THE RECOVERY BROADENS, From Bob Doll, vice chairman and chief equity strategist for fundamental equities at BlackRock
Equities advanced again last week, with the Dow Jones Industrial Average climbing 1.0% to 10,850, the S&P 500 Index advancing 0.6% to 1,167 and the Nasdaq Composite rising 0.9% to 2,395. The highlight of the coming week will be the March payrolls report. Recent declines in unemployment claims, coupled with hiring trends for temporary workers (including the addition of 75,000 census workers), have many guessing that somewhere around 200,000 jobs will have been created. As a reference point, roughly 115,000 jobs need to be added per month in order to keep the unemployment rate flat. Before too long, we should also see some indications of first-quarter earnings and gross domestic product (GDP) growth. For earnings, we have seen several quarters of positive surprises and we are expecting the same for the first quarter of 2010. Meanwhile, GDP data should further evidence the ongoing recovery and we expect that by the third quarter of this year the United States will have moved from recovery to expansion mode.
Although we remain generally positive about the course of the economy and markets, there are some downside risks. One of these is that money supply growth has been very weak, consistent with a lack of credit demand and availability. Another issue of potential concern is the interest rate picture. Treasury yields remain relatively low across the curve, but rates have been trending higher. In our opinion, a move up to a 4% yield for the 10-year Treasury would simply represent a confirmation that the economy is recovering, but a surge significantly higher than that could present problems. Regarding the Federal Reserve, lingering weakness in credit markets and the absence of inflationary threats should prevent the Fed from prematurely raising rates. Finally, another risk that investors need to be aware of is the ongoing possibility of protectionist trade actions being taken by Washington, D.C. In our minds, a serious shift toward protectionism would be a negative for the economy and bearish for risk assets.
In sum, we would characterize the current environment as one of a broadening global economic recovery marked by improving corporate earnings, low interest rates, increasing business and consumer confidence and, we hope, a labor market that should soon turn more positive. Markets have turned increasingly bullish on economic growth, both in terms of how fast the economy will grow and in confidence that it will actually happen. Since the mid-January to mid-February market correction, stocks have climbed more than 10% and are currently up between 4% and 5% for the year. So far, equity markets have frustrated the bears, since any signs of price weakness have been quickly reversed. In the short-term, there is a possibility that stocks may have gotten ahead of themselves, as some technical indicators are looking stretched. Nevertheless, an ample amount of cash remains on the sidelines, and the macro backdrop suggests to us that the long-term path of least resistance for stocks continues to be up.
A HEALTHY RALLY? From Jeffrey Kleintop, chief market strategist, LPL Financial
Our predicted path for the stock market is for a volatile, but upward-sloping market in the first half of 2010. This performance began to emerge late last year when, after a powerful rally, the S&P 500 pulled back 6% from October 19 – October 30. Following the pullback, stocks rallied back 11% from Oct 30 – Jan 19. This pattern of volatility around a rising trend was repeated from January 19 – February 8 as the S&P 500 experienced an 8% pullback and then rallied 10% from February 8 through March 17.
The ups and downs in the stock market have not been big daily swings. Instead, the moves have unfolded over weeks or months. The daily moves have been relatively small and mostly in the same direction whether the market is going up or down. In fact, only five of the 26 days during the rally from February 8 – March 17 had daily moves bigger than 1% and none that reached 2%. We believe this type of multi-week, rather than daily, volatility is likely to continue.
Another stock market pullback of 5 – 10% unfolding over a few weeks would not be unusual. There are a few reasons to question the health of the recent rally. Some technical indicators suggest the stock market is now overbought and recent gains have been on light trading volume, suggesting the buyers are becoming fewer. In addition, a potential catalyst for a pullback is that we are now entering the first quarter earnings pre-announcement season (when some companies provide guidance on how they fared during the quarter about a month ahead of their official earnings releases). It is worth noting that the last three 5 – 10% stock market pullbacks occurred leading into or during each of the last three earnings reporting seasons.
MACROECONOMIC OUTLOOK, From Christopher Molumphy, chief investment officer, Franklin Templeton Fixed Income Group.
While long-term headwinds certainly persist, the fundamental economic indicators point to a low likelihood of a double-dip recession in the U.S. and, if anything, point to a higher probability of growth this year.
GDP growth: Economic indicators pointed to a higher probability of trend rate growth in 2010, perhaps in the neighborhood of 3% versus the previous estimate of approximately 2%. In the near term, we believe that growth will be likely buffered by a rebound within the traditional cyclical components of the U.S. economy, via the rebuilding of inventories as well as corporate investment and capital expenditures, all which were significantly pared back over the past 18–24 months. In addition, we have seen some signs of stabilization in the U.S. housing market. Nevertheless, we remain mindful that other economic headwinds persist.
