Market Roundup - May 2011A new meme for May
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
John Lynch, Chief Equity Strategist
James Kochan, Chief Fixed-Income Strategist
Two memes—terms that spread from person to person within a culture—are being used these days to describe the markets. Sometimes the meme is “Teflon market.” At other times it’s “climbing a wall of worry.” These phrases can be cute, and sometimes even useful, but they don’t perfectly characterize what’s going on in the financial markets, so they can create dissonance when they break down. “Teflon market,” for example, means that no matter what bad news you throw at it, market prices keep going up. “Climbing a wall of worry” means that people are skeptical about the likelihood of a continued economic recovery. Newscasters will pick up on whichever of these two memes is appropriate for the day. If the market is up, it’s a Teflon market. If the market is down, it’s because we’re still climbing a wall of worry.
Maybe we need a new meme: The market is as the market does. There is good news and bad news, and the market will react accordingly. This was demonstrated in April, as the market moved up on the good news despite plenty of worries: high commodity prices, geopolitical unrest, geological disasters, and other bumps in the night. In this Market Roundup, we attempt to identify some of today’s risks and opportunities in the economy, equities, and bonds.
But this export-led growth, which has helped China and other emerging markets economies create jobs and output by selling to the developed world, can create economic imbalances. When a country sells to the U.S., it gets U.S. dollars in exchange. Typically it will buy U.S. Treasury securities, which has helped to keep U.S. interest rates low. Over time, a country can accumulate only so many U.S. debt securities before other options start to look appealing, like buying U.S. goods and services or buying other U.S. assets (like equities or real estate).
To this end, China and other emerging markets governments both within and outside of Asia have begun to talk about diversifying their foreign-exchange reserves. They are tired of getting a meager interest rate on their U.S. government debt securities and are looking for a higher return on their investments. This could represent a tidal shift, as emerging markets governments accumulating U.S. government debt start to buy other U.S. assets, goods, and services.
Instead of fearing the idea of China outgrowing the U.S., we should embrace the opportunity to rebalance the global imbalances caused by the years of emerging markets export-led growth. U.S. equities should do well in the long run, while investors may want to trim their exposure to U.S. government debt. There are opportunities in the high-yield and municipal debt area that are relatively more attractive than sitting on U.S. Treasury securities.
High prices at the grocery store and the gas pump do not signal inflationAs of the writing of this Market Roundup, the national average price of gasoline was $3.94 per gallon. In 12 states, gasoline cost more than $4 per gallon. In Hawaii, it was more than $6 per gallon. Isn’t that inflation? Sadly, no. It is merely expensive gasoline.
High prices at the grocery store or the gas pump do not signal inflation. What constitutes inflation is an environment in which all prices continue to go up. One of these prices—perhaps the most important—is wages. A lot of people think of a wage as income, which it is, but it is also the price companies pay to hire someone to work. By this measure, prices, including wages, are not going up in tandem with gasoline. What we’re seeing instead is an erosion of consumer purchasing power and wealth. Painful? Yes. Inflation? No.
This distinction probably gives investors little comfort, but it is important. When wages don’t go up with consumer prices, the consumer price increase is unlikely to result in a persistent increase in the growth rate of prices. Instead, price levels may jump intermittently. Think of it this way: If gasoline prices go up from $3 to $4 per gallon, that’s a price jump. If gasoline goes up in price 10% per year, from $3 to $3.30 to $3.63, that’s inflation. The Federal Reserve is looking at controlling inflation (the continual increase in prices), not at preventing one-time jumps in prices. At the same time, consumers are concerned about price increases. This disparity means that the Fed can keep rates low longer than consumers might like. Loose monetary policy can push prices higher, causing pain for consumers, but don’t forget that equities, fixed income, and commodities also have prices that can go higher, creating opportunity for investors.
The April gains were broad based among all the indexes we follow. See Chart 1. For example, capitalization favored larger companies, as the DJIA outperformed the Russell 2000 Index in April, leading to year-to-date outperformance for the bigger names. Regarding investment style, growth stocks outperformed value last month, narrowing their year-to-date underperformance differential. Looking overseas, developed markets handily beat the emerging space last month, building further on their year-to-date outperformance.
CHART 1: MARKET PERFORMANCE AS OF APRIL 29, 2011
From a sector perspective, health care was the leader within the S&P 500 Index, buoyed by a combination of better-than-expected profit growth and increased merger activity. The consumer staples sector was next, puzzling us because this is an area that is susceptible to margin erosion as input costs rise with the increase in commodities. Companies are unlikely to pass these costs on to customers in an environment where lofty unemployment levels persist. Some leading financial names disappointed investors during earnings season, which led to the sector’s poor showing in April. In another apparent oddity, the energy space failed to keep up with the surging price for oil. Is this perhaps another example of “buy the rumor, sell the news?”
Whither the dollar?The U.S. dollar continued to weaken in April as monetary policymakers reiterated their plans to fulfill the $600 billion Treasury bond buying program. To be sure, the greenback has been on a steady decline since QE2, as suggested in a speech by Fed Chairman Ben Bernanke last August. These concerns have been exacerbated by the longer-term implications of federal deficit spending measures. See Chart 2.
