Lacking Conviction

Key Points

• Markets continue to bounce around, with no consistent movement one way or the other. While a pullback is possible, we continue to believe economic data and earnings will improve, setting the stage for yields and equities to move higher by the end of the year.
• The recent Federal Reserve meeting caused some consternation, but the Fed remains quite dovish in our view and will be very moderate in its normalization of monetary policy. Meanwhile, geopolitical events remain a risk and have also reinforced the importance of the rule of law.
• Europe has increased risk from Russia, and the European Central Bank continues to stand on the sidelines when it appears they should act; but equities remain attractive. China’s weak market performance may be an overreaction to recent soft data and we remain positive on Chinese equities.
• Despite multiple triple-digit Dow days, stocks are hovering roughly around where they began the year. Investor conviction seems to be lacking, but it’s understandable. Economic data has been skewed by severe winter weather, while the Russia-Ukraine situation has caused concern, but doesn’t appear economically damaging at this point. We’re in between earnings seasons, which will also probably be impacted by weather, while valuations appear reasonable. We are in a transition period within the Federal Reserve, with both the Chair and several members changing. This cacophony of events makes it hard to get a read on near-term market movements.

Stocks, however, remain near record highs and alternative investment options are again lacking broad appeal. Interest rates remain low, cash yields are non-existent, emerging markets are struggling, and the European Central Bank (ECB) continues to sit on its hands despite the threat of deflation. This may be behind some of the resilience in US equities. Knee-jerk reactions cause a move away from stocks, but once investors realize the landscape hasn’t really changed, and there aren’t many great options, they move back into US stocks. This sort of action could continue for some time, and we are heartened by the pullback in some of the most frothy over-valued areas within the market; notably within biotechnology and emerging technology.

The threat of a correction still exists, but there remains a distinct possibility the market has a “melt-up,” where stocks move higher as investors who have missed out on gains rush to get in. We would actually prefer more of a grind-higher kind of market as melt ups typically don’t end well. At this point, we continue to believe that a still-dovish Fed, an improving economy, relative fiscal peace, and solid performance on the earnings front will allow stocks to end the year higher from here. We again reiterate our mantra that equity investors need to keep the long-term picture in mind, and not to get caught up in day-to-day or even month-to-month gyrations.

Economic skies starting to clear

There will likely continue to be some weather impact for several more weeks, but we are starting to emerge from the winter-induced haze. Regional manufacturing surveys improved and indicate expansion, with the Empire Manufacturing Survey rising to 5.6 from 4.5 and the Philly Fed Index moving from -6.3 to +9. Additionally, industrial production posted another solid reading, rising 0.6%. Housing data still is impacted by the weather, according to the National Association of Realtors and the National Association of Homebuilders. Housing starts fell 0.2%; but permits, which are a leading indicator, rose 7.7%; while existing home sales fell 0.4%—stabilization for now, and looking for improvement later. Finally, initial jobless claims are a leading indicator and one of the few releases not significantly impacted by weather. They continue to show labor market improvement.

Additionally, CEO confidence has been improving, at least modestly, which helps to support one of our major themes this year—capital expenditures by business driving growth in the economy. According to a Wall Street Journal survey in the March 19th edition, almost half of CEOs plan to increase capital spending this year, versus only 39% only three months ago.

We believe pent-up demand will help to bolster spending at both the corporate and consumer levels over the next several months. Consumers appear to have put off purchases due to severe weather that we believe will, at least partially, be made up; perhaps enhanced by some spring fever-related buying that may be a bit greater this year. And as we’ve pointed out, companies may be forced to spend as their technology and equipment ages, as it becomes less productive and efficient.

New Fed Chair stumbles, but underlying message remains

New Fed Chairwoman Janet Yellen’s initial post-meeting press conference was probably not quite what she had hoped. She seemed to lack a bit of confidence and sent the markets into a tizzy when she suggested a six-month timeframe following the end of quantitative easing for interest rate hikes. The damage was short-lived, however, and overall the Fed is committed to both economic growth and winding down quantitative easing, but the timing will remain data dependent.

A separate issue is the continued evolution of a "communication strategy" by the Fed. It has confused some investors by first instituting calendar-based guidance, then moving to an explicit unemployment rate threshold, but then removing it in the most recent meeting and moving to more qualitative guidance. We weren’t big fans of explicit number guidance as it seemed to limit the Fed’s flexibility. A consistent, coherent message coming from the Fed’s full body of members would be a better backdrop for the markets.

Russia dispute simmers, rule of law remains important

Although the US/Europe-Russia/Ukraine dispute continues to fester, it seems unlikely that any military action will be taken or that either side will impose overly-severe economic sanctions. However, underlying risks will likely remain as Putin seems intent on expanding the Russian footprint, which could cause flare-ups in the future. However, demonstrated again was that investment capital goes where laws are upheld and consistent. Money has flowed out of countries like Russia and Venezuela recently as governments have changed the rules of the game on a whim. This should benefit countries like the United States where laws and the political system are relatively stable.

Will the ECB act?