Job market & consumer spending: Consumer spending has historically represented roughly two-thirds of the U.S. economy. We continue to see headwinds impacting the consumer in 2010 and beyond, as the consumer continues to deleverage and unemployment remains high. Although an unemployment rate hovering around 10% represents a challenge for the consumer, we have seen gradual improvement in the pace of job losses for the past 12 months. We believe that job creation could occur at some point in the first half of 2010, and the unemployment rate could subsequently start to decline.
Inflation: Our view is that inflationary expectations are overstated in the near term. Core inflation data has been running in the neighborhood of 1–2%. While we believe that we could see some increase in this rate, it’s important to remember that the United States is based on a service-oriented economy, which means inflation is primarily driven by labor costs. Given that significant employment slack exists, we think it’s extremely unlikely that we see significant wage pressures this year. There is a lot of uncertainty as well as differences of opinion with regard to how monetary policy will play out this year. In an environment where the economy is growing at a decent but not-too-fast pace, coupled with muted inflationary pressures, we believe that the Fed should remain on hold over the near term.
RISING RATES CAN BE HARMLESS, from Stephen J. Huxley, Ph.D., chief investment strategist, Asset Dedication
The specter of rising interest rates and the damage they will do to portfolio values is weighing heavily on the minds of bond fund managers and probably many advisors as well. The fear is that they have not educated their clients sufficiently about the inverse relationship between interest rates and bond prices. If rates rise as predicted over the next six months, falling portfolio values may generate irate phone calls from clients who thought bonds were much less volatile than stocks and therefore much less risky. To the extent that bond vendors or advisors have oversold bonds as safe investments, they deserve those irate phone calls and corresponding loss of confidence.
Blind allegiance to modern portfolio theory can lead even well-meaning advisors into the untenable position that bond investments are safe because they are less volatile. Putting a client into 40% bond funds because that is what everyone else is doing is not a good way to do business. Nor is it a good way to help clients get the most from their bonds.
The truth is that there is no way to immunize the value of a bond portfolio from changes in interest rates. When rates rise, values fall. So the question becomes, how best to work around this inherent reality?
The solution lies in moving the focus to the principle advantage that bonds bring to the table as financial instruments: predictability. The cash will flow from the coupon interest and redemptions, fixed for the life of the bond.
When the client is a retiree making withdrawals, the cash flow needs are obvious. Setting up a ladder of individual bonds so that the coupon interest and redemptions match the withdrawals when the bonds are held to maturity renders the intervening values meaningless. The value of the portfolio itself is not immunized, but the cash flow stream is. By simply changing the focus from portfolio values to cash flows, the fear of rising rates disappears. The risk of holding bonds is nullified where it counts.
In fact, for retirees following a dedicated bond ladder strategy, rising yields are a welcome sight. The cost of bonds to supply the income stream will be cheaper. A recent analysis showed that an 8-year income stream starting in 2011 at $50,000 in today’s dollars and growing at 3% per year for inflation would cost about $400,000 (the portfolio consisted of CD’s for 2011-13, TIPS for 2014-18). If rates rose 2%, the cost of this portfolio would drop to about $370,000, or 8% less.
By shifting the conversation from portfolio values to dedicated cash flows, worries about the impact of rising rates goes away, or at least is cast in a much better light. Clever advisors can take advantage of the benefits of dedicated portfolios to calm the fears of their squeamish clients.
US CREDIT WATCH, From Tom Sowanick, chief investment officer, OmniVest
The resolution of the Greek crisis pushed credit default swaps down from a recent high of 321 basis points to close last week at 292.6 basis points. It is interesting to observe that credit default swaps on US Treasury debt rose from 37.6 basis points to 42.9 basis points last week. Another development that should be watched is the inversion of 10-year swap rates to 10-year Treasury yields. Typically, Treasury yields rest comfortably below equal maturity swap rates. However, in the past week, 10-year Treasury yields have risen above swap rates (inversion). The inversion may be due to quarter-end funding pressures or corporate bond issuance. An alternative explanation could be the market’s realization that the credit quality of the US Treasury market is deteriorating on global basis. It is premature to rely heavily on information derived from credit default swaps; nonetheless, these spreads need to be followed.
REPORT CALENDAR
Monday, March 29: February Personal Income and Expenditures
Tuesday, March 30: January S&P/Case-Shiller Housing Price Index; March Consumer Confidence; March State St. Investor Confidence; March Farm Prices
Wednesday, March 31: Mortgage Applications (weekly); February ADP Employment Report; February Factory Orders
Thursday, April 1: March Domestic Auto Sales; March Challenger Job-Cut Report; March ISM Manufacturing Index; February Construction Spending
Friday, April 2: March Employment Situation
