Marking Time

April 15th, 2014 | By Nick Sargen


In the wake of last year's 100+ basis point rise in U.S. bond yields and 32% return for the stock market, financial markets took a breather this past quarter: The S&P 500 Index returned only 1.8%, roughly matching the Barclay's Aggregate Index. January witnessed a stock market sell-off of 4%-5% and a dip in bond yields amid concerns about the U.S. economy and emerging markets. However, the market subsequently recouped its losses in February and went on to post a record high in March, as investors shrugged off economic data as being influenced by severe weather.

In the meantime, investors are assessing what is in store for U.S. monetary policy with Janet Yellen as the Federal Reserve's Chair. At her first FOMC press conference, she surprised market participants by suggesting the Fed could raise short-term interest rates as soon as six months after it completed its current bond tapering operation. This triggered a rise in the front end of the Treasury yield curve. However, investors reassessed the interest rate outlook when Yellen subsequently clarified that labor market conditions are far from normal while inflation is well below the Fed's target.

U.S. Slowdown: Temporary or Ongoing?

Against this backdrop, the trend in financial markets should become clearer once investors can form a view of the economy when weather is not a factor. At the beginning of this year, there was considerable optimism that 2014 could be a breakout year in which the economy would post real GDP growth of 3% for the first time since the 2008 Financial Crisis. Part of the rationale is that there will be considerably less "fiscal drag" from tax hikes and sequestration than in 2013, when they subtracted one and one half percentage points from overall growth. In addition, economic conditions abroad appear to be improving, as Japan overcame two decades of deflation while Europe emerged from recession.

Meanwhile, two developments have raised questions about the prospects for stronger U.S. economic growth. First, the economy appears to have gotten off to a sluggish start, with real GDP growth for the first quarter estimated to be 2% or less. Second, the pace of economic growth in China and several other emerging economies, including Brazil, India, Indonesia, Russia, South Africa, and Turkey has slowed as well.

Our assessment is that the U.S. slowdown is partly a payback for stronger-than-expected growth of 3.3% annualized in the second half of last year. We believe it is temporary, and take comfort from the ongoing improvement in the manufacturing sector and in jobless claims, as well as the recent pickup in nonfarm payrolls and auto sales. Our call is that the economy will regain traction in the spring quarter and sustain it into the second half of this year at close to a 3% annualized pace. Key indicators to watch include purchases of big ticket items such as homes and autos, as well as an array of indicators for the job market, including nonfarm payrolls, part-time workers, and long-term unemployment.

By comparison, we are less confident about a quick turnaround in the emerging economies. The Chinese government may try to sustain growth of 7%-7.5% via fiscal stimulus measures, but we do not expect monetary policy to be eased materially given concerns about excessive credit in the system. At the same time, countries that have taken steps to defend their currencies and contain inflation, such as Brazil, India, Indonesia, South Africa, and Turkey will continue to feel the effects of higher interest rates on their economies. The good news is their external imbalances are improving, which should lessen the risk of financial contagion.

With respect to developed economies abroad, recent developments have been mixed. The good news: Europe is emerging from recession gradually and worries about the euro-zone have lessened, as evidenced by significant declines in bond yields of the troubled countries. At the same time, concerns about the risk of deflation are growing with the overall inflation rate for the euro-zone having fallen to 0.5%, well below the European Central Bank's (ECB) target of 2%. This, in turn, has increased expectations that the ECB will unveil a bond-buying program before too long. In Japan, the efforts of the Abe government to tackle two decades of deflation are working, but the economy's near-term outlook is cloudy due to the imposition of a higher sales tax on consumer goods that went into effect on April 1.

Withering Fed Policy?

At the start of this year investors were anticipating the Fed would wind down its bond purchase program by the fourth quarter. At the same time, the bond market was not expecting the Fed to tighten monetary policy until the second half of 2015 at the earliest. In the wake of Janet Yellen's comments after her first FOMC meeting as Fed Chair, however, bond investors revised their expectations for an earlier Fed rate hike.

Our own assessment is not to read too much into Yellen's remarks (or any Fed spokesperson), and to stay focused on how the economy and job situation is evolving, as this will ultimately drive bond yields. If the economy regains momentum and grows at about 3% in the balance of this year, for example, we would look for the 10-year Treasury yield to rise to 3.5%-3.7% later this year. Should the economy grow faster – say 4% – bond yields would likely end this year higher. Conversely, if the economy stayed sluggish and grew at 2%, the opposite would hold.

One issue that could receive greater attention is the role of financial stability considerations in the conduct of monetary policy. The prevailing view within the FOMC is that monetary policy should be focused on the Fed's dual mandate of achieving low inflation and low unemployment, while financial stability should be the purview of regulation and supervision. Recently, the media flagged that Jeremy Stein, a Fed Governor, had proposed that financial stability considerations become part of the discussion in setting monetary policy. While he subsequently announced he would be leaving his position to return to Harvard, Stanley Fisher is slated to become a Fed Governor. During his stint as the head of Israel's central bank, he was known to jawbone financial institutions about curtailing credit during boom periods. Consequently, Fisher could play a significant role in shaping Fed policy on financial stability issues.

Positioning Portfolios

Our view at the beginning of this year was that stocks would continue to outperform bonds, albeit by a much narrower margin than in 2013. With results for the first quarter in, we are not inclined to alter our view, and we are maintaining a moderate overweight in equities in balanced portfolios. The reason: in the wake of the stock market's large run up last year, we recognize it is no longer cheap, but we do not consider it excessively valued. At the same time, we believe bond yields are likely to trend higher, albeit by less than in 2013.

Part of our rationale is that the U.S. economy is in the middle phase of the economic expansion, where stocks typically outperform bonds. While the stock market is likely to experience jitters as yields move higher and the Fed comes into play, we foresee profits growing at a trend pace close to their long-term average of 8% per annum. If so, this should support the stock market. Some observers are concerned that profit margins are at record levels; however, we do not foresee an imminent decline with unit labor costs rising slowly and interest rates relatively low.

Typically, a bull run ends either when inflation accelerates noticeably or when there is a credit bubble. In this regard, inflation and inflation expectations are relatively tame, and we do not believe a credit bubble is forming thus far. The main risk to the stock market in our view is that it has had an unusually long run – more than 2 years – without a correction of 10% or more. This is nearly four times longer than the historical average. Therefore, we are reluctant to add to our overweight in equities at this time and would wait for a pullback to do so.