Tuesday, February 24, 2015

February 22, 2015

US and International markets have rallied in February in the face of growing fears that Greece will disrupt the unity of the European Union (EU) by dropping out of this important politico-economic organization. Greece and the EU (along with the International Monetary Fund—IMF, and European Central Bank—ECB) have struggled to find common ground with the newly elected Greek leadership and negotiate new debt service terms agreeable to both sides. However, late Friday it was announced that the parties involved had agreed to a four-month extension of the debt deadline. The agreement provides both parties time to continue negotiating without the immediate threat of Greece’s economic collapse. While the markets cheered this development, the crisis is far from resolved and the retention of Greece within the EU remains uncertain.

The US equity market is now up each of the first three weeks in February reversing January’s negative performance. In addition to reacting favorably to news about Greece, investors were satisfied for now with Federal Reserve Chair Janet Yellen’s recent comments suggesting that raising short-term interest rates remains on hold for now. For the year, the tech-heavy NASDAQ index leads the major indices I follow. Noticeably, smaller capitalization stocks (Russell 2000 index) are holding their own this year after a disappointing performance in 2014.

The top three economic sectors for the year are Health Care (+6.1%), Materials (+5.9%), and Telecommunications (+4.7%) while the bottom three performers are Utilities (-2.9%), Financials (-0.3%), and Energy (+1.6%).

International markets have also rallied in February. Greece certainly is at the forefront of issues facing international markets, but the Russian incursion into Ukraine, and a slowing Chinese economy are also contributing to concerns. Investors appear to be looking beyond these issues for now and overseas markets are strengthening after a poor 2014. Europe-heavy STOXX 600 index leads among all the broad international indices with most European markets up in the 10% to 15% range so far this year. China is flat, Japan is up 5.1%, and India is up 6.3%.

US interest rates continue to rise. The benchmark 10-year US Treasury bond yield has added 43.6 basis points (a basis point is the interest rate equivalent of a penny to a dollar) since the start of February closing Friday at 2.119%. As you can see from the chart below, this is a very significant increase in rates over a relative short period.

The roller coaster move in rates in January (-49 basis points) followed by a 44 basis point jump in February is in part, I believe, driven by investor uncertainty over EU/Greece concerns and timing of US Federal Reserve rate hikes. Fears of a Greek departure from the EU drove investors into US Treasuries creating demand. The more demand there is for anything, the higher the price buyers are willing to pay. In the case of bonds, this demand/price increase pushes yields on bonds down. When negotiations got under way in Europe with the newly elected Greek government officials, bond investors’ sentiment improved lessening the demand for US Treasuries and yields have risen as prices have fallen. Additionally, many bond investors believe the US Federal Reserve will raise short-term rates later in 2015 (mid-summer or early fall) and rates are moving upwards in response. Where interest rates are ultimately headed is still a huge unknown (as it generally is) and how this sorts out will be determined by how my big four economic themes unfold (Greece/EU, US Federal Reserve rate increases, Geopolitical uncertainty, and Domestic political uncertainty) as the year progresses.

One of the immediate effects of higher interest rates has been the decline in the Utility and Real Estate Sectors. Over the past 30 days, the Utility sector has dropped 6.8% while the Real Estate sector has declined 2.3%. Both the Utility and Real Estate sectors are interest rate sensitive, and I believe they will suffer additional pullbacks if rates continue to rise. It is very, very difficult to say how far rates will climb due to the many cross currents influencing bond investors and I would encourage bond investors not to overreact to the current rate jump at this time. Bond markets are too choppy and I believe it is premature to make major adjustments to bond portfolios.

Commodities weakness continues driven in part by falling oil prices. The Dow Jones UBS Commodity Futures index is down 1.5% in 2015 after losing over 17% in 2014. WTI Oil prices fell 9.4% in January, gained 9.4% over the first two weeks in February only to give back 4.6% last week. The net result is that WTI Oil closed Friday at $50.34 per barrel and is down 5.5% so far this year. Oil needs to find a degree of price stability, and the past few weeks may have been the start of a bottoming process. However, as long as supplies continue building (US inventories were up 7.7 million barrels last week), I believe oil prices may continue to come under pressure. Heating Oil prices are the one exception with heavy demand this winter pushing prices for heating oil up over 16% this year.

