Stocks Bounce Back
Monetary Policy in Europe
Fixed Income
Dennis Fitzpatrick Founder, CEO, and Chairman
The stock market was volatile in the first quarter, with stocks down around 5% in late January, before rallying in February and again in late March. Stocks are now being driven primarily by economic growth data and their resultant impact on earnings expectations, a healthy change from last year’s market moves which were driven more by expected changes in interest rate policy. Higher interest rates will present a headwind for stocks, but equity investors today are more comfortable with their inevitable rise, and with the timing hinted at by central bank leaders.
Policymakers at the U.S. Federal Reserve are continuing with their stated plan to slow and eventually end quantitative easing (the purchase of Treasury bonds and agency mortgage backed securities), and this plan is now well understood by market participants. The important issue in the financial markets going forward will be the Federal Reserve’s ability to manage investors’ expectations of the timing of interest rate rises. If the Fed moves too quickly, the stock market will suffer short-term losses, which if severe enough could threaten economic growth (something the Fed is very anxious to avoid). If, on the other hand, the Fed raises rates in line with or slower than investors’ expectations, stocks will instead be driven by economic data and earnings, as is the case in more normal times. This would bode well for stocks since the economy – both globally and in the U.S. – is gaining strength.
The good news from the perspective of the equity market is that Fed chair Janet Yellen is known as an inflation dove. In recent speeches she has spoken about the weak state of the U.S. economy and the still fragile labor market. We view this as increasing the probabilities that the Fed will raise rates on the slow side
of market expectations.
Despite the recent increase in stock prices, equities are still attractive when compared to bonds. Treasury yields fell in the first quarter, and a 10-year Treasury currently yields 2.64% (barely a positive real return, as market expectations for inflation during the next 10 years are 2.14%). Emerging market equities are still cheap, as are European shares, while U.S. stocks are fully valued.
MONETARYPOLICYINEUROPE
The U.S. economy continues its slow but steady recovery. GDP growth was 1.9% in 2013 and is set to accelerate to the 2.5%-2.7% range this year. The unemployment rate has fallen to 6.7% and the underemployment rate (which includes discouraged workers) is currently 12.7%, its lowest level since late 2008. Data out of China have been mixed, though the Chinese economy is still set to grow around 7% this year. The Eurozone has returned to positive economic growth for the first time since 2011, though growth was only 0.5% last year and the European economy is obviously still very weak.
How European policymakers react to this continued malaise will be very important for global financial markets in the remaining nine months of 2014. It is well understood that the U.S. Federal Reserve is set to raise interest rates during the next few years, the only question is the timing. In Europe, however, economic growth has been much weaker and policymakers at the European Central Bank are considering increased monetary stimulus. Due to political constraints, fiscal stimulus was never tried in Europe during this recession, which has left the ECB as the only government institution with the power to encourage growth in the short term. In recent days ECB leaders have been preparing the market for a new policy, and one that has been seldom used: negative interest rates.
The ECB is floating the idea of
lowering the deposit rate – the rate the ECB pays on private bank reserves held at the central bank –below zero. The hope is that this will encourage banks to remove their money from the ECB and lend it to businesses, thereby spurring economic growth. A secondary goal is to weaken the euro, which is at a three year high against the U.S. dollar. A weaker euro would make imports more expensive, and would help to achieve the goal of higher inflation (which is below 1.0%).
There are also rumors that the European Central Bank is considering even more stimulus later in the year. Specifically, the ECB is considering implementing
its own quantitative easing program to buy Eurozone sovereign debt just as the Federal Reserve has been buying Treasuries and mortgage backed securities during the last five years. The ECB is said to be running models to see how such a policy could work, and how to optimize its implementation. This would be a watershed event for Europe, and would be very good for risky assets, especially emerging market and European equities.
