A Choppy First Quarter
The start to 2014 was the tale of two very different months, with January’s steep sell-off in stocks followed by a sharp rebound in February when emerging markets stabilized and U.S. and European stocks recovered their year-to-date losses. March found most equity indices still searching for direction and ending the quarter marginally higher, which was a far cry from the double-digit gains registered in the first quarter of 2013. But, while the major indices have remained range-bound in recent weeks, many cyclical and high-price momentum stocks have experienced declines of more than 20%
In short, the strong economic and equity-market momentum evident at the end of 2013 has become a more mixed picture over the past three months as frigid weather has made U.S. economic data murky and evidence of improving global growth is being complicated by fears of growing geopolitical concerns.
While global equity indices in the first quarter were generally flat, fixed-income and interest-rate sensitive assets rallied following a weak 2013. The Barclay’s Capital U.S. Aggregate Bond Index returned 1.8% for the quarter while the Dow Jones U.S. REIT Index and S&P Utilities sector each rallied over 10%. The decline in long-term interest rates in the first quarter of the year is partially explained by the mixed U.S. economic data and rising geopolitical concerns creating a “flightto-safety” trade. In addition, although somewhat counterintuitive, the Federal Reserve’s ongoing process of reducing its monthly asset purchases likely played a role. While this tapering process is leading the Fed to buy fewer bonds each month, which all else equal would lead to a rise in yields, the two prior periods when the Fed ceased its asset-purchase programs were notable for a significant decline in interest rates and concurrent fall in riskier asset prices. This tendency for bonds to rise and risk assets to fall when quantitative easing ends likely reflects money at the margin exiting the riskiest parts of the capital markets and finding its way into the perceived safety of fixed income due to concerns over whether the global economy can sustain itself without the training wheels of extraordinary monetary accommodation.
The strength of the U.S. economy has been an issue for most of 2014 due to the confusing impact of severe winter weather. For example, the Fed’s latest Beige Book, which surveyed economic data from early January until February 23, cited severe weather as contributing to a softening in consumer spending and a sharp slowdown for many retailers. As we enter April, it remains unclear whether Old Man Winter’s impact has been temporary as pent-up economic demand and increased backlogs of work potentially create resurgent growth when the spring thaw finally comes. Some recent data has been encouraging in this regard, suggesting that much of the first-quarter economic sluggishness was in fact weather-related. For example, the March reading of the ISM Manufacturing Index rose by 0.5 points to 53.9, which has historically been a level consistent with abovetrend economic growth. Much of the recent labor data has also been encouraging, with weekly initial unemployment claims trending lower and sitting near cycle lows and the Challenger Gray layoff announcements for February falling 7.3% to the lowest February total since 2000.
The modest improvement in U.S. economic data was largely trumped by global and geopolitical concerns. Of note, the German stock market registered modest losses in the first quarter, weighed down by the Ukrainian standoff. The heavy reliance on energy supplied by Russia among Germany and other members of the European Union has complicated the West’s response and thus far prevented harsh economic sanctions from being implemented. As far as global markets are concerned, any move by Russia to de-escalate the situation in the coming weeks by reversing the buildup of troops along the Ukraine’s border would likely be viewed very positively.
More recently, while U.S. stocks have been stuck in a trading range as investors struggle to digest the effects of potential changes in Federal Reserve policy and the drag of winter weather on the U.S. economy, emerging markets have rallied – an unfamiliar condition in recent years. Commodities, which are closely tied to emerging economies, staged a rally as well with the Reuters-CRB Commodity Index gaining nearly 10% for the quarter. Emerging-market strength continues to come from India, where the expectation of a new government leading to better economic growth has pushed equities to record highs. It’s unclear, though, whether the recent strength in emerging markets is an oversold rally or the early indications of a new “risk-on” phase in global equity markets. One counter argument to a broad move higher is the strong recent underperformance in U.S. technology, biotech and small-cap sectors — typically viewed as leading “risk-on” asset categories, along with the relative outperformance of the defensive utility and healthcare sectors. These performance divergences warrant close scrutiny in the coming weeks as a potential sign that the market rally is reaching its exhaustion stage, a concern which is heightened by a number of market indicators that are again approaching overbought levels.
|Asset Class Performance||% FEB||% 2013|
|Real Estate – DJ-Wilshire REIT||0.9%||10.4%|
|Commodities – RJ Commodities Price Index||0.7%||8.8%|
|Gold – Front Month Future||(2.9)%||6.7%|
|Bonds – Merrill Lynch High Yield||0.2%||3.0%|
|Bonds – Barclays US Aggregate Bond Index||(0.2)%||1.8%|
|US Equities – S&P 500 Index||0.8%||1.8%|
|Global Equities – MSCI World Index||0.2%||1.4%|
|US Equities – Russell 2000||(0.7)%||1.1%|
|Developed Foreign Equities – MSCI EAFE Index||(0.6)%||0.8%|
|US Dollar – DXY Index||0.5%||0.1%|
|Emergin Market Equity Index – MSCI Emerg Mkt Index||3.1%||(0.4%)|
In light of the bourgeoning signs of technical divergences, overbought market conditions and generally stretched valuations of U.S. equities we believe the risk of a significant market correction in the coming months is elevated. However, there continues to be insufficient weight of the evidence among our intermediate and long-term macro indicators to take a highly defensive investment posture at the current time and evidence of widespread economic deterioration remains minimal. Our current positioning reflects a modest defensive tilt in recognition of the growing risk of a correction but we will require further evidence that a correction is taking hold before additional defensive portfolio actions are implemented.
The strong gains posted by many commodities thus far in 2014 have led some to question whether the severe winter weather is behind the gains, which would be likely to prove temporary, or whether inflation pressures are becoming a longer-term problem. In terms of gauging when rising inflation matters for the stock market, the accompanying chart is of interest.
As shown by the box in the upper left, when the annual Consumer Price Index (CPI) change exceeds its five-year average by 1%, the S&P 500 has lost 2.5% per annum compared to annualized gains of 13.5% when it has been below its 5-year average by 0.5% or more. Currently, the CPI’s 1.1% annual rate is well below its five-year average of 1.6% and thus this model suggests inflation is not yet an imminent concern for investors.
First Allied Asset Management, Inc.
- Craig Columbus, President
- Jeff Mindlin, CFA, Chief Portfolio Strategist
- Tom Samuelson, CFA, Chief Investment Officer
- Lon Gerber, Chief Operating Officer
- Brian Wright, CFA, Senior Portfolio Manager
- Collin Martin, CFA, Investment Consultant
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All data gathered from sources believed to be reliable. No guarantee is made with respect to accuracy. The index returns reflect the reinvestment of income, dividends, and capital gains, if any, but do not reflect fees, brokerage commissions, or other expenses involved with investing. Investors may not make direct investments into any index.
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