CHART 2: U.S. DOLLAR INDEX COMPARED WITH THE 50-DAY AND 200-DAY MOVING AVERAGES
To be fair, Fed and Treasury officials are in a difficult spot. If they pursue higher interest rates to support the currency, they risk the already shaky recovery in employment, which could further pressure home prices and potentially send the economy back into recession. In addition, higher interest expense is not an attractive alternative as lawmakers in Washington currently battle over the federal debt limit. Consequently, it appears that officials are willing to take their lumps on the dollar, possibly hoping that the end of QE2 will result in a bid for both the currency and market interest rates. Further, a potentially more devious strategy is that officials may simply be waiting for the next sovereign debt problem to escalate in Europe, which could also result in a bid for the dollar as global investors seek the traditional safe-haven status of the world’s largest reserve currency during times of crisis. In the meantime, a weak dollar, at least theoretically, should serve to promote export growth and to help drive profits for those companies with significant international operations.
As mentioned in the economy section earlier, we are not convinced that the weak dollar necessitates a long-term inflationary problem. While food and energy prices have jumped recently, we are willing to stand with Fed officials in their statements that these developments are likely “transitory.” Indeed, food and energy comprise approximately one-seventh of domestic inflation measures, whereas they can add up to more than one-half that in many emerging markets nations. Not to underestimate the pain many domestic households are experiencing with, for example, higher gasoline costs, but for a longer-term inflationary problem in the U.S. to develop, and persist, housing and wages must participate. Unfortunately, that scenario seems unlikely to occur anytime soon.
Meanwhile, gold and silver continued to hit new highs as the dollar has struggled. Of the two, we believe gold should enjoy more bids over the longer term as foreign central banks hesitate to buy dollars due to deficit spending concerns, while also possibly limiting their purchases of euros—which some may consider expensive at current levels, particularly given the sovereign debt issues on the continent. In our opinion, the recent action in silver appears “day-trader excessive.”
For those companies with significant international operations, the weaker dollar enhances the affordability of their products and services, while also serving to increase profits once foreign-sourced revenues are re-priced into domestic currency earnings. Generally speaking, the larger-cap sectors that would fit into these categories include energy, materials, industrials, and information technology. However, a hurdle exists for many companies as the weaker greenback increases commodity and input costs, resulting in margin pressures. Many businesses, particularly in the consumer discretionary and consumer staples sectors, have difficulty passing these rising costs along during periods of high unemployment. This establishes yet another case for a fully diversified and actively managed long-term equity portfolio.
The very steep yield curves were the major factor influencing returns in April and year to date. In April the one- to three-year maturities returned 0.3%, while the seven-year and longer maturities returned 2.2%. Year to date, the longer maturities have returned 3%, while the one- to three-year segment has returned 0.9%. Returns across the credit spectrum were more uniform. In April, the AAA/AA credits returned 1.7%, while the A/BBB credits returned 1.8%. Because the corporate market also performed well in April, the municipal-to-corporate yield ratios remain at or near record levels. Instead of the normal ratios of 0.7 to 0.8, the 10-year A-rated municipal-to-corporate yield ratio is now 1.0. These exceptionally high ratios mark the municipal market as substantially undervalued versus Treasuries and corporates.
Both the investment-grade and high-yield corporate markets continue to outperform Treasuries. By virtue of their higher yields, the bank and finance sectors are performing better than the industrial and utility sectors. Year to date, bank and finance returns are a percentage point better than industrial and utility returns. Among all investment-grade issues, the intermediate and longer maturities have produced year-to-date returns in the 2.5% to 3% range, much better than the 1.4% return from the one- to three-year segment. The high-yield corporate market continues to perform exceptionally well, with the weakest credits still outperforming the stronger credits. The CCC sector now has a year-to-date return of 7.2% versus a return of approximately 5% for the BB/B sectors. Steep yield curves are also a major factor influencing returns in the high-yield market. The one- to three-year maturities have a year-to-date return of 3.7%, while the longest sectors have returns of more than 8.5%.
The Treasury yield curve is virtually unchanged thus far in 2011, thanks to a fairly strong rally during April. Yields fell almost 30 bps in the three- to five-year segment of the curve last month and 10 to 15 bps in the 10- to 30-year segment. That rally brought the yield on the 10-year note down to 3.30% at month-end, which is at the low end of the range for 2011. Except for a very brief drop to 3.20% in mid-March, the range for this yield has been 3.30% to 3.75%. With the Fed planning to reduce its purchases of notes and bonds by $60 billion per month starting in July, yields below that range might prove to be unsustainable in the months ahead.
The April and year-to-date total returns remain consistent with what we have called the income phase of the fixed-income investment cycle—the phase in which interest income contributes to the bulk of total return. Only the high-yield market has seen a significant amount of capital gains thus far in 2011. Because yield curves in every market are unusually steep, returns are substantially greater on the longer maturities. Even in the municipal market, which has been struggling somewhat this year, returns in the intermediate and longer maturities are substantially stronger than they are in the short maturities. In fact, we expect the short-term sectors to continue to underperform in the months ahead. Fed Chairman Bernanke and the Federal Open Market Committee continue to insist that the fed funds rate should stay unusually low for an “extended period.” That probably means for the rest of 2011, or perhaps longer. In that event, cash and cash equivalents would be expected to produce the poorest returns of any investment sector.
CHART 3: BOND MARKET TOTAL RETURNS, AS OF APRIL 29, 2011
THE BOTTOM LINE