Market Insights: May 5, 2014
Economic Outlook: First quarter weakness?
- The big news of last week was the release of the initial estimate of U.S. GDP for the first quarter of 2014. It posted only a +0.1% annual rate of growth. Most observers expected a weak number, anticipating the results would likely be depressed due to unusually cold weather. This was weaker than consensus, however. We will of course watch the various revisions to this number over the next few weeks to get further clarification on first quarter activity.
- The ADP Employment report came in strong with a gain of 220,000 jobs for private payrolls in April. This was ahead of what most economists were predicting.
- The Personal Income and Outlays report showed personal income growing at 0.5% in March, which makes the 12-month gain about +3.4%. This is quite a ways ahead of the inflation rate for the past year, and indicates the job market is improving for those with the requisite skills to fill the available positions.
- ISM’s Manufacturing Index improved again to 54.9 in April.
- These payroll, income and manufacturing metrics cause us to be doubtful that the weak first quarter GDP number represents some sort of turning point in the continuing slow economic recovery that has persisted since 2009.
- The one significant international economic metric for the week was Japan’s PMI Manufacturing number for April. It slipped below 50, which suggests contraction rather than growth in the economy. This will be something to keep an eye on.
Equities Outlook: Recalling the “Fed Model”…
- Clients ask us frequently about all the chatter around companies buying back their own shares in the market and what this really says about their available opportunities to invest in expanding business.
- At today’s low interest rates, companies can actually improve the earnings return to shareholders by borrowing money to retire some of their own shares. In 2013, non-financial corporations in the U.S. issued a record amount of new bonds. Some of the money from those bond issues funded retirement of their own shares in the market, benefiting shareholders by increasing earnings per share.
- An extension of this is what is now being seen in the heightened level of merger and acquisition activity in the market. Corporate managements judge that they can borrow at inexpensive rates and fund mergers that will boost earnings to shareholders of the combined new entity.
- Until recently, managements seemed to be “hunkered down” with respect to borrowing, remembering the financial crisis of 2008. It appears that there is now increased optimism about the future, and we expect this merger and acquisition trend to continue for some time. The extent to which this optimism will affect direct capital spending plans is less certain, but a pick-up would not be surprising.
- At today’s level of interest rates, and given these factors, stocks may not be dirt cheap, but they certainly do not appear over-valued. In fact, using the venerable “Fed Model” as a guideline, stocks have remained under-valued consistently since the end of the 2000-2002 bear market which followed the over-valuation of the late 1990s.
- While the Fed model is not effective as a market timing tool, it has proven of value to sound warnings when equities have reached over-valued levels. No such warnings are sounding today.
- If there are any warnings to be heard at all, they might apply to a degree in the case of smaller stocks where valuations are significantly higher than the blue chips. (For all of 2013, smaller stocks significantly outpaced the gains of their larger counterparts.) As of last week, the Russell 2000 Index (smaller companies) is down 7.1% from its record high back in March. By contrast, the Russell 1000 (larger companies) has declined only 0.1% over the same period.
- And lest we forget, European stocks continue to perform well. The MSCI Europe Index is up 4.65% for the year, putting it ahead of the U.S. market.
The Fed and Fixed Income Markets: Fed modeling and rates…
- The Ten-Year Treasury slipped in yield during the week, likely due to the poor GDP number posted for the first quarter. It had opened the previous week at a yield of 2.69%, and closed down at a yield of 2.58%.
- We are not the only ones paying attention to the various modeling methods employed by the Federal Reserve. On April 16th, Fed Chair Janet Yellen mentioned the model when she said the Fed has to “watch carefully” to see if inflation picks up as their models would anticipate. If inflation does not move toward the Fed’s announced 2% goal, “the longer the current target range for the federal funds rate is likely to be maintained,” she said.
- If inflation remains below the Fed’s target, Yellen will stick with the current monetary policy of super-low interest rates. This will favor more of the buybacks and M&A as we mentioned above, and higher stock prices. It will continue to make the environment challenging for fixed income investment. It should favor what we’ve talked about in the past several months – watching duration management over credit risk.
- Most sectors of fixed income have remained positive so far in 2014. Municipals have recovered strongly from some weakness at the end of 2013, with the principal municipal index showing a gain of 4.56% so far in 2014. Despite softening of rates this year, even floating rate debt has positive returns.
The Week Ahead: A slow news week…
- EU, PMI Composite (Markit)
- China, PMI Composite (Markit/HSBC)
- Janet Yellen speaks before Joint Economic Committee in Washington