12 months. So, we don’t give much credence to what the Fed says about valuations—yet. It is probably more of a fig leaf to shield the Fed from those who say it is causing asset price bubbles rather than an indicator of any imminent shift in monetary policy.
Job growth is decent, but wage growth is not. The debate of the day is whether wage inflation is going to pick up soon. While the long-term and short-term unemployment rates have come down, median weekly earnings haven’t gone anywhere. In fact, year over year, the percentage change in median weekly earnings of the nation’s 106.6 million full-time wage and salary workers in the second quarter was a big goose egg. Zero. No change. Over that same time frame, inflation—as measured by the Consumer Price Index—increased 2.1%. Real earnings are down for full-time workers. That’s not the stuff of wage inflation. These are not the conditions that make the Fed anxious to tighten monetary policy.
Equities: Indicators point to opportunity in the U.S. and in EuropeBy John Manley
Stocks dealt with a number of international crises in July, but a number of U.S. equity indexes spent much of the month bumping up to new highs. The potent combination of an accommodative Fed and robust second-quarter earnings results against the background of moderate valuation worked again to give the stock market a healthy tone through much of the period.
While sentiment has improved over the past 18 months, we continue to find it far from exuberant. Despite the tragic headlines, the world’s economies seem to be moving away from the unusual dislocations of five years ago and toward a more normal environment. Yet, a number of strategists roil the airwaves with worries that run from inadequate volatility and the paucity of 10% corrections to seasonality and the presidential election cycle. Just below the surface, individual investors still harbor acrid memories of the market’s collapse in 2008.
We continue to believe that equities here and in Europe offer attractive opportunities. We believe that earnings expectations can rise as the world’s economy slowly and unevenly pushes higher but that inflation and higher interest rates are on hold for a while. We would favor economically sensitive areas (but not commodities) over defensive or high-yield plays.
The black line is the one to watch—expectations for earnings are still rising
Though valuations are up, they are at normal levels
Fixed income: Globally, signs of sustained bond-yield increases are absentBy James Kochan
There are a few signs that investors in the fixed-income markets are becoming more cautious toward the riskiest taxable bonds. In the past several weeks, the investment-grade corporate market has continued to perform well while the high-yield market has recorded negative returns. Among investment-grade sectors, yields on 10-year notes are now approximately 10 basis points (bps; 100 bps equals 1.00%) lower than they were on June 30, close to the 2014 lows reached in late May. New deals in the investment-grade arena continue to attract strong demand.
Yields in most segments of the junk bond market are higher now than they were on July 1. In the 10-year maturity segment, yield increases this month are in the range of 25 bps to 40 bps. High-yield bond funds and ETFs have had net outflows over the past two months, and that has contributed to this relatively poor performance. One reason for the outflows might be warnings from Fed officials, including Chair Yellen, that investors reaching for yield in this market might be accepting more risk than is prudent. Or, more likely, investors felt that at the yields reached in June, they were no longer being adequately compensated for the credit risks inherent in high-yield bonds and loans.
It is tempting to compare this episode of outflows with the outflows from municipal bond funds that drove those yields sharply higher last year. Negative credit events such as the Detroit bankruptcy and the downgrades of Illinois sustained those outflows for almost six months. But that overreaction attracted buyers this year and that, in turn, has helped produce strong total returns from municipal bonds. In recent weeks, the high-yield segment of the municipal bond market has seen strong investor demand.
This experience suggests setbacks such as the recent decline in corporate high-yield bonds are likely to be relatively mild. At a time when the safest government notes yield only 1.25% in Germany, 0.50% in Japan, and 2.50% in the U.S., markets that still offer relatively high yields will probably continue to attract solid demand from global investors. As much as domestic investors might want to see more realistic yields, low yields around the globe are a powerful force, encouraging investors to participate in the U.S. credit sectors, even after a modest backup in yields.
It is worth restating that the fundamentals that typically have produced substantial and sustained increases in bond yields are still absent from the global economic scene. GDP growth is essentially flat in Japan and Europe and slow in the U.S. Leading indicators of inflation, such as labor costs and money supply growth, are far weaker than in previous cycles, and private-sector borrowing has yet to show a cyclical rebound. It is popular to warn that bond prices can go only lower from current levels, but such warnings have been premature for almost 5 years, and we believe they are likely to remain so for at least another 12 months.
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.
Neutral positioning is the percentage of market capitalization meeting the classification criteria of a broad market index
Neutral positioning is 50%
The bottom line
The Fed is worried about a false dawn for the U.S. economy. High oil prices due to conflicts between Ukraine and Russia, conflicts between Israel and Hamas, and conflicts in Syria all place an extra burden on the U.S. economy. Yet, the economy is trundling along. Consumer confidence is improving marginally, and business confidence, as shown by purchasing manager indexes, is pointing toward continued economic expansion. The bounce in activity from the first quarter may not be as great as many expect, but it’s likely good enough to keep profits growing year over year. We don’t think this environment signals a false dawn for the economy. We certainly don’t think it signals dusk for the bull market.