The bears in this market keep getting the rug pulled out from under them. The markets once again shook off the recent malaise from some of the air being taken out of the highfliers. Today’s unemployment claims report was better than expected at 304K and the Philly Fed manufacturing report was in-line with positive expectations. Meanwhile, corporate earnings growth for the first quarter is struggling. So far with 81/500 companies reporting, growth is at -2.2% with consensus for all 500 at -1.7%. This is a concerning outlook for fundamentals although it is still early in the reporting season and corporations have shown a remarkable resilience in beating expectations. Please see our recent monthly article, "Bears Again Confounded by Market Reversal."
Industrial Production posted a stellar March reading of 0.7% versus expectations of 0.5% with positive revisions to February. What polar vortex? Home construction starts rose an unimpressive, but still positive 2.8% in March. Meanwhile, China's GDP grew at a lower than target 7.4% that we take with a grain of salt. Please see our latest article "First Quarter Global Expansion Intact Despite Challenges" for more info.
When is good news bad news? When it involves interest rates of course. An inflation indicator, CPI ex-Food & Energy, was reported higher than expected or double expectations for March and 1.7% year over year. Finally, the economy is growing, evidenced by yesterday’s strong retail sales number and recent good employment data, and commensurate with a growing economy interest rates should begin to rise – eventually. Instead the market initially sold off and bonds rallied on the “bad news” of rising inflation - still below the Fed’s target of 2%. The S&P 500 continues to be a compelling value at a 15 forward P/E, but there are excesses within the market that will be exposed in a rising rate environment. Please refer to Global Perspectives “Stock and Bond Valuation” on page 31 of the book.
After the worst week of the year, major equity indices opened higher today based on better than anticipated earnings reports and a surprise in retail spending. U.S. retail sales jumped to their highest level ever, $433.9 billion in March. This was a 1.1% increase over an upwardly revised February (revised to .7% more than double from the original .3%), and the biggest gain since September 2012. Gains were widespread across sectors but automobiles, furniture and home supply stores were the biggest leaders. Additionally, sales at the well-known chain general merchandise stores rose 1.9% their biggest gain one month gain since March 2007. This solid report on retail sales is indicative of the expected spring bounce and the brighter economic outlook on the horizon. Please follow retail sales on page 13 of the Global Perspectives book.
When is a stock like a bond? Well, both are financial instruments that are discounted by interest rates. Chair Yellen said that rates are due to rise six months after QE ends which puts it around mid-2015. That certainly seems far away but markets seemed to have discounted that rates would never rise again. Now, that there is clarity that we are headed back to normal rates this will hit long duration financial instruments the worst. Sure bonds and dividend paying stocks would be adjusted but not nearly as much as go-go growth stocks that include biotech, internet retail, semi-conductor equipment and healthcare technology stocks. A cursory glance at these sub-industry sector’s stock price-to-earnings ratio include P/E’s of 40, 80, 175 and even “n/a” meaning no earnings at all. P/E ratio can be thought of the length of time in years that the earnings will pay for the price of the stock. In the case of the 175 P/E ratio, it would take a mere 175 years or in the case of the “n/a” – never. So a tiny increase in the expectation of a rate rise a year and a half in the future is having an enormous impact on these “long duration” stocks. The 10-year bond rallied yesterday amid a great initial employment claims report because this is short duration compared to the 175 year duration of these euphoric priced stocks. It didn’t help that today’s PPI inflation measure was higher than expected. Rising rates is a growth story and ultimately is good news. Please see the latest Global Perspectives monthly commentary, “First Quarter Global Expansion Intact Despite Challenges.”
The biggest takeaway from the release of yesterday’s FOMC minutes is the Fed’s concern with the U.S. economy’s persistently low inflation rate. While low prices may seem like a good thing at first, ultra-low inflation is actually associated with low wage increases, slack demand, excess business capacity, heightened pressure on debtors and a lower future consumption cycle. Japan’s struggling economy has been battling deflation for a decade and Europe has been contemplating more stimulus in the wake of their latest weak inflation numbers. The markets interpreted the Fed’s comments as less hawkish than previously thought, so equity markets rallied and bond yields ticked down. Meanwhile, the latest round of U.S. employment news sure looks like it is staging a spring revival. On Tuesday it was reported that job openings rose to 4.17 million in February, the highest level in over six years and about 4% higher than this time last year. Today’s initial unemployment claims report was also very positive showing that initial claims fell to 300,000. This is the lowest number of people filing new unemployment claims since May 2007. Please follow inflation on page 65 of the Global Perspectives book.
Europe looks like it is turning the corner. Yes, inflation is painfully low and unemployment is dangerously high but the feared risk of total financial collapse looks more remote each day. Italy and Spain were huge concerns because unlike Greece at 2.5% of the Eurozone economy they make up a combined 25%, too big for even powerhouse Germany to bail out. But investors have been enthusiastically returning to the Italian and Spanish debt markets pushing yields down to the levels that look low on any scale. The 10 year rates in these countries is now around 3.2% down from the mid 7% range in 2012. Compare this with the latest 10 year yield of 2.72% for safe haven U.S. treasuries. And yields on Greece’s 10 year bonds that were one time above 27% are now sub 6%. Today the U.S. market opened on an up note but will be focused on this afternoons Fed minutes’ release and the ensuing analysis of Janet Yellen’s every word. Please follow the Eurozone economy on page 16 of the Global perspectives book.
The bears are at it again trying to take this market down. Two ugly days in a row for the market is enough proof for most savers, I mean investors of course, to capitulate and head back to the comfort of cash. Cash may be comfortable but it earns a near zero return and when compared to inflation at around 1.5% this is guaranteeing a negative real return. Real return is the zero return for holding the cash, short duration bonds are in this group too, minus the inflation rate. In the past 5 years bonds have returned 9.4% and equities a stunning 20.3% annualized or on average each and every year for 5 years. In other words bonds protect the downside better than cash by earning a “real return” whereas the cash saver, with a negative real returns, is “comfortable” getting poor slowly. Please review Global Perspectives book page 5 for an example of an effectively diversified portfolio.
Last year’s stellar market returns were narrowly focused in the U.S. equity arena with 5 out of the 10 major asset classes posting negative returns. This year is shaping up to look more like 2012 where broad global asset allocation served investors well. So far this year Global REITS are leading the equity pack in returns, emerging markets have surged in the last few weeks and turned positive for the year and U.S. equity is firmly positioned in the middle. And surprisingly for the first quarter bonds outperformed the S&P 500 despite a quarter where reported earnings growth, the fundamental driver of markets, was notably robust. This is likely to be a year where popular large cap growth stocks are not the best performer. Please read the latest global perspective on the markets.
The much anticipated non-farm payrolls report was good, but not great. The report shows 192K jobs were added in March compared to a consensus estimate of 200K. The good news is in the positive revisions. February was revised up from 175K to 197K and January was revised up to 144K. If you recall, the initial January number released in the midst of the polar vortex hype was only 113K. The unemployment rate remained unchanged at 6.7% because 503,000 more people entered the work force in March, and the participation rate climbed to 63.2% from 63%, the highest level since last September. This report is consistent with a slowly improving U.S. economy. The fact that it is not spectacular will most likely be received positively by the market as it gives the Fed and Janet Yellen breathing room when it comes to the tapering timeline. Please follow the Global Perspectives outlook on the markets and a review of the first quarter.