After a weak start to the year, the market rebounded in February with the S&P 500 gaining 5.5% in its best month since October 2011. Oil prices stabilized, Russia and Ukraine agreed to a ceasefire, Greece received a four month extension of its bailout package, and thus a number of key risk factors for global equity markets receded. We are starting to see some ‘green shoots’ with regards to the European economy, and the labor market in the U.S. continues to firm. The VIX (volatility index) saw its biggest ever monthly decline, though as we anticipated this reprieve was a bit short-lived.
In Europe, better than expected GDP, retail sales, and unemployment data pointed towards improvements, with the European Commission increasing their growth outlook for both this year and next. Weak foreign economies have been a concern of ours, with Europe being one of the most significant, and budding evidence of a turnaround is a positive development.
In addition, we are encouraged by recent U.S. labor market data. In January, 257,000 jobs were added, and with positive upward revisions to November and December data, we saw the best three month pace of hiring since 1997.
Strong employment data influences the Federal Reserve’s decision on when to begin tightening interest rates. On March 18th the Fed moved closer to beginning that process by removing the word “patient” (with regards to rate changes) from its official statement. However, with recent data on consumer spending, housing, and industrial production weaker than anticipated, the Fed also downgraded its economic outlook and reduced its inflation expectations. This led investors to conclude that an initial rate hike will likely take place in the fall rather than summer, and markets responded positively.
We view Fed Chairperson Yellen as an astute communicator who was able to deliver potentially negative news in a way that did not roil markets. In her comments ahead of the meeting, she communicated that the Fed was likely to remove the word ‘patient’ while implying that this removal does not necessarily mean that rate hikes will be imminent. In reiterating the Fed’s data-dependent approach, she set the stage for greater flexibility going forward in determining policy at each meeting based on the latest economic data.
Overall, we maintain our cautious optimism. A firming labor market and lower energy prices should benefit the consumer, and we are starting to see some anecdotal evidence of wage growth (with large retailers such as Walmart and TJX having recently boosted salaries), which also bodes well for consumption. In combination, we believe these factors should provide a tailwind to the economy and corporate earnings. While we recognize that current stock valuations are modestly above historical norms, we do not see them as stretched, and believe that earnings growth can still take stocks higher.
We entered February with a portfolio bias intended to benefit from rising interest rates. As this came to fruition, with 10-year Treasury yield rising significantly during the month, we pared back on our exposure and moved closer to a neutral position with regards to interest rates, and this benefitted us so far in March. We are not overly concerned that the Fed will likely start to normalize rates this year, though we do see this as a likely source of volatility going forward.
In our analysis of prior periods of rate hikes, we found that when they commence from very low levels (as they are today), they typically are not a major headwind for equities. That said, if the economy heats up too fast, and inflation starts to rise materially faster than expectations, this could cause the Fed to normalize sooner – and more importantly, at a more rapid pace than the market currently anticipates. Compared to a gradual and measured increase in interest rates, a period of accelerated rate hikes by the Fed would likely hurt equities in our view.
Globally, the threat of deflation remains a key risk, and is the primary reason why bond yields are so low. We are encouraged that European growth seems to be improving, which should diminish the likelihood of prolonged deflation there. As we have written about in the past, most major central banks remain in highly accommodative stances, proactively attempting to combat deflation from taking hold.
Nevertheless, we continue to expect that volatility may increase as we progress through the year. Greece will likely return to the headlines again when the recent bailout extension nears an end. In the U.S., while we do not see interest rate normalization as a negative element overall, we could see choppy markets as we move closer to initial Fed rate hikes. With a number of uncertain elements both abroad and at home, we believe this highlights the importance of a disciplined investment process in navigating market volatility.
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