Market Roundup - February 2013
February: A month of minor milestonesBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
Despite being the shortest month of the year, February is chock-full of holidays, including Groundhog Day, Mardi Gras, Ash Wednesday, Valentine’s Day, Presidents Day, and perhaps others. This year, February could also be full of milestones. Major market indexes entered the month running up to highs not seen since October 2007, leading many commentators to question whether these levels can be sustained. To put this into perspective, corporate earnings have surpassed their 2007 highs, and the Federal Reserve’s (Fed’s) balance sheet is larger than it’s ever been. It’s also important to note that, adjusting for inflation, the S&P 500 Index would have to be above 1,700 to surpass its October 2007 high. While we think the levels are justified, that doesn’t mean the markets will remain at or above them. Rather, it simply means we think there is long-term value in equities even at these elevated levels. However, feeling excitement or contentment with fixed income at this point seems harder to justify.
The economyBy Brian Jacobsen
In the fourth quarter of 2012, the growth rate of U.S. gross domestic product (GDP) was -0.1%. Yes, that is a negative sign in front of the GDP growth rate. Markets and many economists, ourselves included, shrugged off the negative reading for a variety of reasons. First, a slowdown was expected with weather and political problems dampening economic growth. Second, the number from the Bureau of Economic Analysis (BEA) is subject to revisions and is likely to be revised to +0.2%, based on data released just before the GDP numbers were announced. Third, a declining inventory growth compared with the third quarter and a cutback in defense spending accounted for the bulk of economic deceleration. These are often temporary factors that don’t point to continued slowing. Finally, it’s important to remember that these numbers were for 2012, not for the future. We’re more interested in where the economy and markets are heading, not where they were.
Government spending growth is likely to continue slowing, so that is already built into our forecasts. Also, with the fiscal cliff deal, the spending cuts that were to affect defense and discretionary nondefense federal spending were postponed until March 1. We’ll likely hear much political talk about how to avoid these cuts or offset them in the run-up to the deadline. In our opinion, it appears unlikely that a majority of the cuts can be avoided, so we’ve already built continued declines in defense spending and some federal spending into our forecasts. It’s important to note that the spending cuts—referred to as the sequester—will not affect Social Security, Medicare, or Medicaid. Along with defense, those are the big drivers of government spending, so the sequester may not be that noticeable from an economy-wide perspective. In other words, the pain may be more selective than systemic.
Because the Senate hasn’t passed a budget since 2009, the federal government has been operating on the basis of six-month continuing resolutions, which are just short-term agreements that keep federal programs funded. The latest agreement expires on March 27. Thus, there will likely be more political discourse in February and March about whether the federal government will shut down or not. We’ve seen this before, and it is unlikely to have much of an economic effect. If the federal government shuts down, essential services are still provided, including defense, food safety measures, and distribution of Social Security checks and tax refunds. It really only becomes an economic drag if it is a protracted shutdown, which seems highly unlikely. The last time the federal government shut down for an extended period was in 1995 and 1996, which ultimately cost the majority party in the House (Republicans) dearly in the next election. The strong re-election instincts of politicians will likely lead to the avoidance of a shutdown, or at the very least, they will keep it short.
Thanks to the expiration of the payroll tax reduction of 2011 and 2012, consumers will now have to adjust to a cut in their take-home pay. We think the hit to consumer spending will be dampened as consumers choose to save a little less rather than forgo consuming. Saving rates—the percent of disposable income households don’t use for consumption—rose from 4% to 4.7% when the payroll tax cut was introduced, so we could see a simple reversal of that now that payroll taxes have reverted to previous levels. Also, in our estimation, the payroll tax cut spurred purchases of consumer durables (for example, cars, washers, dryers, etc.), so a reversal of the tax cut could affect particular industries rather than consumer spending as a whole.
For 2013, we think the Federal Open Market Committee (FOMC) will maintain or possibly accelerate its pace of bond purchases before it begins to trim its purchases. By the end of the year, we anticipate the FOMC could stop purchasing securities and let the balance sheet shrink naturally as securities mature. The FOMC would then likely keep its target for the federal funds rate at or near zero well into 2014. Of course, if economic or financial conditions change abruptly, which is always a possibility, Fed policy will change as well.Geopolitically, we will closely watch the election in Italy and the developments in the Middle East in February. In Italy, we expect the next prime minister chosen to be someone sympathetic to Mario Monti’s reform agenda, which we think would be positive for eurozone government bond yields and eurozone equities. In the Middle East, the violence in both Egypt and Syria continues to worry us. With the anticipation of a presidential election in June in Iran, we would not be surprised if that country enters the geopolitical picture at some point in the next few months, which could keep oil prices elevated.
