March 15th, 2012 | By Nick Sargen
The ability of markets to confound investors should not be underestimated. For example, the prevailing view at the beginning of this year was that financial markets would continue to be highly volatile. Several factors were commonly cited to support this view including ongoing tensions in the euro-zone as the region slipped back into recession, a projected slowdown in China’s robust economy, and lackluster growth in the U.S.
Instead, financial markets have begun the year on a very strong note: U.S. equity markets have risen to their highest levels in nearly four years, while international and emerging market equities have rebounded from a poor showing in 2011. On the bond side of the ledger, U.S. treasury yields have remained within trading ranges, while credit spreads have compressed. With markets staying unusually calm, however, many observers are wondering how long this situation can last.
Our assessment is that the rally in financial assets mainly reflects better-than-expected U.S. economic performance and diminished fears about a European financial crisis. In this regard, efforts by the Federal Reserve to lower long-term bond yields and those by the ECB to provide ample liquidity to European financial institutions have helped restore investor confidence. Nonetheless, there are legitimate questions about whether underlying problems on both sides of the Atlantic have been resolved.
With respect to the United States, the economy ended 2011 on a positive note, growing at a 3% annual rate – its strongest showing in more than a year, while job growth has exceeded 200,000 workers for the past three months. While these developments are encouraging, Federal Reserve officials have been cautious about the economic outlook, and they attribute some of the improved job gains to an unusually mild winter. Consequently, the Fed has left the door open for a third round of quantitative easing.
While the Fed succeeded in lowering long-term bond yields last year via “Operation Twist” and other policy pronouncements, we believe it faces a more difficult challenge ahead. With the economy on the mend and oil and gasoline prices rising, it does not want to be seen as stoking inflation. Consequently, the Fed reportedly is considering taking steps that would increase its balance sheet, such as purchasing additional treasury or mortgage-backed securities, while taking offsetting action to leave the money supply unaffected. Such action, however, would tend to boost short-term interest rates, and it could also cause bond yields to rise if investors shifted into equities and other risk assets.
As regards Europe, Mario Draghi, the newly appointed head of the European Central Bank, is widely credited for calming financial markets by permitting European banks to obtain 3-year financing from the ECB at a 1% interest rate. This action has reduced worries about the ability of European institutions to fund their operations. More recently, the European authorities negotiated a debt swap for private holders of Greek debt that lessened the risk of an unruly default.
Still, there is considerable skepticism about the medium- and longer-term prognosis for Europe. Indeed, key issues such as the need to recapitalize European banks and efforts to build a firewall to seal off debt problems of countries in the periphery from those in the core of Europe are still unresolved. Other issues such as the need to create a European fiscal union and to tackle still too high Greek debt have yet to be dealt with. Consequently, many observers believe it is only a matter of time before European markets heat up again.
In addition to these considerations, several other developments could tests markets at some point. One is the growing uncertainty about how the western powers will deal with the potential nuclear threat from Iran. This development has contributed to a surge in oil prices, which have sent gasoline prices in the United States to an average level in excess of $3.80 per gallon. With the summer driving season on the horizon, some experts are calling for gas prices to exceed $4 per gallon and possibly to reach $5. In that event, we would expect headline inflation to surge and the economy to slow, as it did a year ago.
Another factor that will likely weigh on markets later this year is the outcome of the national elections. Typically, in an election year the stock market turns volatile as the campaign season gets underway, and then rallies once the outcome of the election is known. It is questionable whether this will be the case this year, however, especially if the election outcome is a divided government.
Following last year’s debt-ceiling debacle, which resulted in Standard&Poors downgrading U.S. treasuries, the rating agencies signaled they would wait until after the election to ascertain whether the U.S. Government could achieve significant long-term deficit reduction. Should the current stalemate persist, however, the debate could become highly contentious again. This time, however, treasury yields could spike if the situation in Europe does not flare up again.
In this context, we are positioning portfolios for ongoing gradual improvement in the U.S. economy, a recession in the European periphery and a slowdown in China. On the equity front, we believe deeper-value stocks will continue to rebound as long as the economic environment stays favorable. However, we are also maintaining high-quality dividend paying stocks in the event the environment turns more volatile.
On fixed income, we are maintaining overweight positions in High Yield and CMBS to boost yields, while trading treasury securities actively. In our opinion, however, the risk is now tilted in the direction of higher treasury yields over the balance of this year.