EWM Team

After a long and difficult winter, many investors are wondering whether the Spring thaw will bring with it enough sustenance to reinvigorate the economy. First quarter data was less than upbeat, and despite a modestly positive start to April, several questions remain:

1. Has oil reached a bottom?
2. Does the US dollar have enough support to continue its upward trajectory?
3. Has the Federal Reserve Bank (Fed) planted enough seeds for domestic growth?

Oil prices continue to weigh heavily on the stock market, as the price for a barrel of crude has precipitously fallen from a peak of $98 in September 2014 to $56 as of yesterday’s close. It dipped as low as $45 dollars a barrel in March but has rebounded back in recent weeks, supported by a strengthening in fundamentals and a tightening in supply.Global quantitative easing along with impending interest rates hikes have buoyed U.S. dollar strength.

The 10 year yield fell to 1.9% yesterday (4/16/15), hovering near all-time historical lows. Prior to 2011, the last time the 10 year yield was under 2% was February 23, 1951. Since that time, it has fluctuated regularly between 1.43% and 3.75%, falling below 2% on 357 of 1,073 trading days over the past four years.

As the Fed lays the groundwork for raising rates, it will have to consider when and at what pace. Although Janet Yellen did not rule out a June hike in the March meeting, the consensus handily favors September. Inflation is expected to remain low, and job growth slowed in March— driven in part by cuts in the energy sector which has historically been a key driver in non-farm job creation. Nonetheless, unemployment remains relatively stable at 5.5%, and the first quarter marked twelve consecutive months of job gains in excess of 200,000—the longest streak in nearly two decades.

So the big question is, does the recovery have legs, or will the engine stall? The signals are mixed. Following Wednesday’s disappointing industrial production numbers, estimates of real GDP growth fell to as low as 0.1% according to Atlanta Federal Reserve’s new GDPNow1 indicator; this comes in sharp contrast to GDP growth of 2.2% in Q414. Industrial production has been on the decline for the past three months, and March’s decline of 0.6% marked the largest decrease since 2012. A strong U.S. dollar is crippling exports, and weak oil prices have encumbered the operations of energy stalwarts.

On the positive side, consumer spending remains high, and housing starts are on the rise. Residential housing rebounded last month, although by less than expected.  The stock market is showing areas of opportunity, particularly in small- and mid-cap, with healthcare demonstrating solid gains.  It is worthwhile to note that at this juncture last year, Q1 2014 GDP also contracted, but the economy quickly recovered making positive strides for the rest of 2014. Although first quarter growth may similarly stall, the long term picture should remain robust, as we decelerate from an above trend environment to one of more moderate growth.

1 – The growth rate of real gross domestic product (GDP) is a key indicator of economic activity, but the official estimate is released with a delay. The GDPNow forecasting model provides a “nowcast” of the official estimate prior to its release.

Source:  https://www.frbatlanta.org/cqer/researchcq/gdpnow.cfm

On Monday, the European Central Bank (ECB) kicked off its widely anticipated quantitative easing program of bond buying. The goal of this program is to help fulfill the ECB’s price stability mandate and to stimulate Europe’s economy, which has been experiencing low growth, low inflation, and high unemployment.  This program, which had been announced by ECB President Mario Draghi in January, is focused on buying sovereign bonds of euro area central governments. The ECB has said that it expects to increase its bond purchases to a €60 billion euro level  each month through at least September of 2016 (buying at least €1.1 trillion worth of bonds along the way). With that, bond buying is expected to continue until the ECB sees inflation move towards its medium-term goal of 2%.  The rationale behind the bond buying is that this will further ease monetary conditions in Europe allowing  firms and households better access to cheaper financing. In addition, such a move is expected to devalue the euro providing European exporters more competitive pricing in foreign markets. This is expected to help support investment and consumption which will ultimately lead to the return of inflation rates closer to 2% along with a healthier economy. For their part, the BBC (British Broadcasting Corporation) cites that the ECB has raised its forecast for economic growth in 2015 to 1.5%, from 1% in December.

The impact of the European quantitative easing was felt immediately during the week as new bond buying has further driven up bond prices and correspondingly lowered yields even more. One of the surprises in the ECB statement is that the bond buying wouldn’t be limited to just the front end of the yield curve, but all maturities would be eligible.  This had the effect of pushing down short, intermediate and long term rates across the Eurozone. With that, the yields on the sovereign debt of Germany, France, Italy, and Belgium have recently hit all-time lows. According to Bloomberg, Germany’s 10-year Bund was down about 17 basis points and was yielding a meager 0.23% earlier this week. Meanwhile, Italy’s 10-year sovereign debt was offering a 1.21% yield. These yields are significantly below that of the 10-year U.S. Treasury yield, which had recently been at 2.13%. Furthermore, many shorter duration European bonds have actually been offering negative yields. German 2-year Bunds were at -0.24%, while their 5-year counterparts were at -0.13%. There have also been impacts on some non-European Union countries as Swiss 10-year sovereign debt was recently trading at -0.14%. All in, according to the Wall Street Journal, Morgan Stanley estimates that approximately $1.5 trillion in global sovereign and corporate debt trade at negative yields.

