“Equity valuations remain reasonable … monetary and economic fundamentals are still favorable to stocks .”
Though U. S. equity markets ended the first quarter of 2014 little changed from year end levels, individual stocks were more volatile, with the last few weeks featuring a rotation out of growth and into value stocks. Commentary from the Federal Reserve seemed to confuse investors, with new Chair Janet Yellen hinting that actual rate increases might begin as soon as six months after quantitative easing (QE)tapering ends in the autumn. Since then, however, the minutes of the Fed’s March meeting have shown a much more accommodative central bank, with any monetary tightening not likely until well into the second half of 2015.
After five years of expansion, the U. S. economy continues to grow steadily. Due to the very severe winter experienced throughout most of the country, real GDP is expected to be around 1.5%, but it is expected to increase to 2.5% in the second quarter and continue to trend higher in the second half, as spending and construction projects snap back and the fiscal drag from last year’s tax increase fades. Important indicators, such as bank lending, jobless claims and trucking surveys indicate a springtime pick-up in activity. The energy boom due to improved natural gas extraction techniques such as fracking will help to provide jobs and reduce the trade deficit.
Foreign market returns varied considerably, with Asia featuring lower markets in China, Japan and South Korea with improvement elsewhere, while European markets were flat to moderately higher. Emerging markets rallied in March after swooning early in the year. We still favor developed economies as valuations in these markets are reasonable, and fundamentals continue to improve. Additionally, we recently initiated a small position in Spain, as that country is finally emerging from a deep recession after instituting strict fiscal austerity measures.
During the first quarter, 10 year U. S. Treasury yields traded in a tight range between 2.60-2.80%. With the economy expected to perk-up this spring, we anticipate rates edging past 3.00%, with the yield curve steepening. We maintain our current fixed income holdings in portfolios, as we feel current bond yields do not offer enough value to be adding to positions. Municipal bonds have improved so far this year, with Puerto Rico completing a successful $3.5 billion offering last month. We continue to monitor the situation there closely, especially for signs of a positive turn in the island’s economy.
U. S. equities may continue to experience choppiness, as profit taking after last year’s strong rally lasts a bit longer. Nonetheless, we believe the secular (multi-year) bull market in stocks will continue. Periodic pullbacks help correct excesses and curb bubble behavior. As previously mentioned, the Treasury yield curve is probably the best predictor of recessions and major stock market downturns, with a steep curve indicative of both a healthy economy and stock market. As seen in the graph on the next page, the yield curve is quite steep and in stark contrast to the situation in 2000 and 2007, when the yield curve was inverted or flat and the economy entered recessions. Overall equity valuations remain reasonable and monetary and economic fundamentals are still favorable to stocks. The longer term outlook remains positive.