Weekly Commentary Overview

  • U.S. stocks and bonds treaded water for most of last week, but equities managed to squeeze out a new high on Friday following news of a tentative deal between Greece and the European Union (EU) finance ministers to extend the Greek bailout for four months.
  • Investors spent much of last week pondering what the Federal Reserve (Fed) will do with respect to raising rates in the coming months. That has helped reverse some of the recent uptick in short-term yields and made investors more cautious on rate-sensitive assets. However, there is growing comfort with other areas of the bond market, namely high yield.
  • Meanwhile, international markets continue to set the pace for stocks. Japanese equities have hit their highest levels since May 2000.
  • European assets have also performed well. However, while Friday's news should provide some short-term relief, the issue of Greece's place in the eurozone is unlikely to go away.
  • We continue to prefer international over U.S. equities, and within bonds, credit over long-term Treasuries and other rate-sensitive assets.

A Late Rally on Greek News

U.S. stocks and bonds treaded water for most of last week, but equities managed to squeeze out a new high on Friday following news of a tentative deal between Greece and the European Union (EU) finance ministers to extend the Greek bailout for four months. Both the Dow Jones Industrial Average and the S&P 500 Index rose 0.67% to close the week at 18,140 and 2,110, respectively, while the Nasdaq Composite Index climbed 1.27% to 4,955. Meanwhile, the yield on the 10-year Treasury inched up from 2.06% to 2.12% as its price correspondingly fell.

While the major indexes were relatively stable last week, we continue to see several trends below the surface that lead us to maintain our preferences: International over U.S. equities, and within bonds, credit over long-term Treasuries and other rate-sensitive assets.

Reading the Fed Tea Leaves

Prior to Friday afternoon, U.S. stock and bond indexes were generally flat for the week, with little in the way of corporate earnings and on the heels of mixed economic data releases. For example, producer prices fell at a much quicker pace than expected in January, even after stripping out energy prices.

Investors spent much of last week pondering what the Federal Reserve (Fed) will do with respect to raising rates in the coming months. Minutes released from the Jan. 27-28 meeting suggest the Fed is somewhat divided over when to raise rates, given that inflation is low and global risks elevated.

Ambiguity over the pace of monetary tightening reversed some of the recent uptick in short-term yields. However, 10-year U.S. rates remain roughly 45 basis points above their January lows. The shift in the rate environment has had a more noticeable impact on rate-sensitive assets as investors grow more cautious. U.S. utility exchange traded funds experienced significant outflows last week. Finally, gold prices, which are historically sensitive to real interest rates (the interest rate after inflation), have slid as rates have risen, with gold now down 8% from its January peak.

While investors have become more cautious on investments most likely to be affected by higher interest rates, there is a growing comfort with other areas of the bond market. Flows into high yield bonds have surged and as investors have favored the asset class, spreads––the difference between the yield of high yield bond funds and Treasuries––have narrowed by more than 50 basis points over the last few weeks. We still see relative value in this asset class, despite outperforming both nominal Treasuries and Treasury Inflation Protected Securities this year.

Greece will remain a chronic issue for investors for some time to come. Still, we maintain our preference for international equities over U.S. stocks, given the high valuations of the latter.

International Markets Continue to Rally

Meanwhile, international markets continue to set the pace for stocks. Japanese equities have hit their highest levels since May 2000. The Topix Index is now up 6.5% year-to-date, outpacing U.S. equity markets by roughly 4%.

What has distinguished this year’s rally is that Japanese equities no longer appear dependent on a weak yen. With the Bank of Japan declining to add further monetary stimulus, the yen has been relatively stable year-to-date. We continue to see good opportunity in Japanese equities.

European assets have also performed well, as investors are taking comfort from a steadier economy and the tailwind of quantitative easing by the European Central Bank (ECB). But the rally suggests investors had been discounting an eventual agreement between Greece and its creditors. This view appeared to be validated on Friday when EU finance ministers agreed to extend aid to Greece for four months.  Whether this will be sufficient time to address the longer-term differences between Greece and its creditors remains an open question.

Prior to the announcement, it was revealed that factions within the German government were prepared to let Greece leave the eurozone. This hardline stance is partly a function of shifting domestic considerations. As the new anti-euro Alternative party continues to gain momentum in Germany, Chancellor Merkel’s latitude to compromise with the Greek government is increasingly constrained.

While Friday’s news should provide some short-term relief, the issue of Greece’s place in the eurozone is unlikely to go away. As the negotiations continue, investors should focus on a couple of metrics: bank deposits and government finances. Greece has been bleeding deposits since late last year and is now dependent on the ECB’s emergency liquidity assistance facility. A second problem is a plunge in tax collections as individuals withhold tax payments on hopes for future relief.

In short, Greece will remain a chronic issue for investors for some time to come. Still, we maintain our preference for international equities over U.S. stocks, which are fully valued at the moment.

The New Normal


Russ Koesterich comments on the volatility we've seen in the market at the start of the year, and why it might not be as unusual as it seems.

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