Monday, February 9, 2015

February 8, 2015

Most equity markets reversed their January losses during the first week in February and are now essentially flat after five trading weeks in 2015.

European markets (STOXX 600) continued to rally as the European Central Bank (ECB) embarks on its own version of quantitative easing (QE).

US markets rallied last week primarily upon consistent economic data and strong job growth numbers. On Friday morning, the Bureau of Labor Statistics (BLS) announced that job growth in January grew by 257,000 jobs and revised previous reports upwards as well. According to the BLS, the US has created over 1 million new jobs since November by far the best increase over a three-month period in years. The unemployment rate, however, ticked up from 5.6% to 5.7% due to a jump in the number of formerly unemployed people re-entering the work force. Not everyone is impressed by the jobs numbers including Gallup chairman, Jim Clifton, who wrote an editorial on the Gallup website arguing that the unemployment rate is extremely misleading and under-reports how many people are either unemployed or severely under-employed. He cited his company’s own statistics that report only 44% of Americans 18+ work at least 30 hours per week and receive a regular paycheck. He blames the government’s methodology of not counting those who have not looked for a job in the past 30 days and those severely under-employed as not being in the workforce for making the numbers appear far more bullish than what is really going on in the job market. He may be right, but there is no denying that jobs growth continues.

I believe the biggest story last week was the surge in interest rates. The US Treasury 10-year yield jumped 25.6 basis points (a basis point is 0.01% of a percent, like a penny to the dollar) to close Friday at 1.94%. This was the largest increase since June 2013. The catalyst for the yield increase was the jobs report and its possible impact on Federal Reserve monetary policy (more on that in a moment). Interest rate sensitive sectors like Real Estate (-1.6%) and Utilities (-3.4%) suffered pullbacks as the rest of the major sectors rallied.

Oil rallied both at home and abroad. WTI Oil closed Friday at $51.69 up 13.4% in the past two weeks. A union walkout at several US refineries and a report showing a significant curtailment in operating oil rigs in the US have led investors to reduce anticipated production of crude oil in the coming months. Market Watch reports that US rigs in operation fell 24% since early December and total producing rigs are at their lowest level in five years. This is consistent with my belief that oil producers will make adjustments to bring supply in line with demand. It is the natural ebb and flow of commodity production. Natural gas prices have continued to fall and are now down more than 13% since the start of the year and down over 38% since the start of 2014.

Strength in the US Dollar continues to gather steam as many countries and regions (like the European Union (EU)) are embarking on some variation of QE to help weaken their currencies and improve their competitive edge among other nations. Growing fears of a turbulent falling out with Greece and the EU also contributed to the overall demand for the US Dollar by Europeans. For the year, the US Dollar Index is up 4.5% adding to the gain of 12.8% in 2014. A stronger US Dollar coupled with rising interest rates hurt gold prices pushing the precious metal down 3.5% for the week and cutting the year-to-date gain nearly in half.


In my last Market Update and Commentary, I laid out four important issues facing investors in 2015 that could have a real impact on how markets move during the year. Those issues are Greece and the EU, the Federal Reserve’s monetary policy actions, geopolitical uncertainty, and domestic political uncertainty. I want to spend a little more time today looking at the Federal Reserve.

The Fed has kept short-term interest rates in a range between 0% and 0.25% since late 2008. Everything about this policy is unprecedented. The Federal Reserve’s website states it lowered interest rates (and engaged in QE) “in response to the financial crisis to help stabilize the U.S. economy and financial system.” QE has ended but the federal funds rate still remains near zero.

There is little consensus among economists and financial experts about the effectiveness of these actions, and I am not going to debate whether this policy move and duration was proper. What I am interested in is what’s next and what impact will a rate increase have on the markets?

I believe that the Fed will raise the federal funds rate (the rate at which banks lend money held on deposit with the Federal Reserve to other banks) sometime in 2015. Following the January jobs report and continued positive economic reports, consensus now expects the Fed to announce a rate increase of 0.25% on June 17th after the June meeting. Fed Chair Janet Yellen is widely expected to signal this June hike following the March meeting on March 18th. What impact this will have on markets depends a great deal on how you view what happened to the liquidity created by the Fed resulting from its bond purchases and low interest rates.

I have found that there are generally two schools of thought regarding the impact of QE on the stock markets. One is that the liquidity created by the Fed flowed directly through to the stock market, and that the highs made by the stock market over the past couple of years is a result of this liquidity and not by productivity and economic activity. If you believe this, and many do, then you should expect a major market selloff beginning when the Fed signals a rate increase and building until the actual announcement. If you believe, like I do, that the vast majority of the liquidity created by QE went directly on deposit with the Fed as banks and their depositors demanded safety above all else, then you will see the rise in rates as an overall positive to the markets. I support this latter view because inflation has not materialized, the money supply remains on a normal trajectory, and business lending remained subdued during most of this low interest rate period. I will point out that according to the Federal Reserve, commercial lending has jumped 13.7% over the past year and has accelerating to an annualized rate of 15.1% over the past three months. Money is moving into the economy and the demand for safe assets is dropping which will force the Fed to move sooner rather than later.

I believe that those who feel like the markets are at an artificial high will sell into the news and will create some initial downward pressure on the markets. However, I further believe this will be temporary and the markets, all else being equal, will continue to improve as the economy continues to grow.

The Federal Reserve does not act in a vacuum. With the ECB and a number of other countries embarking on their own versions of QE, there is pressure for the Fed not to act out-of-step with the rest of the world. This is a real consideration for delaying any rate hikes, however, I do not believe the Fed can ignore the economic data here and let the money supply and inflation get out of hand. If the Fed does move forward in the face of QE abroad, I believe the US Dollar will continue to gain against other currencies, and I believe that gold prices will fall.

Those of you that follow my writing know that I do not generally try to make predictions because it is so hard to do correctly on a consistent basis. I am making an exception here because I believe this issue is so important that I feel compelled to provide a foundation of knowledge and understanding on this topic as we move towards this extremely important policy change.


There have been no changes to my macro view of the markets. US equities and Bonds are the preferred major asset categories followed by International stocks, Money market funds, Currencies, and Commodities. As I noted before, rising interest rates has already had an impact on the Utility and Real Estate sectors and I will be watching rates very closely in the coming weeks to see if this trend will continue hurting these two strong sectors.

Even though bonds remain in the #2 ranked position of the major asset categories, it has been a tough time for bond investors. With the jump in interest rates last week, the Barclays US Aggregate Bond index fell 1.2%. This is the largest single week drop since late June 2013 when the Barclays fell 1.9%. Particularly hard hit were longer duration bonds which have performed so well as rates have fallen. I continue to like the high-yield, bank loan, and multi-sector bond sectors going into 2015.

There is minimal economic reporting due next week and markets will be closed the following Monday (February 16th) for President’s Day. Later the following week there will be reporting on housing, prices, and the release of the detailed minutes of the Fed’s January meeting. The every Thursday Jobless Claims report is always important as an indicator of how the Fed may act with regards to rate increases, so keep an eye on those reports.

Beyond the US, I will continue to watch Greece’s efforts to get free money out of the rest of the EU. The Germans who have given the most money to Greece till now do not seem particularly inclined to give away anymore of their money. Pressure will be mounting on both sides to get some kind of deal done following the elections because the Greeks are likely to run out of money to pay their bills within the next couple of months. How this situation is handled will, in my view, have significant repercussions on the EU and possibly our markets here at home.

If you have any questions or comments, please do not hesitate to reach out to me.

Paul L. Merritt, MBA, C(k)P®, AIF®, CRPC®
NTrust Wealth Management

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