US Ecomomy and European Central Bank (ECB) announcements

Quick Recap

Domestic stocks have experienced a little more volatility than what has been usual this year; however U.S. equities continue their winning ways. Although the August employment data were somewhat disappointing, investors were encouraged by strong manufacturing trends. Events outside of the U.S. also contributed to the positive tone. The European Central Bank (ECB) announced a surprise rate cut, and a cease fire agreement in Ukraine eased tensions in that region. Defensive sectors generally did better than cyclical sectors, with utilities and consumer staples performing particularly well. On the cyclical side, consumer discretionary stocks outperformed, but the energy sector suffered noticeably as a result of falling oil prices.

Five Recent Themes impacting sentiment

1. Jobs growth slowed in August. Non-farm payrolls increased by a much-less-than-expected 142,000 last month, with the largest slowdowns coming from manufacturing and retail trade. On the bright side, unemployment ticked down another notch to 6.1%, and average hourly earnings advanced slightly. The silver lining is that the poor showing takes some pressure off of the Federal Reserve to be more aggressive about raising interest rates. The consensus still believes that the bond buying program will end in the next few months, and the Federal Reserve (Fed) will start to raise rates sometime between March and June of next year.

2. Two Institute of Supply Management surveys reached new post-recession highs. Both the ISM manufacturing and non-manufacturing surveys trended up last month, a sign the economy continues to move in the right direction.

3. ECB easing is supporting global growth. The ECB’s unexpected announcement that it will cut interest rates by 0.1% and increase its bond-purchase programs should help both European and world growth. In the immediate aftermath of the announcement, European stocks advanced while the euro declined versus the dollar and yen. Both European stocks and emerging market stocks have experienced considerably more volatility than their U.S. counterparts, and that will most likely not end soon.

4. Russia/Ukraine turmoil represents a growing risk. Notwithstanding last week’s ceasefire, the conflict is hurting European growth, and the threat of additional sanctions could further undermine the region. More broadly, there is a potential risk that the turmoil could begin to affect the rest of the world economy. In particular, there is concern about the possible negative effect on U.S. multinational company’s earnings and U.S. exports.

5. The United States appears set to become energy independent by the end of this decade. The U.S. is already the world’s largest producer of natural gas and is on pace to become the largest producer of crude oil within the next couple of years. At present, the U.S. is still importing oil, but the pace is diminishing, and more is coming from Canada and Mexico than from OPEC countries.

Stocks versus bonds moving forward

Domestic equities and longer term government bonds have both performed well this year. Accommodative monetary policy and economic growth have been good enough and fast enough to provide support but not so fast that fears of Fed tightening have taken hold. Government bond markets have also been supported by risk aversion due to rising geopolitical tensions and pockets of disinflation fears around the globe.

But how much longer can this Goldilocks scenario continue for both asset classes? Global economic growth is improving, and it is thought that we will soon be at a point where growth will still be a tailwind for equities; however this growth will also put stronger upward pressure on interest rates. We are not expecting the Fed to move rapidly or dramatically, but we do believe the central bank will begin increasing the fed funds rate next year, which should put further pressure on government bonds. It has been the thought for some time that rates had to move higher, but for much of the year that has not been the case and has caused problems for those allocating portfolios with the anticipation of higher rates.

The expectations for both equities and bonds is that both will be choppier than what we have seen so far this year, and we also anticipate these asset classes will show more divergence. Specifically, we believe U.S. Treasuries will come under increasing pressure in the face of stronger growth and tighter policy, which may lead to under-performance. The outlook for equities varies a bit more. Should economic growth slow significantly (a scenario we believe is less likely), stock prices could fall. Should growth continue to improve, we would expect stock prices to grind higher.

Detail on European Central Bank (ECB) announcement

Bottom-line is, the European Central Bank (ECB) announcements surprised positively across the board:

1. Rate cuts were a positive surprise.
2. Without much detail at this point, the ECB also appears to be planning to increase its balance sheet substantially, largely through bond purchase programs announced today.

It has been a common view that the risk of deflation in Europe is one of the most important risks for global markets this year. Recently, there has been doubt whether the ECB would act aggressively enough to offset it, as inflation expectations and inflation break-evens in European financial markets collapsed. At last month’s US Federal Reserve (Fed) meetings at Jackson Hole, Wyo., ECB President Mario Draghi indicated that the ECB would be more aggressive and highlighted the importance of the ECB meeting. Despite his comments, market expectations going into the meeting seemed relatively low. However, the ECB did not disappoint.

Key measures may turn inflation around

Rather, the central bank announced three key measures we believe could help turn European inflation expectations and actual European inflation around.

1. The ECB cut its three main interest rates by 10 basis points. The deposit facility rate was taken further into negative territory, to -0.20%.
2. It announced a new asset-backed security (ABS) purchase program to begin in October.
3. It will resume its covered bond purchase program with details to be announced in October.

Because Mr. Draghi indicated that these measures represent the limit of what they can do on the interest rate front, it is not expected there will be further cuts in the future.

Fighting deflation pressures

Most importantly, Mr. Draghi announced plans to bring the ECB’s balance sheet back up to 2012 levels through a combination of a new bond purchase program and targeted longer-term refinancing operations (LTRO). This aggressive expansion of the ECB’s balance sheet surprised the market. Mr. Draghi also mentioned that government bond quantitative easing was discussed but not agreed upon.

Most believe this was the right move by the ECB to fight deflation pressures, and the markets reacted positively. The short end of the German bund yield curve rallied and the curve steepened, suggesting a recovery in inflation expectations. Inflation breakevens can be expected to reverse their declining trend. The US yield curve also steepened, suggesting confidence that the ECB’s efforts to do what is necessary to fight deflation will also have global impact. Peripheral sovereign bonds and other European credit assets also rallied.

Implications of central banks moving in opposite directions

We emphasize that today marks a big change for the markets. It’s the first time in many years that the Fed and ECB are moving in opposite directions — Europe will begin expanding its balance sheet, while the Fed is tapering its balance sheet expansion. We shouldn’t underestimate the impact that this can have on currencies. Let’s look at the implications.

• Currency: These moves could be very negative for the euro. Based on the above-mentioned divergence between the European and US central banks, many believe this divergence will be an ongoing driver of the euro-dollar exchange rate. The euro was down more than 1% on the announcements. Despite recent weakening, we believe the euro to continue to decline and the dollar to do well against all European currencies.
• Credit: We see the move as good for European credit, both in the periphery and for European assets overall. It is believed by many that European assets will outperform US assets as far as credit is concerned.
• ABS (asset backed security) purchases: Mr. Draghi said the ECB would accept residential mortgage-backed securities and newly created European ABS, which we believe bodes well for the size of the program because the current European ABS market is relatively small. It appears that plans are to increase the size of the ABS market with this program.
• Dissenting views: It’s worth noting that Mr. Draghi mentioned that while the decision was based on a comfortable majority, it wasn’t unanimous. We might hear some concerns voiced by certain speakers going forward.

We know at times the details can take us down into the weeds. We try to mix up the information and make it as timely as possible. The last few weeks have been consumed with meetings that will most likely have a dramatic impact on both equity and bond markets as we move forward. We thought it necessary to share those details for those that would like a little more explanation on topics they may have heard about, but may not know the implications or understand the impact.