Asset Management

Markets respond as confidence in the recovery grows

Lisa Black, Head of Global Public Fixed-Income Markets
William Riegel, Head of Equity Investments

The Ides of March—a date associated with bad omens—apparently came a day early for U.S. Treasury investors. On March 14, demand for safe-haven government bonds fell sharply amid further evidence of an improving U.S. economy and a change in the Federal Reserve’s language that conveyed a more optimistic economic outlook. Falling Treasury prices pushed up 10-year and 30-year yields by 15 and 17 basis points, respectively—their largest one-day increases since last October. At midweek, the 10-year yield stood at 2.29% and the 30-year yield at 3.43%.

Weakness in the Treasury market was reflected in the total return of the Barclays Capital U.S. Aggregate Bond Index, a broad measure of U.S. investment-grade fixed-income performance, which turned negative for the year to date as of March 14. Meanwhile, higher-yielding, non-Treasury sectors continued to outperform. Based on Barclays Capital indexes, U.S. corporate high-yield bonds and global emerging market bonds have returned 5.51% and 6.16%, respectively, for the year to date.

The Fed’s public comments on March 13 acknowledged the improving job market and other signs of relative strength in the U.S. economy. Among the week’s data releases supporting a favorable economic view were first-time unemployment claims, which fell by 14,000 and remain in a range associated with strong GDP growth; small business optimism, which edged up for the sixth consecutive month in February; solid retail sales for February, along with upward revisions to figures for January and December; and continued gains in regional manufacturing indexes.

Many fixed-income strategists believe the Fed’s statement signaled less need for future quantitative easing, a form of monetary stimulus that has helped keep Treasury yields at artificially low levels over the past year. Meanwhile, the Fed’s “Operation Twist,” which was launched last October to help lower long-term interest rates by selling short-term securities and exchanging them for longer-term securities, remains in place. Of course, if the economy were to lose momentum, the likelihood of further quantitative easing would increase again, potentially leading to another decline in Treasury yields.

Overall, however, this is the first time since early 2011 that fixed-income investors seem confident that the recovery may be self-sustaining—i.e., not dependent on further Fed stimulus efforts or fiscal support. Ultimately, the critical numbers to watch are growth in nonfarm private-sector payrolls and overall labor rate participation. It’s entirely plausible that the unemployment rate could remain stable or even rise somewhat if job seekers who had previously given up reenter the labor force quickly.

U.S. equity markets have responded to the generally positive economic news by rising to new highs for this market cycle. One sector that has consistently lagged in the broad upturn is financials, where stocks are almost 60% below their 2007 peak levels. As balance sheets heal, we may be on the verge of a better period for financials, which is important for the overall health of the market. The results of the Fed’s second round of “stress tests”—showing that a majority of large U.S. banks have adequate capital to withstand a severe economic shock—added a dose of optimism in this regard.

Nonetheless, as we have highlighted in prior weeks, we would not be surprised to see a cooling of the U.S. equity market’s upward trajectory. Factors contributing to a more guarded market outlook include lower earnings estimates for U.S. companies, short-term sentiment that has surged into the “bullish” danger zone, and the fact that recent gains have been on very low volumes. Moreover, while equities appear to be fairly valued, the run-up in stock prices this year has made valuations less attractive.

Of particular concern are rising gas prices, the net drag of trade, a rising dollar, and higher interest rates. Equally concerning is poor productivity, which could presage further pressure on corporate profit margins. While we do not yet think the market is vulnerable to the sort of market corrections that occurred in the spring of 2010 and 2011, we are on the watch for a sideways trade and/or a rotation into larger-cap stocks, which at the margin continues in the U.S. and globally.

Outside of the U.S., Greece concluded its debt restructuring last week, but much more needs to be done. Markets have largely discounted the impact of Greece, but sentiment can change quickly as the drama wears on. In Asia, China’s leading indicators turned down in January, and the market remains concerned about the housing cycle. Meanwhile, Japanese stocks have gained on stronger export demand, a weaker yen, and hopes that Japan’s central bank will deliver on promised liquidity and inflation target measures. Official policy moves have been disappointingly tentative, however. We remain focused on key appointments to the central bank’s policy boards as confirmation of an expansionary intent.

The information provided herein is as of March 16, 2012.