EquitiesBy John Manley
According to the U.S. government, the old year ended on December 32. In a feat of brinksmanship that rattled the capital markets in the days after Christmas, Congress and the president reached a compromise to avert the fiscal cliff (remember that?) on New Year’s Day and unleashed the bulls of January.
A combination of relief, positive earnings surprises, and recognition of subtle worldwide economic improvements (recently obscured by fixation on the cliff) pushed equities higher in January. The advance was both widespread and worldwide. Interest rates on Treasury securities ticked higher, and flows into mutual funds reversed course and headed toward equities. Individual investors, long content to stay on the sidelines and settle for 20-basis-point (bp; 100 bps equals 1.00%) yields, seemed, at last, ready to resume their interest in equity securities and funds.
Our analysis of similarly strong and accelerating Januaries suggests that, normally, there is still incremental interest and more appreciation yet to come. While such historically derived predictions of future performance must always be viewed with some skepticism, the latent buying power that would cause such appreciation does appear to exist. For individual investors, last month’s stock surge may have dulled the anxiety of recent times and rekindled some of the happy memories of the pre-2007 equity markets. However, in our opinion, this transformation seems far from complete.
The S&P 500 Index advanced 5.2% in January to cap a 16.8% annual gain. It is interesting to note that this surge occurred despite the near free fall of its then largest component, Apple Inc. Without Apple to retard it, the large-capitalization, high-quality Dow Jones Industrial Average gained 5.9%. By contrast, the Nasdaq Composite Index, with an extremely heavy component in Apple, only gained 4.1%.
Small stocks definitely set the pace in January. The Value Line Arithmetic Composite Index rose 8.8% as the Value Line Geometric Composite Index rose 8.4%. Both the individual investor as well as a slight diminution in risk avoidance across the board may have played a roll. The market also had a decided tilt for value over growth. The Russell 3000® Value Index gained 6.5%, while the Russell 3000® Growth Index added 4.5%. As before, we wonder what role Apple’s decline played in this disparity.
From a sector perspective, there was no significant cyclical tilt in performance last month. Energy led the pack with an increase of 7.6%. We like the energy sector for a number of reasons, including high-quality, low valuations and modest and early exposure to the commodities area, but we believe the area probably followed the price of oil higher. Signs of easing economic fears around the world may have aided the commodity’s appreciation.
In contrast, the second best-performing sector in January was health care, which gained 7.5% despite the imminent implementation of Obamacare. It would seem that Wall Street is finally beginning to realize that an increase in tax dollars directed toward health care will likely end up as revenue or profit in that industry. We also favor the sector and note the cash-flow flexibility and dividend-paying prowess of its larger companies and their aptness for funding yield-hungry pension accounts.
Other outperforming sectors included consumer discretionary, consumer staples, industrials, and financials. Laggards included materials, utilities, telecommunication services, and information technology (IT). We recognize that IT was dragged lower by Apple but suspect that other large-capitalization IT names more fully participated in the rally.
Overseas, while January performance was solid, it lost some of its momentum from the fourth quarter of last year. Among the stable developed countries, the U.K. was the exception with a 6.5% (local) gain. The CAC 40 (France) and the DAX (Germany) lagged with 2.5% and 2.2% respective gains. However, because the euro strengthened against the U.S. dollar, currency moves significantly increased dollar-based returns on European Bourses to levels above those produced by the S&P 500 Index. Greece was particularly strong, rising 8.7% and 11.9% in local and dollar terms, respectively. Switzerland also posted a near double-digit gain.
With the exception of Brazil (-2.0% in local, +0.9 in dollar terms), all of the emerging and resource markets rose during the period. A sagging dollar generally augmented local currency returns. Argentina led with a 21.3% gain, but Russia also managed to post a respectable 6.2% appreciation. The developing Asian markets, in general, slightly lagged U.S. markets. However, Mexico, with its oil and U.S. trade exposure, managed to outperform the U.S. in dollar terms.In summary, foreign markets posted respectable gains. We continue to urge meaningful exposure to these areas but would not yet adopt massive overweights.