European sovereign bonds have rallied significantly in the last six months, and have already priced in the likelihood of an ECB quantitative easing program. For example, the yield of a 10-year
Eurozone Unemployment Rate
Spanish government bond has fallen to 3.07%, down almost 200 basis points since last summer to its lowest level since 2005. Italian government bonds have moved similarly. The yield of a 10-year Italian sovereign bond has fallen to 3.10%, off 150 basis points since last summer. This is also its lowest level since 2005.
European and emerging market stocks have not fully priced in the likelihood of ECB action. The FTSE Developed Europe equity index is up only slightly more than the S&P 500 during the last year, and currently trades at 14.5 times expected 2014 earnings, a significant discount to the S&P 500, which trades at a multiple of 15.7. That discount is even bigger when using the market’s expectation for 2015 earnings. The case is even more stark with emerging market stocks, which have underperformed U.S. stocks during the last year. The MSCI Emerging Market Index is trading at 10x 2014 earnings, and just 8.4x 2015 earnings. If the
ECB decides to go ahead with a quantitative easing program, both European and emerging market stocks are very likely to outperform as investors seek higher returns in areas deemed of higher risk.
Emerging market stocks may have begun to react to this dynamic, as the MSCI Emerging Market index is up 9% since mid-March. Some emerging market indices have performed even better. The MSCI Indonesia Index, for example,
which was hit hard last year in the wake of Fed “tapering”, is up 28% year-to-date in U.S. dollar terms. Emerging market currencies have also risen in recent weeks. The Colombian peso is up 6% vs. the U.S. dollar since the end of February, and the Brazilian real is up 5%.
Brandon Fitzpatrick
The fixed income market, after surging in the first two months of the year, declined in March. Yields increased significantly for U.S. Treasury notes with three to seven year maturities as Federal Reserve Chairwoman Janet Yellen changed financial markets’ expectation for benchmark interest rates.
The financial markets were expecting short term rates, guided by the target Fed Funds rate, to be at the current rate, 0.25%, until the end of 2015. However, Janet Yellen said on March 19th that the Fed Funds rate hike may come as soon as April 2015, about six months after the end of the Fed’s quantitative easing program. This spooked the financial markets with 3, 5, and 7-year U.S. Treasury rates increasing by approximately 0.20%.
As a result, 30-year U.S. Treasury bonds returned 0.90% in March while the 10-year bond declined 0.34%. The Barclays U.S. Aggregate index lost 0.17%, as the U.S. Mortgage Backed Securities
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(MBS) and Intermediate U.S. Government indices declined 0.32% and 0.39%, respectively.
There will be an upward pressure on yields as the Federal Reserve unwinds the current bond buying program. However, if the U.S. economy’s growth momentum stalls (with or without low inflation), rates may stay at current levels or even fall. Additionally, increased geopolitical risk in Russia/Ukraine and disappointing economic data from China may lead investors to seek safety in U.S. Treasuries, thereby keeping rates low for the remainder of 2014.
We anticipate U.S. growth momentum picking up to offset other concerns (slowdown in China, currency problems in emerging countries, and geopolitical risks) and that U.S. Treasuries rates will increase gradually in the coming months. With a modest increase in inflationary expectations (resulting from a stronger economy), we expect the 10-year U.S. Treasury
Exhibit 1: U.S. Treasury Rates (%)
yield to increase to 3.0 - 3.5% range by the end of 2014. We expect spreads (to Treasury securities) on Agency MBS bonds to increase 15 to 20 bps, as triggered by increased MBS issuance and flat or decreasing MBS bond demand as the Federal Reserve unwinds its current bond buying program.
We took advantage of lower yields in February to reduce duration of the DBF Short Duration and DBF Intermediate Duration portfolios, with the goal of cushioning the effects of probable rising rates in 2014. We reiterate our expectation that both short duration and intermediate duration portfolios will perform relatively well in 2014 and beyond as portfolio cash flows are reinvested in a rising yield environment
Prabhab Banskota
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