Macro, US

Markets in Equilibrium: Anticipating the Next Move

May 6th, 2014 | By Nick Sargen

Highlights

  • Our assessment at the start of 2014 was that U.S. stock and bond markets were reasonably priced, and their prospects depended on how the U.S. and global economy fared, and on Fed policy developments. So far, the principal surprise has been a 40 basis point decline in Treasury yields, which is an enigma for many investors.
  • One year ago, when yields were roughly 100 basis points below current levels, they surged when the Fed announced it was contemplating winding down its bond purchase program. But it is unlikely the Fed will surprise investors again, and investors are comfortable that quantitative easing will be completed by the fourth quarter.
  • Meanwhile, the strength of the U.S. economy is likely to be the key market driver in the balance of this year: Should the economy grow in the neighborhood of 3% while monthly payroll gains average 200,000+, Treasury yields are likely to resume their upward trend. Accordingly, we are underweight in duration in fixed income portfolios, and have closed out high yield positions for tactical reasons.

Market Lull: How Much Longer?

Following a bond rally and stock market sell-off in January, U.S. financial markets have settled into narrow trading ranges in the past three months: The yield on the 10-year Treasury has been centered about 2.7%, while the S&P 500 Index has fluctuated around its level at the beginning of this year. The initial moves reflected investor concerns about a U.S. slowdown, as well as political and economic developments in several emerging economies. More recently, investors have shrugged off weaker-than-expected U.S. GDP growth in the first quarter, fears of an economic slowdown in China and other emerging economies, and heightened tensions over Ukraine. These developments suggest financial markets are in a state of equilibrium, which is likely to continue until there is a major market surprise.

One year ago, the main development that jarred the bond market was the announcement by the Federal Reserve that it was contemplating phasing down its bond purchase program. The announcement caught investors off guard, as the economy was off to a sluggish start and 10-year Treasury yields had fallen to 1.6%-1.7%. Just when investors had concluded yields were likely to stay below 2% indefinitely, they surged by about 100 basis points in the next two months, and they closed the year about 3% on the back of stronger-than-expected economic growth.

The situation today has some parallels, with bond yields having reversed their rise in the second half of 2013 as the economy faltered in the first quarter. This time, however, investors are unfazed that the Fed has cut its bond purchase program roughly in half and is set to eliminate it by the fourth quarter. The principal reason is the Fed has succeeded in convincing investors it is not in a hurry to raise short-term interest rates: Inflation remains well below the Fed's 2%+ target while the unemployment and underemployment rates are considered unacceptably high. And even though the unemployment rate fell from 6.7% in March to 6.3% in April, investors do not expect the Fed to alter policy, considering that the labor force participation rate also declined and wage increases are modest.

In these circumstances, we do not foresee an imminent change in the Fed's policy stance leading to a shift in market sentiment. Instead, the key driver of financial markets is likely to be the performance of the U.S. economy in the remainder of this year.


U.S. Economy: Is 3% Growth Still Attainable?

The consensus view at the beginning of this year was the U.S. economy would accelerate in the next two years, and some forecasts called for real GDP growth of 3% for the first time since the Financial Crisis. With the preliminary estimate for the first quarter being virtually flat, economists have been trimming their growth forecasts for this year.

Nonetheless, it's relevant to consider whether 3% growth is attainable for the balance of this year and next. My assessment is that it is feasible for the following reasons:

  • The private sector of the economy – consisting of personal consumption, residential and business investment, and net exports – has been growing at a 3% annualized rate for the past two years. Consumer spending, which accounts for nearly 70% of total spending, expanded at a 3% pace, partly due to higher heating and healthcare expenses. At the same time, disposable income grew by 3.3%, which should buttress future consumption.
  • The first quarter slowdown mainly reflected declines in business and residential investment spending, net exports, and inventories. However, the softness in investment appears weather related and the decline in inventories is expected to moderate. Meanwhile, key economic indicators such as nonfarm payrolls, manufacturing output, and car sales all point to an economic rebound in the current quarter.
  • As regards to the government sector, "fiscal drag" in the form of tax increases and spending cuts is estimated to have cut overall growth in 2013 by 1½ percentage points. In 2014, by comparison, the amount of fiscal drag is estimated to be about one half as large.

There are also several caveats to weigh. One is that a pick-up in residential housing is critical for the economy to accelerate, considering the sector has softened in the past two quarters. While the first quarter decline in housing may be partly weather related, new household formation has fallen short of expectations. A second caveat is that stronger U.S. export growth is partly dependent on China and other emerging economies stabilizing. This appears to be the case, as evidenced by an improvement in market conditions in emerging economies. More generally, the softness in the global economy in the first quarter may be payback for stronger-than-expected growth in the second half of 2013.


Bonds Appear Mis-Priced

In this context, the 40 basis point decline in Treasury yields and further narrowing of credit spreads versus Treasuries so far this year make bonds look expensive to us. Our view is that the economy has transitioned from the early stages of recovery to a more solid expansion over the past year, with the 8.7 million increase in unemployed workers during the Great Recession now being reversed. Moreover, monthly nonfarm payrolls have been averaging more than 200,000 workers over the past year, which suggests a cyclical upturn is well underway. That said, we acknowledge structural problems persist with those who have been out of the workforce or working part time for several years.

If this assessment is correct, we would expect bond yields to rise as the expansion continues. This was the pattern in 2013; however, it has stalled recently for the reasons cited earlier. While the recent bond rally may reflect increased concerns about Ukraine, we would expect yields to rise if tensions lessen. Accordingly, we are underweight in duration in our bond portfolios.

The main change we have made is to eliminate our former overweight position in high yield bonds, on grounds that bond yields in the neighborhood of 5% do not compensate investors for interest rate and credit risks. This move is similar to a tactical one we made a year ago at this time. Thus, we are prepared to reinstate positions should yields rise by 50-100 basis points.