BondsBy James Kochan
The taxable fixed-income markets struggled again in January while the municipal market recovered from a December sell-off. Treasuries performed poorly for the second consecutive month, as the yields on the benchmark 10-year note rose 20 bps. Without the benefit of strong demand from foreign investors, the Treasury market tends to falter, and that was the case over the past two months. With yields at exceptionally low levels, even modest price declines are sufficient to produce negative returns.
The mortgage market also recorded negative returns, as mortgage-backed securities (MBS) yields rose in step with Treasury yields. With MBS spreads only about one-half their long-term averages, the mortgage market has become unusually vulnerable to any rise in Treasury yields.
Sectors with higher yields performed somewhat better during January. In the investment-grade corporate market, the AA and A credits recorded negative returns, with the BBB credits performing only slightly better. This was similar to the pattern of returns during December. The high-yield corporate market again posted a spectacular performance last month, with the weaker credits performing best. Total returns were 0.8% and 1.2% for the BB- and B-rated sectors, respectively, and 3.0% for the CCC and weaker credits. Spreads to Treasuries narrowed further during January, and average yields for this market reached new all-time lows.
The municipal market recovered nicely in January following a December sell-off that produced a return of -1.95%. As has been the pattern for the past two years, the best returns were from the weaker credits. While the AAA credits returned 0.4%, returns from the A and BBB credits were 0.8% and 1.3%, respectively. Municipal-to-Treasury yield ratios are now below 1.0 on AAA bonds but remain in the 1.5 to 2.0 range in the A and BBB sectors. Those ratios mark the weaker credits as far better relative values than the high-grade issues.January returns illustrated why accepting credit risk rather than duration risk might be the preferred strategy in 2013. Credit fundamentals are expected to remain favorable in the months ahead, which should keep spreads to Treasuries from moving significantly wider. While a steady fed funds rate should rule out a prolonged cyclical rise in Treasury yields, it would not be surprising to see the 10-year yield move above 2% sometime in the first quarter, as it did one year ago.
Table 1: Year-to-date bond market total returns (%)
Asset allocationBy Brian Jacobsen
Investment horizonsFor investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Short-term, over the next three months, we think investors can still be rewarded by looking at higher-yielding fixed-income investments as well as growth-oriented equities.
Equity markets have continued to recover, but it’s important to look at the context. Although they are improving, they have not fully recovered. From a valuation perspective, we think there are still opportunities, especially in a globally diversified equity portfolio. Eurozone and Japanese equities have performed relatively well thanks to Mario Draghi’s pledge to do whatever it takes to keep the eurozone together and Shinzo Abe’s pledge to increase the Bank of Japan’s inflation target. Time will tell if the Draghi/Abe dyad will be successful, but investors have responded excellently to it thus far. We think investor sentiment is still sour but improving, which should be positive for those areas.
Value versus growthThe global economy is likely to grow 3.5% to 4% for 2013. It’s not stellar growth, but it’s still growth. We think investors are on high alert for the next crisis, meaning that even mediocre economic results could be surprisingly positive. As a result, across the value/growth spectrum, globally, we prefer looking for mispriced growth opportunities globally across the value spectrum. We believe many of these are in technology, broadly defined as the way inputs are converted into outputs in a more efficient way. That argues, we believe, for investing in business-facing businesses rather than consumer-facing businesses.
Large caps versus small capsWhile we still think large-cap companies are better positioned for global growth than small-cap companies, that doesn’t mean small- and mid-cap companies should be ignored. It’s more important to be more discerning in what the economic exposure of a company is rather than just its size.
Fixed incomeBased on our economic outlook, we believe interest rates are likely to remain low for the next year. This presents an opportunity for investors to take on additional duration and credit risk, but we prefer more credit risk rather than more duration risk. Provided the economy does not dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues would.
Asset allocation summary table1
The bottom line
In the classic movie (is it fair to call a movie from 1993 a classic?) Groundhog Day, a weathercaster is doomed to relive the same day over and over again. He seems to relive it until he changes his attitude and priorities to find the love of his life. Maybe that’s what’s happening in the U.S.: We’ve seen these political debates again and again. They play out according to the same patterns, though over different time frames. We don’t want to say that 2013 will be different than 2012 or 2011 in terms of political progress, but we do need to point out that incremental changes are being made. And some of those incremental changes can add up. If anything, businesses have seemed to prove that their profits are relatively shielded from politics.