Concerns about Global Growth

In January, U.S. stocks posted their biggest monthly losses in a year while bond prices traded higher and market volatility surged mostly due to concerns about the lack of global growth. February experienced almost the exact opposite with U.S. stock markets hitting new highs. The S&P 500 gained 5.49%, the Dow Jones Industrial Average (DJIA) jumped 5.64%, the world’s developed stock markets gained more than 6% (EFA), and emerging markets posted solid returns as well, climbing more than 4% (EEM).

For the month, U.S. stock markets experienced their biggest monthly percentage gains in more than two years. Market volatility plummeted in February, as investors appeared to discount mixed economic data and the world’s geopolitical troubles for the time being. However, trading volumes in recent sessions have been muted and stocks have traded in a narrow range, signaling a lack of conviction by market participants.

The U.S. economy remains in expansionary territory. Gross domestic product (GDP) for the fourth quarter of 2014 was revised down from 2.6% to 2.2% in the second estimate, which was still better than what the consensus of economists expected. For the full year, GDP rose 2.4% in 2014, versus 2.2% in 2013, an improvement, but not that great considering the stimulative policies at work since the Great Financial Crisis.

U.S. real consumer spending advanced at a robust 4.3% annualized pace in the fourth quarter, a solid reading that is a testimony to improved economic fundamentals. Consumers are exercising caution so far in 2015, as reflected by weak retail sales data. The U.S. unemployment rate stands at 5.7%. Jobs growth has improved in recent months, and the number of Americans who continue receiving unemployment aid after one week dropped by 21,000 to 2.4 million in February. The S&P/Case-Shiller home price index rose 0.9% in December, which was more than expected. Appreciation was broad-based, with all 20 cities posting gains. Over the past year, the S&P/Case-Shiller home price index rose 4.5%. Longer term data shows inflation in the U.S. is very muted. Meanwhile, real hourly wages rose 1.2% for the month and 2.4% from a year ago.

The dramatic retreat in the price of oil and other commodities has muddied the waters for those trying to assess inflation. After declining by more than 50% since June 2014, crude-oil prices posted the biggest monthly rally in a year in February. However, the world is still awash with oil, and the over-supply more than the lack of demand is what has caused the price of oil to plummet over the last nine months. Prices appear to be stabilizing as rigs are curtailing production, and countries like China are increasing their demand. At month’s end, the price of crude oil settled at $49.76 a barrel.

The outlook for foreign stock markets is a bit more mixed as non-U.S. growth continues to struggle.  Chinese economic growth is weakening, Russian GDP growth is plummeting, and Brazil may be moving into a recession. However, global equity valuations still appear attractive and recent market strength in some troubled regions such as Europe may be a positive sign for the future.

Overall, the major European stock markets have done well so far in 2015. Germany’s stock market and the Eurostoxx market each attained fresh, post-crisis highs this year. The Eurozone economy appears to be slowly improving as data there continues to beat expectations. German and French manufacturing data advanced strongly in January as indicated by the Purchasing Managers’ Index. Germany’s PMI data was its strongest in 7 months. France’s was its best in more than 42 months. In the United Kingdom inflation now stands at a record low of 0.3% over the past year, dragged down by low food and oil prices. Business, investor and consumer confidence have been ticking up, which should translate into better growth and ease fears of deflation. While unlikely to have been caused by the European Central Bank’s (ECB) recent announcement of their monetary stimulus program, these improvements may get a further boost from policy easing. Europe still faces a number of headwinds, including the need for more structural reforms, as well as political turmoil in Greece and Russia.

Greece’s proposals for economic reform were approved by ECB finance ministers, giving Athens an additional four months to figure things out, but the Greek crisis is far from over. While this agreement temporarily reduces the risk of a so-called “Grexit,” the agreement between Athens and its lenders is so fragile that it could collapse at any point. In addition, the threat of a Greek default has not disappeared as Greek leadership is already hinting at default on $1.7B in IMF debt due this month. The Eurozone is prepared to deal with a major Greek crisis in the event that such an event were to occur, but European leaders appear committed to keeping Greece from going through a messy exit of the European Union. Financial markets reacted well to the provisional Greek bailout extension, however risks for Europe remain elevated for the time being.

In Asia, upbeat Japanese industrial output data led the Nikkei to hit fresh 15-year highs at month-end, but fourth quarter economic growth came in well below expectations at 2.2%. China’s economy is on track to slow significantly in the next few years. Last year, China’s economy grew by 7.4%, its lowest rate in 24 years. A rapid build-up in Chinese debt over the last few years is now a challenge that policy makers will need to address. However, the Chinese government has the wherewithal to smooth this transition with aggressive fiscal and monetary measures. China’s central bank has already cut its one-year interest rate for deposits by .25% to stimulate the economy. India’s government has projected its economic growth to accelerate to more than 8% in their next fiscal year, making the nation one of the world’s fastest-growing economies. The projection is much higher than the 7.4% growth for this fiscal year as falling oil prices and the government’s commitment to implementing economic reforms have improved the country’s outlook.

There are trouble spots abroad, any one of which could unsettle global markets. The ongoing confrontation in Ukraine, political and social instability in the Middle East and North African countries, and Venezuela–a country on the verge of a major internal crisis–may ultimately fall. Russia is also at the precipice of recession, where collapsing oil prices and intensification of Western sanctions could further exacerbate the situation.

Bond investors await signals from the Federal Reserve regarding the first interest rate hike in nearly 8 years. Debate is heating up on whether the Fed will raise official interest rates in June or wait longer to act. Federal Reserve Chair Janet Yellen completed her two-day semiannual congressional testimony during the last week of February, reiterating the message that the Fed could raise rates later this year if the economy continues to expand. She again stated that the Committee does not see conditions that warrant a rate hike “for at least the next couple of meetings,” and that a change in forward guidance will occur before the first rate hike.

When the Fed does begin to increase rates, it will have a number of effects on financial markets. For the bond markets, a rate hike will likely cause short-term yields to move up while longer-term yields would move erratically higher. For stock markets, a move by the Fed would increase volatility, but equities should continue grinding higher. For the month, Treasury prices tumbled, sending the 10-year yield to 2.002% at month-end, much higher than the 1.679% yield in place at the end of January. For the year so far, the 10-year U.S. bond market is still posting a +0.91% total return, including price changes and interest payments. U.S. bonds sold by lower-rated companies, “below investment grade” or “junk” debt, has returned over 3% so far in 2015.

However, the Federal Reserve meeting minutes show that a majority of Fed officials are in no real hurry to make that first rate hike. It is far more likely that the Fed will commit the error of maintaining interest rates too low for too long than to commit the mistake of raising interest rates too soon or by too much. “Patience” by the Fed is likely to become one of the key themes in 2015.

Ahead of the European Central Bank’s bond-buying program announcement, investors are paying Germany for the right to lend the country money. In a first, Germany auctioned off 3.281 billion euros worth of five-year bonds at an average interest rate of   -0.08%. On the other side of the globe, Japanese bonds have caused some hand wringing. A recent uptick in Japanese bond yields amid the largest price swings on record has renewed anxiety about the health of the nation’s $8.4 trillion government-debt market. Yet few investors expect U.S. bond yields to jump significantly as they’re attractive compared with ultralow yields investors can get from other high-grade government bond markets around the world.

Regarding global monetary policy, several central banks are still in the early stages of their easing programs, which should help keep global financial liquidity ample when the Federal Reserve finally begins raising rates. Financial market volatility is likely to increase when those rate hikes begin.

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