The first six weeks of 2014 have been nothing to cheer about in terms of market performance, with the major indices down anywhere from 5-7% (although they have bounced back with S&P500 Index down only 0.75% YTD) and questions popping up about economic growth. Of course, the question investors are likely asking is whether we are at the start of a longer-term downtrend or merely a speed bump in the road.
The best way to approach this question is to think about what areas of the economy are unlikely to be very affected by an economic slowdown. Traditionally, when it appears the market is in for a sustainable downtrend and economic growth is slowing or reversing, areas of the market known as the defensive sectors have held up better than those known as cyclicals. Sectors such as utilities (people always need power), health care (people get sick in any economic environment), and consumer staples (the need for toilet paper stays relatively constant), have been considered defensive. Interestingly, thus far in this pullback, only the utilities and health care sectors have held up while consumer staples have actually performed worse than the broader market. Likewise, technology, an area that has been traditionally thought of as very sensitive to market and economic swings (cyclical), has held up better than most. For that reason, we believe that we are not at the start of longer-term downtrend and that these +/-5% pullbacks should be expected during the current bull market.
New Federal Reserve Chair Janet Yellen’s emphasis on continuity of monetary policy was widely expected and the House and Senate both passed a clean debt ceiling bill this week. These actions were well received by the markets and helped initiate recent market strength. We believe economic growth will continue to accelerate throughout the year, benefitting the more cyclical areas of the economy. Therefore, we are recommending that investors refrain from making any tactical moves to a more defensive position and ride out the bumpiness that may continue in the near term. It is not always pleasant, but it can help set up the next sustainable move higher, which we believe is the case this time around.
Reinforcing the bumpy ride mentioned earlier, the global manufacturing picture still appears a bit murky. However, we continue to believe the industrial sector should outperform. The national ISM Manufacturing Index remained in territory depicting expansion but weakened quite a bit from the previous month. Many that follow the index believe the weakening was due to unusually bad winter weather and that the upward trend should return in the near future. Additionally, Europe remains weak but there are some encouraging signs as governments appear to be shifting from some of the more onerous austerity policies that could help boost growth, and the European Central Bank (ECB) is finally being more aggressive.
Recent EM financial market turmoil is likely to slow EM economic growth and postpone the reacceleration of EM growth that was forecasted by the International Monetary Fund (IMF) last fall. Notably, manufacturing and exports outperformed services in January, and countries with closer ties to developed markets posted stronger growth. While EM growth is likely to slow further in the coming months, the data thus far support a slow moderation, not a collapse.
In closing, we believe that 2014 will have a few more speed bumps (i.e. a 5% sell-off) and quite possibly an actual market correction (i.e. a 10% sell-off). However, we do not believe this is the beginning of a longer trend downwards. Improving labor markets, sustained GDP growth, low inflation, low interest rates, accommodative global monetary policy, strong corporate earnings/balance sheets and positive investor sentiment all point to a continued trend upwards for equity markets across the globe.