“May you live in interesting times” goes the ancient Chinese saying – whether a blessing or a curse is presumably up to the individual. 2011 has been a most interesting year so far from the standpoint of financial markets. It has been a good year for many asset classes from US and European equities to real estate and, of course, the seemingly irrepressible energy, agriculture and precious metals commodities. Even the bond market – where one could logically suppose that higher inflation and a weaker dollar would conspire to pull US Treasury rates out of their low single-digits – has been rallying in recent weeks.
Two things make this performance particularly remarkable – and paradoxical. The first is that there really has not been a lot of great economic news to go around. First quarter growth in the US has been underwhelming, while spiraling commodities prices have been pushing headline inflation into uncomfortable territory. Corporate earnings are up but unemployment remains stuck around 9%. Meanwhile the major growth engines among emerging economies appear to be taking a bit of a pause – China, India and Brazil have all been more ponderous lately – and Europe has bifurcated into a small coterie of stable paymasters trying to keep the basket cases on their periphery from coming apart at the seams. The economic news is not terrible by any means, but there are reasonable concerns that the tepid pace at this stage of the recovery does not bode well for the kind of sustained growth cycle that investors have become used to during previous post-recessionary periods.
The second remarkable thing about year-to-date market performance is the relentless number of potentially destructive X-factors that have been popping into existence since the year began – the ongoing unrest all across the Middle East, humanitarian and economic devastation in Japan, flooding along the Mississippi River and year-long droughts in states just to the west of the deluge. It would seem that the combination of sudden market shocks and a generally fragile economic undertone would threaten to lead markets lower. But no – the Russell 3000 index sits above 9% (as of the 5/10 market close). True, there has been volatility aplenty, but investor sentiment (for now at least) appears to be determined to keep the good times rolling. Whether that lasts for much longer is another question. We think there is a decidedly odd tenor to the market currently. Here are a handful of things that we find strange about the current state of play:
Europe: To Default or Not to Default?
The debt problems in second-tier Eurozone nations have not gone away. Credit spreads of Greek sovereign debt to US Treasuries are over 12% currently, and spreads on Portuguese issues have nearly doubled since the beginning of the year. Just about six weeks ago the Greek stock market was the Continental high-flyer. The MSCI Greece index was at 23% year-to-date on March 25, and Portugal was up by just under 10%. As of May 6 the Greek index had plummeted and was up just 1.5% YTD. As for Portugal? It was actually 3.4% higher, closing at 13.1% on May 6. So far this year the rally in European equities has been largely thanks to the strong performance of the shakiest economies (Ireland, Spain and Italy have also been strongly outperforming the region). This does not seem like a recipe for stability – and Greece’s entry into bear market territory may be a harbinger of things to come for the region. Would that the Delphic oracle were still around…
Emerging Markets: Two Cheers for Hungary.
Likewise in emerging markets, the distribution of returns among countries and regions has been curious to say the least. Among the MSCI emerging markets countries Hungary has been leading the parade with a 30% return for the year to date. Hungary, you may recall, was another nation seemingly one step away from the poorhouse last year during Europe’s summer of woes. Meanwhile the BRIC index representing the world’s growth engine economies is flat for the year to date – and the only reason it is not deeper in negative territory is due to the least growth engine-y of that quartet – Russia, which is up just under 11%. Again – not the kind of thing that leaves us swimming in confidence.
US Debt Markets
Anyone? Of all the space oddities in this market environment perhaps nothing is quite so confounding as the US bond market. Safe haven for risk-averse portfolios? Puh-leese. Stratospheric commodities prices, a chronically weak US dollar and steadily increasing inflation are not supposed to be ingredients for bond market strength, especially when government bond yields have hovered around historical all-time lows for much of the past eighteen months. And yet – over the past two weeks yields on the 10-year note have plunged from 3.61% to 3.14% (remember that when bond yields fall, bond prices rise).
What makes bonds look so attractive that the scarlet letters of inflation and currency weakness can’t keep investors away? The CW, for what it is worth, seems to be pointing the finger at the expected end of QE2 in June. Really? If QE2 does in fact end then (which is probable but not at all certain given the Bernanke doctrine of asset price support at all costs) then all that happens is that the Fed stops buying bonds. But not buying bonds would, all else being equal, increase yields – which would be bad news for someone buying a 3.14% coupon bond today. The rationale seems to be that going off QE2 would put an end to the current rally in stocks and other risk assets (which, to be fair, really got its full head of steam during the run-up to the QE2 announcement last summer) – and that would bring money out of other securities back into bonds. We find this unconvincing and do not see anything compelling about government bonds at current market levels.
That is by no means the end of the litany of the strange. In US stocks we have the curious case of the Toxic 200. The Russell 1000 is an index of large cap stocks which is further divided into two additional benchmarks: the Top 200 is otherwise known as the mega-cap index, and the remaining 800 stocks of the Russell 1000 show up in the Mid Cap Index. The Mid Cap has outperformed the Top 200 (and therefore, logically, the 1000 Large Cap) in just about every way possible over the last ten years and continues its run this year – and this is also true in both the growth and the value style indexes as well as the blend. It is perhaps plausible that in certain industry sectors – Big Oil, Big Finance and Big Pharma come to mind – the leading names in the sector have become too closely associated with US government policy and its attendant political risk – hence the chronic underperformance. We will be digging into this more and it will likely be the subject of further commentaries this year.
All in all, paradoxes and conundrums abound. This is not a market for feeling safe or supremely confident in performance against a single benchmark. It is, in our belief, a market in which risk management is the paramount objective – because there are risks aplenty.