The Russian situation is also causing problems for Europe's economic recovery as it is still in the early stages and has downside risks. Russia's recent moves are a threat to energy imports into Europe and economic growth. The European Union (EU) is less dependent on Russia than in the past; but some smaller countries still rely on Russia for as much as 100% of energy imports. While the United States could supply Europe with natural gas over time, at this point the earliest liquefied natural gas shipments would likely not start until late 2015. We believe both the EU and Russia have mutual interests in keeping energy flows open, but a significant and lengthy reduction in access to Russia's energy is a risk to monitor.

Deflation, or a broad-based decline in prices, is another risk to the European economic recovery. Falling prices could become self-fulfilling if people postpone purchases on the expectation that prices will be lower in the future. Thus far, eurozone inflation is still in positive territory, but even the European Central Bank (ECB) is not forecasting hitting its target of "at or above 2%" for several years—the 2016 forecast is 1.8%.

A contraction in credit issuance has also hindered growth in the eurozone. Bank lending has been constrained due to deleveraging, and bank uncertainty regarding potential new regulations related to forging a "bank union"—one of the missing pieces of the currency union exposed by the peripheral government debt crisis. The recent deal for a Single Resolution Mechanism (SRM) to wind down failing banks and bank stress tests in the second half of 2014 could help improve confidence in the financial system and banks' access to funding. However, the funding for the SRM appears small at 55 billion euros, and stress tests need to be more stringent than in the past.

The continued strength in the euro also reinforces the "muddle through" nature of the euro zone recovery. While not a policy target, the ECB is monitoring euro strength as it is increasingly a risk to deflation, resulting in increased talk the ECB adopts a quantitative easing (QE) program similar to the U. S. Fed. Currently, the ECB's asset purchases are "sterilized," wherein liquidity injections are offset by asset sales. Ideas floated for modifying the QE program include pausing the sterilization, purchasing assets across all euro zone countries, or having the ECB buy foreign assets such as U. S. Treasuries. The hope is that QE could stabilize overnight interbank interest rates and push the euro down. However, we believe the ECB may need to see a worsening in conditions or the outlook before taking meaningful action.

We believe the eurozone's recovery will continue, albeit at a sluggish pace. Despite the risks and the potential for volatility, we remain positive on European stocks, due to the prospects for economic and profit margin improvement.

China concerns likely overblown and stimulus forthcoming

Massive credit issuance in a few short years may have fueled over-investment in factory and mining capacity, property, and infrastructure in China. The similarities to the build-up to the subprime crisis in the United States has resulted in an outbreak of concerns of a repeat of Lehman, Bear Stearns or even a "Minsky moment" in China, where asset values collapse in a downward spiral.

We think these concerns need to be put into perspective. China's current situation and that of the United States in the pre-Lehman days are apples and oranges by comparison. Big differences are that China "over-saves," with domestic savings of about 50% of gross domestic product (GDP), translating into new savings of $4.5 trillion every year; and China is in a current account surplus position, not reliant on foreign capital for growth. As China has an immature equity market, debt issuance is the main method by which the savings pool gets put to work. Other differences are that a majority of bank assets are government-controlled; China has a closed capital account that restricts money moving in and out of the country; and $3.8 trillion in foreign exchange reserves to fight a liquidity crisis.

That said, we believe imbalances in China's economy have built, due in part to the heavy influence of the government; which necessitates structural change and slower growth to repair. In light of this, the reforms announced last fall are a positive development, but there is the risk that China's policymakers push reforms through too quickly and reduce credit growth too much, resulting in a plunge in economic activity.

Recent weakness in economic data has also fueled concerns, but we believe stimulus is forthcoming to thwart the downturn. While the HSBC manufacturing PMI has fallen below the 50 level, indicating factory growth below potential, it does not have a good history of forecasting China's overall economy. The decline is reflective of the slowdown for small and medium-sized exporters, but the recent weakness in China’s currency, the yuan, can be a form of stimulus.

Another area of concern is the recent property market slowdown, which could have repercussions for the overall economy if it deepens or is lasting. The decline in sales transactions and moderation of prices appear related to credit restrictions. Already China’s government is loosening access to capital by resuming approvals for property developers to issue equity; and is piloting a program to allow the country's biggest companies to issue preferred shares for the first time.

We believe part of the slowdown in China at the turn of the year was due to a reduction in government spending, resulting in government deposits at the central bank swelling by 40% to 2.9 trillion yuan ($479 billion) at the end of 2013. This war chest may now be getting deployed; with recent announcements including $163 billion to redevelop shantytowns, $23 billion in rail spending, and Premier Li saying China will "accelerate preliminary work and construction on key investment projects."

Forthcoming stimulus amid pervasive pessimism could provide a base for Chinese stocks to recover and outperform the emerging market (EM) universe.

So what?

Lots of movement to go nowhere can characterize the first quarter of 2014 for US equities. We believe the secular bull market is intact but that a pullback would be healthy from a sentiment perspective. We believe economic data will improve, interest rates will drift higher, and equities will end the year higher. In our view, Europe and China both provide attractive opportunities, largely due to diminished expectations, but policy makers may be key to the near-term performance and investors should be prepared to be a bit patient.