Stocks moved higher in May, with the S&P 500 advancing 1.3% for the month. We believe investors were heartened by improving economic data, particularly from the labor and housing markets. It was government bonds however, which garnered the lion’s share of capital market attention in recent weeks. German yields in particular moved sharply higher – in our view, a function of better economic data and inflation readings, on top of a considerably overbought market. We were impressed with the equity market’s resiliency in the face of these interest rate moves, and feel that this may bode well for a continued rise in stock prices as the year progresses.
After a lackluster start to the year, the U.S. economy appears to have regained some momentum in recent weeks. 280,000 jobs were added in May, far ahead of expectations for 225,000. Personal income also picked up, as hourly wages grew by 2.3%, the largest year over year gain since August 2013. Other labor market indicators appear healthy as well, as both initial and continuing jobless claims reached new lows for the current economic cycle. We also saw considerable strength from the housing market, where April starts and permits achieved their best levels since November 2007 and June 2008, respectively. New home sales jumped by 26% and are on pace for the strongest first half since 2008. Pending home sales exceeded expectations while growing for the fourth consecutive month, reaching levels not seen since December 2006. The latest auto sales data were robust as well, coming in at an annualized rate of 17.8 million during May, the best pace since July 2005.
Conditions appear to be improving in Europe as well. The Eurozone GDP grew by an annualized rate of 1.6% during the first quarter, a pace not seen in nearly two years. Retail sales in April turned in the largest monthly gain in over a year, and labor market conditions continue to improve, with April’s unemployment rate of 11.1% coming in at the lowest level in three years. Inflation too is moving in a healthy direction. With deflation a key concern for the European economy in recent years, we were encouraged by recent core consumer price gains which came in ahead of expectations at 0.3%. Moreover, the European Central Bank recently raised its CPI forecast to 0.3% for the year as compared with its earlier projection for no gain.
These economic improvements and hints of inflation did not go unnoticed by bond market investors. The German 10-year bond yield in particular has increased rapidly in recent weeks, jumping from 0.05% during the latter part of April to 0.89% in early June. In our view, while the data justified a portion of this move, conditions were also severely overbought and ripe for a correction. U.S. government bond prices also weakened, with 10-year yields recently hitting an eight month high of 2.4%. We believe that this was in part a function of the jump in German yields, which made U.S. Treasuries appear less attractive on a relative basis. In our view, other factors include the aforementioned strengthening of economic data, which has increased the odds of an initial Fed rate hike at some point later this year.
One of the key debates for stocks in 2015 is how they will fare when the Fed finally starts to raise interest rates. Many investors fear that the bull market cannot sustain itself once the Fed starts to tighten monetary conditions. Our view has been that while the uncertainty pertaining to the timing of an initial increase in rates may cause some volatility, ultimately a normalization of the interest rate environment does not necessarily bode poorly for stocks. This is particularly so given that the Fed has signaled that it will move at a very measured pace in an attempt to minimize any disruption to capital markets. In this regard, we are encouraged that equities were able to advance during the month despite the sharp run-up in bond yields. Though there are no guarantees that stocks will sustain this type of performance when the Fed begins its tightening campaign, we do take it to be a positive sign that the market has demonstrated such resiliency in the face of this recent spike in interest rates.
We have been forecasting a pick-up in economic activity based on our view that certain transitory headwinds would begin to dissipate. With adverse winter weather behind us, the West Coast port shutdown resolved, and the dollar having come off of its recent highs, we believe that we are starting to see this unfold. Moreover, the recent spate of better than expected data has increased our conviction in this scenario.
We maintain a positive outlook on the market. We continue to believe that improving economic conditions will drive increased consumption and higher corporate profits. We are also encouraged that the labor market has rebounded strongly following a very weak March report that now appears to have been an aberration. Our belief is that this positive trend will continue, in part due to our expectation that the energy sector will be less of a drag on employment moving forward. We have been keeping a close eye on rig counts, and while they continue to decline, the pace has moderated substantially.
Those with bearish views on the market cite valuations which are above historic averages. While it is true that the market price to earnings (PE) ratio is extended, it is not to a point that has us overly concerned, particularly in light of still very low interest rates, even after the recent run-up. All else equal, PE ratios are typically elevated when interest rates are low. Other risk factors include the ongoing negotiations between Greece and its creditors. With Greece having decided to bundle its June IMF redemptions into one payment due at the end of the month, it is likely that this uncertainty will continue for at least the next few weeks. While we are closely watching this situation, our position remains that it is unlikely to have a meaningful impact on the U.S. market. Finally, many investors are understandably concerned with how stocks will fare when the Fed begins to tighten policy. As noted, we think the market can remain resilient in the face of this campaign, particularly if the Fed is true to its word and acts in a measured, data-dependent fashion.
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