The US Dollar has found some stability recently among the other key currencies in the world. The US Dollar index is down 0.6% in February after rising 5% in January and 12.8% in 2014. The cooling of the Greek crisis calmed Euro traders. The Euro has gained 0.8% against the US Dollar this month after falling 6.7% in January. While currency stories do not typically lead the news cycle, a global competition is developing between central bankers as they try to push down the value of their currencies to spur exports. The US Federal Reserve, in my opinion, has been held back from raising rates partly due to the European Central Bank’s announcement that it would begin purchasing bonds (quantitative easing--QE) in March. This European version of QE is widely anticipated to put downward pressure on the Euro. February’s moves aside, I believe the US Dollar is likely to move higher relative to other key currencies in the months ahead. If this happens, US exports will be more expensive (bad for US manufacturers), imports cheaper (good for US consumers), commodity prices may continue to drift downward, and investments abroad will face a currency headwind putting a drag on returns.


The Greek problem for the EU and investors is not going away; it has simply been pushed back four months.

The far-left party, Syriza (Syriza is an abbreviation in Greek for Coalition of the Radical Left), has been forced to accept for now, that they must negotiate with Greece’s creditors to find a way out of the economic mess the country is in. Recall that Syriza’s Prime Minister, Alexis Tsipras, was elected on the promise that he would not negotiate with Greece’s creditors and demand an end to the austerity programs the previous Greek government was required to implement in order to secure additional loans to keep the country afloat. The four-month extension agreed to Friday by Greece calls for the Tsipras to provide, by Monday (February 23rd), a list of economic and policy reforms that will satisfy Greece’s lenders. This extension agreement does allow Tsipras to set his own priorities, but it does not fundamentally alter the situation. Greece must make meaningful progress to grow their economy, collect taxes, slash bureaucracies, and ultimately repay all the money they have borrowed if the country wants to remain in the European Union. To me, unless Tsipras adopts solid, growth-oriented policies, he will accomplish nothing. Quoting one of my favorite clich├ęs, all this talking will be like rearranging the deck chairs on the Titanic.

My optimism about Greece is subdued because Tsipras is a radical left-wing politician, a former member of the Greek Communist Party, and his ideological beliefs do not conform with the actions he must implement to put Greece on a solid economic footing. His coalition partner in Greece is the far right wing nationalistic Independent Greeks party that equally hates the austerity measures imposed by the Europeans and who want to leave the EU. Tsipras and his allies must find a way to overcome their internal biases and come up with a solution that satisfies the EU, their own electorate, and actually reforms the economy. This is a tall order for any group of politicians, right, left, or in-between.

I want remind everyone that the European Union has much to lose as well if Greece fails. The turmoil created by Greece’s departure is more political than economic. The latest economic data I have on Greece’s GDP is that this country of just over 11 million people produced about $249 billion in economic output in 2014 (Source: Global Finance Magazine, Stanford University). For comparison purposes, this ranks Greece between Oregon (25th) and Louisiana (24th) in economic output, and the Commonwealth of Virginia (11th) is producing 1.9 times more economically than Greece.

For the EU, the stability of the union is paramount, and a Greek exit from the EU could open the door to other weaker nations like Portugal, Ireland, and even Italy to follow. A shared currency has benefits to all participants, however, it can only happen if each country surrenders some of their sovereignty to a higher power (the EU and ECB) to maintain order. I believe both sides, after political grandstanding and brinksmanship, will give a little and an agreement reached to keep Greece in the EU for now. This has been the way before and I expect it to continue.


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. I prefer the floating rate and high-yield bond sectors and caution investors about any longer-term maturity bonds.

Looking ahead to key US economic events/reports, Fed Chair Janet Yellen will be speaking to Congress on Tuesday and Wedensday mornings. Her comments always attract the interest of investors. Additionally, housing data will be out (slight decreases expected over December data), and the second estimate of the 4th quarter Gross Domestic Product (GDP) will be released this Friday morning. The first estimate disappointed investors dropping from a consensus growth of 3.2% to 2.6%. The consensus anticipates a further revison downward to 2.1%. Anything below 2% would be problematic in my mind.

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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