Macro, U.S.

Cross-currents in Financial Markets

April 7th, 2015 | By Nick Sargen


  • U.S. stock and bond markets fluctuated in broad ranges in the first quarter, as investors assessed a wide range of issues including the prospect for oil prices, the U.S. dollar, overseas interest rates and U.S. monetary policy. Economic news was mixed. Real GDP growth may have slowed to 1% in response to a severe winter, but jobs growth continues to be the strongest since the late 1990s, despite a softer-than-expected showing in March.
  • The inter-play of forces makes the current situation unusually complex: Lower oil prices benefit U.S. consumers and most businesses, but hurt energy producers, while the strong dollar adversely impacts U.S. exporters and multinationals. Nonetheless, we look for the economy to regain momentum this spring and to sustain solid growth in the balance of the year.
  • At the March FOMC meeting, the Federal Reserve signaled that it is prepared to begin normalizing interest rates later this year. However, Fed officials also lowered their forecasts for economic growth and the path of the fed funds rate. Accordingly, the bond market is now pricing in only a 50 basis point increase in the funds rate this year.
  • We continue to overweight risk assets in investment portfolios on grounds that the economic cycle is likely to be prolonged and the Fed will move gradually in raising rates.

Lower Oil Prices Are Supportive

U.S. economic growth appears to have slowed to about a 1% rate in the first quarter, but we continue to believe the underlying trend is stronger and view the 50%+ drop in oil prices since last summer as supportive. Some of the factors slowing the economy - notably a harsh winter in most of the country and a West Coast port strike - are expected to be temporary. Consumer spending may have moderated somewhat after growing at nearly a 4% pace in the second half of 2014. However, we expect it to grow at a healthy pace in the balance of this year, as strong jobs growth and low oil prices boost real disposable incomes, and consumer confidence stays high: Prior to the March report, payrolls growth had averaged 275,000 workers per month over the past year, which is the strongest since the late 1990s.

One factor that is having a dampening effect on the economy is a significant cutback in capital spending by U.S. oil producers. In our economic outlook at the beginning of this year, we indicated overall business capital spending would be vulnerable if oil prices remained depressed, and this appears to be playing out now. We expect capital spending to stay weak in the second quarter, before stabilizing in the second half of the year.

Dampening Effect from a Strong Dollar

In our 2015 outlook piece, we also expected the U.S. dollar to appreciate on a trade-weighted basis, as the U.S. economy outpaced both Europe and Japan by a comfortable margin. However, we did not foresee the magnitude of the dollar's appreciation in the first quarter - more than 10% versus the euro and nearly 8% against the major currencies on a trade-weighted basis. This move boosted the dollar's cumulative trade-weighted appreciation to about 20% since mid-2014.

Given a currency move of this magnitude, U.S. exports are expected to moderate, as exporters lose international price competitiveness. (Multinationals also face losses on their overseas earnings when translated back into dollars.) Therefore, U.S. businesses that compete internationally face greater headwinds than we envisioned at the start of this year. That said, we do not expect a major deterioration in the U.S. trade imbalance, because of lower import costs associated with a stronger dollar and lower oil prices.

Lower (and Negative) Interest Rates in Europe

Another factor we did not envision at the beginning of this year was how low interest rates would fall in Europe: Many countries now have negative interest rates on short and medium term debt, and 10- year government bond yields that are 1% or less. The catalyst for the latest plunge in bond yields was the launch of the European Central Bank's quantitative easing program, in which it is slated to purchase €1.6 trillion of securities through September of 2016 and possibly beyond.

An encouraging development is mounting evidence that the European economies have emerged from a mild recession in 2014. The improvement in economic conditions is a result of the beneficial effects of lower oil prices, record low bond yields and a cheaper euro. Nonetheless, while the euro-zone economies appear to have turned the corner, they are not completely out of the woods given growing uncertainty about Greece's status as a euro-zone member: We believe the euro-zone is much better equipped to handle a possible "Grexit" than it was in 2012, but the risk of some spill-over cannot be ruled out altogether.

Whither the Fed?

The above developments provided the backdrop for the FOMC meeting in March, in which the Federal Reserve communicated that it was prepared to begin normalizing interest rates once it is confident that inflation will approach its target threshold of 2%. The bond market rallied on news that Fed officials had lowered their forecasts for U.S. economic growth somewhat, while also reducing their projections for the path of the fed funds rate by about 50 basis points. In this regard, the view of Fed officials is now closer to what the bond market had been anticipating prior to the meeting. Currently, the bond market is pricing in two 25 basis point hikes in the funds rate by year's end.

In a recent speech at the San Francisco Federal Reserve Bank, Fed Chair Janet Yellen discussed the factors that would guide the Fed's policy decisions.[1] One of her messages was there was no predetermined path of policy tightening: "The actual path will evolve as economic conditions evolve, and policy tightening could speed up, slow down, pause, or even reverse course depending on actual or expected developments in real activity and inflation."

We share the market's view that the Fed will proceed gradually in tightening policy, especially with inflation and inflation expectations well below the 2% threshold. Our own view, however, is that the market is too pessimistic about the long-term prospects for the U.S. economy and inflation. It is pricing in a funds rate of only 1.5% by year-end 2017 and a terminal rate that does not exceed 2.5% later this decade. In our view, the more likely outcome is the funds rate will eventually climb well beyond that level.

Positioning Investment Portfolios

Against this backdrop, we remain overweight risk assets in our investment portfolios for several reasons. First, we believe the economic cycle will be longer than normal, as the economy continues to adjust from the fallout of the 2008 Financial Crisis and inflation remains low. Second, we do not believe Fed tightening will pose a major threat to the economy in the next year or two. Third, valuations do not appear excessive: Credit spreads are above historic lows while default rates are very low, and equity market valuations are not extreme, especially in the context of record low interest rates. That said, we expect financial market volatility to remain elevated until there is greater clarity about the strength of the economy and the future course of U.S. monetary policy.

[1] "Normalizing Monetary Policy: Prospects and Perspectives," March 27, 2015.