A number of encouraging economic indicators including record corporate profits in the U.S. were largely tempered by concerns abroad in the first quarter of 2014. In the U.S., housing prices continued to rise albeit at a slower pace while the general risk adverse attitude of investors seemed to abate as money continued to be directed toward predominantly domestic equity funds. On the flip side, concerns remain about an economic slowdown in China, stagnant growth in Europe, and a sell-off in the emerging markets.
U.S. corporate profits continue to be firm as companies continue to keep a tight lid on hiring and capital spending almost five years in to the economic recovery. As it is difficult to imagine much further margin improvement from cost containment, some top line revenue growth is likely necessary to continue equity price improvement. Recent retail sales statistics show some promise in this regard although some of this may be attributable to pent up demand following a difficult winter. Further, companies are generally still flush with cash and banks are becoming more flexible lenders. This may result in a long delayed increase in capital spending which may support longer term corporate growth and profitability. This would reverse the trend of the last few years which emphasized increased dividends and stock buybacks rather than enhanced funding of operations. Corporations’ determination to expand will also likely be the key to further improvement in the employment picture. The unemployment rate was holding steady at 6.7% with new jobless claims at a seven year low, but any significant improvement would appear to require improved hiring in the private sector.
Another constraint to continued domestic equity price improvement is likely to be monetary policy. Although the Fed continues to be accommodative with aggressive stimulus in the form of its bond buy back program, it has dialed this program back from $85 billion per month to $55 billion per month over the last three meetings. The bank’s sensitivity to the markets reaction to this policy shift can be seen in how they backed off from earlier comments in which it said it would likely begin to raise short-term interest rates when the unemployment rate fell to 6.5%. Now that this rate is at 6.7%, the Fed is looking at other indicators of labor market distress such as people working part-time who want full-time work and the number of people who have been out of a job for more than six months. It would now appear that Fed Chief Yellen is unlikely to raise short-term rates until she is confident the country has returned to full employment, a scenario that at this point is unlikely until 2015 or maybe even 2016.
The U.S. housing market continues to be a double-edged sword. Rising prices have vastly improved the balance sheets of homeowners, banks and home builders after years of decline. On the other hand, affordability has now become an issue, especially for first-time buyers, because prices have bounced back so strongly and mortgage interest rates are up. In addition, inventories remain low and ther are fewer distressed properties on the market.
All of this has added up to a slow start to the spring selling season on the heels of a tepid winter season impacted by adverse weather conditions in many parts of the country. Bank lending for land development and construction has finally started to tick up, but many new home builders are shifting to apartments where potential first-time homebuyers that are priced out of the market are now looking to rent instead of buy. The increased demand for rental units and lack of supply of such units has led to hefty rental rate increases in many parts of the country.
Switching gears globally, the Euro-Zone continues to deal with a potent combination of extremely low inflation and a rising Euro that cheapens imports and hurts exporters. The European Central Bank (ECB) has to deal with the very difficult dilemma of whether or not to add new stimulus measures to guard against this dangerously low inflation. Most recently ECB President Mario Draghi acknowledged that using the U.S. approach of bond purchases may be of limited impact given that most corporate borrowing in Europe is done through banks. ECB policymakers have unanimously agreed that they are prepared to use unconventional tools besides lowering interest rates to guard against deflation, but those approaches go to uncharted monetary policy territory that the U.S. was fortunate enough to avoid.
The general economic malaise has impacted several blue-chip European companies that have had to issue profit warnings and lower near term expectations. An encouraging sign, however, is that the lengthy credit squeeze that has hampered the region appears to be coming to an end and businesses should have easier access to bank credit in 2014 than they have in some time. Indeed, U.S. investment firms have also stepped in to make small business loans where European regional banks have cut back on lending. This raises the specter of hope that more lending, borrowing and spending will lead to a more sustainable economic recovery. The emerging markets currency and Ukraine crises has weighed down the European market over the last couple of months, but should this crisis settle, investors are likely to return their focus to Europe’s fundamentals. European stocks have underperformed U.S. stocks since the U.S. recovery began in 2009 and as such are now more affordable from a valuation perspective.
The continued volatility seen in the emerging markets was largely triggered by the tapering of the U.S. Fed’s bond buying program, concerns over China’s slowing economy, as well as the Ukraine. The U.S. bond tapering triggered fears of rising interest rates, which impacts many emerging market countries that are reliant on foreign investment and borrowing. The tapering also was seen as bullish for the U.S. dollar, which in turn caused the currencies of many emerging markets to fall. However, tighter U.S. monetary policy is likely to go hand-in-hand with stronger U.S. economic growth, which could be good for many emerging markets’ commodity-driven economies. China, meanwhile, which accounts for around a third of emerging markets’ GDP, has reported a broad economic slowdown and recently announced a mini-stimulus package targeting more spending. If this stimulus measure is successful, it could bode well for the emerging markets. Some have compared the recent emerging market sell-off to the 1997 Asian financial crisis, but most analysts believe that emerging market fundamentals are much stronger now. If this is accurate, then stocks in many emerging economies are likely trading at a steep discount compared to their U.S. counterparts.
To conclude, volatility spiked in the first quarter of 2014 as global disruptions that had largely been absent for most of 2013 returned to the forefront. Nevertheless, in most parts of the world, equity markets continued to forge ahead with positive returns. Most investors likely had no illusions that 2014 would be a repeat of 2013, where most equity markets provided strong returns with very little volatility. Indeed, what we are seeing in global equity markets in 2014 is probably more “normal” than what was seen in 2013. This normal volatility is the premise of our suggested investment policy that indicates that time and diversification must be used to mitigate the risk. Affirmatively, but prudently, incorporating this risk into the portfolio will enhance the potential to provide real returns over the longer term.
Urban Financial Advisory Corporation
April, 2014