July 8th, 2014 | By Nick Sargen
The most prominent feature of financial markets in the first half of this year is how calm they have been. U.S. stock market volatility, as measured by the VIX, is the lowest since the onset of the Global Financial Crisis in mid-2007. The market has not had a pullback of 10% or more for two years now. Similarly, corporate bond yields and spreads versus Treasuries are down to pre-crisis levels and currency markets have been unusually quiet. The main reason is that investors are comfortable with the fact that the Federal Reserve is not in a hurry to raise short-term interest rates, even as it winds down its bond purchase program.
The biggest surprise has been a 50 basis point drop in U.S. Treasury yields. It occurred as the economy got off to a weak start, with real GDP declining at a 2.9% annual rate in the first quarter. This decline was partly in response to an unusually severe winter and to changes in healthcare provisions related to the Affordable Care Act. Growth abroad also faltered, and concerns about the possibility of deflation have increased in Europe. Consequently, bond yields in the periphery of the euro-zone are approaching those in the United States, while yields for core countries, such as Germany and France, are more than a full percentage point lower.
Most economic forecasters are undeterred by the weak start. While they have lowered their projections of U.S. economic growth for the calendar year to about 2.25% from 3% previously, the consensus forecast calls for real GDP growth to average 3% in the second half. We believe this pace is attainable considering the economy regained traction in the second quarter and has momentum heading into the third quarter. From our perspective, the most encouraging developments are (i) the upward trend in nonfarm payrolls with average monthly gains of more than 200,000 workers for the past twelve months; and (ii) purchasing manager surveys that show solid gains in manufacturing and services. The caveat, however, is that the economy does not appear poised for a decisive breakout from the 2.2% trend growth rate of the past five years.
Amid these developments, U.S. inflation bottomed in the first quarter, with Core CPI reaching a 1.6% annual rate. Through May, it has risen to 2.0% and forecasters are predicting that it will stay near that level or drift higher in the balance of this year.
For its part, the Federal Reserve is not concerned that inflation is heating up, and it believes some of the recent rise reflects volatile components, such as food and energy prices. In her recent FOMC testimony, Janet Yellen described the inflation data as being "noisy." The pick-up is consistent with the Fed's own forecasts, and it has not been accompanied either by a broad-based increase in wages or by a rise in long-term inflation expectations. Therefore, Fed leadership continues to believe that its top priority is to lessen slack in the labor force rather than fight inflation.
Accordingly, the bond market is not pricing in the Fed to begin raising interest rates gradually until mid-2015 at the earliest. We concur with this assessment, but still expect bond yields to likely move higher in the second half as the economy gains traction.
Compared with the situation at home, developments abroad are more complex, as investors must contend with several cross-currents. As in the United States, the latest purchasing manager surveys show a pickup of economic activity in Asia and Europe following a weak start. However, the economic picture in many parts of the world is clouded by political uncertainties, especially in the Middle East, Russia, and Ukraine.
In Europe, there are signs the euro-zone is recovering very gradually from recession; however, unemployment in the periphery is stuck at record levels. Moreover, inflation has declined steadily in the region, and is now down to 0.5%. The European Central Bank (ECB) has responded by charging interest on banks' excess reserves while also creating incentives for banks to lend to businesses. We believe the ECB should ease more aggressively to reduce the risk of deflation. No one questions the ability of central banks to fight inflation, but markets are justifiably nervous about the potential for deflation to worsen Europe's debt woes.
The political developments in the Middle East are particularly difficult to assess. For the time being, markets have taken the news in stride, and oil prices have increased only moderately – less than $5 per barrel. The wildcard in the outlook is the possibility that turmoil in Iraq and Syria could lead to civil war and spread to other countries, resulting in a spike in oil prices. In that event, economic growth prospects in the United States and abroad would be hindered while headline inflation rates would increase. In such circumstances, we would expect the Fed to delay tightening monetary policy beyond 2015, and bond yields would likely decline.
Amid all these uncertainties, we have not made major changes in positioning portfolios. In fixed income, we are maintaining an underweight duration position and are modestly overweight in credit risk. In balanced portfolios, we are continuing to overweight equities relative to bonds by a moderate amount. This reflects our view that valuations relative to bonds are reasonable, and Fed policy seems likely to remain supportive for an extended period.