With that, investor funds have been flowing into riskier assets that have potential for higher yields and/or returns. Bank of America Merrill Lynch cites that roughly $1.8 billion has been added to emerging market debt funds during late February and early March. Others note that European stocks may also continue to benefit from ultra-low interest rates. With that, the Stoxx Europe 600 Index has been up about 15% this year. Frankfurt’s DAX was up even more, at 18% year-to-date. However, the strong U.S. dollar has given U.S.-based investor returns a haircut and global bond index returns have been negative for U.S. investors this year.

Finally, the quantitative easing (along with other developments such as the potential for Greece’s exit from the Eurozone) has helped move the Euro’s value down significantly and Reuters is now reporting it is at a 12-year low versus the U.S. dollar, having dropped another 12% this year after previous declines in 2014. The Euro has been moving nearer to trading at parity with the greenback ($1.06) this week and some believe that parity may be hit (or the Euro even drops below $1.00) as the European Central Bank’s €60 billion in monthly purchases gets under way, though currency moves are generally difficult to forecast. The euro is also trading at low levels against other currencies as well, as it fell to a seven-year low versus England’s Pound and an 18-month low versus the Japanese Yen. Finally, the U.S. dollar has risen very quickly and significantly versus a broad basket of currencies around the globe due to a flight to quality and as investors search for more compelling yields as the U.S. Fed weighs the prospects of actually raising interest rates.

Fed Chairwoman Janet Yellen offered few surprises in her semi-annual testimony before Congress this week. Testifying before the Senate Finance Committee on Tuesday this week, Chairwoman Yellen continued to use the word “patient” in describing the FOMC’s approach to “normalizing” monetary policy, including raising short term interest rates.  She also reiterated her stance on waiting for the appropriate data that would convince the Federal Open Market Committee (FOMC) inflation would be above 2% for the intermediate term.  Ms. Yellen was relatively clear these conditions had not been met as “the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the fed funds rate for at least the next couple of FOMC meetings1.” These comments pushed 10-year Treasury yields down 13 basis points on the day and back below 2% for the first time in nearly two weeks.  Thursday’s Consumer Price Index (CPI) report, with headline inflation at -0.1% for the trailing 12 months ended January and core CPI at 1.6% over that same period, likely did little to push the Committee toward acting any time soon.  The global rate environment is expected to impact the Fed’s timing as well and recent data is even less compelling there.  Germany sold 5-year Bunds at auction this week with an average yield of -0.08% and Italian, Spanish and U.K. 10-Year rates all set post-financial crisis lows in the last month.

Also included in her testimony was the reiteration that even after the economy strengthened enough to raise the fed funds rate, the lingering effects of the global financial crisis may make it necessary for the fed funds rate to “run temporarily below its normal longer-run level 1.” This “lower for longer” language has been consistently part of Fed comments for some time now and points to the potential for fed funds to remain below 2% for several years.  Given the massive amount of liquidity that has been added to the domestic economy over the last five years, let alone the global economy, the Fed will need to begin removing at least some of that liquidity before any rate hikes will have their desired effect.  Secondarily, Chairwoman Yellen must be aware of the enormous damage to her and the Fed’s credibility with the markets if the rate hikes have to be reversed in short order due to economic weakness.  This alone should keep the Fed on the sidelines as long as possible.

U.S. Markets continued their slow march forward, with U.S. small cap and growth stocks leading the way for the week.  Value stocks of all market caps hovered near the flat line.   Despite the lackluster returns for the week, all of the U.S. equity indexes continue to show significant strength for the month with returns ranging from 4.7% to 7.8%.  As noted in this space last week earnings season has been very strong with nearly three quarters of companies in the S&P 500 beating their consensus earnings expectations.  However, of the 74 companies announcing revisions to Q1 2015 earnings expectations, 85% of them revised expectations downward. Despite the drop in Treasury yields during the week, the investment grade fixed income indexes remain in solidly negative territory across the board for February, but have not given all of January’s gains back yet.  U.S. corporate high yield spreads have narrowed by more than 70 basis points this month, generating very good returns for both the month and the year-to-date.  The only exception remains the distressed credit market (below CCC) which is down more than 2% for the year.  Finally, the continued strength of the dollar leaves the global fixed income markets in negative territory for the most part, though hedging out the dollar impact places most of them on par with the U.S. Aggregate Index.

1 Quotes Source: Chair Janet Yellen, “Semi-Annual Monetary Report to Congress”, February 24, 2015 Link: http://www.federalreserve.gov/newsevents/testimony/yellen20150224a.htm