Economic Update:

• It was a light week for economic data.  The few releases that did appear were positive on the employment front; however, a few showed some imported inflation.
• Equity markets struggled with momentum stocks (those that led the way last year) pulling back.

Stocks experienced more volatility last week over concerns of slowed global growth.  Looking at the sectors, utilities outperformed with a half-percent gain, while financials and health care lost several percent more than the market.  Momentum stocks (i.e. last year’s winners, such as biotech, social media and 3-D printing) stalled and have moved negative over the past month, with an especially poor day Thursday.  Then again, their valuations were getting a bit rich.

We are now in the midst of another earnings season, with the first reports this week being mixed (Alcoa, the traditional first name to report, was positive, but their results have not been shown to be especially correlated with everyone else’s numbers).  Expectations for Q1 earnings have been lowered, through downwardly revised earnings estimates, many of which are weather-related—trickle-downs from the effects of economic data we’ve been reporting on for so many months.  Those weather effects have generally been a negative for consumer goods, but a positive for earnings in areas like utilities.  Then again, it could be the usual Wall Street game of over-revise expectations lower and experience the higher positive surprise at earnings release time—and everyone is happy.  Overall bottom-up S&P 500 estimates are calling for growth of 2% in earnings for the quarter and 5% in top-line revenue.  For the rest of the year, naturally subject to change, earnings growth is expected to expand to 10% quarter-over-quarter while revenue growth consistent at 5%.

One important reason as to why stock earnings have rebounded so strongly in the last cycle is the improvement in profit margins, which have moved from a low of just under 6% in 2009 to just under 9% today.  Profit margins—being the simple fraction of net income (aka earnings) divided by sales revenue—represent one third of the classic ‘DuPont’ return on equity calculation.  So, starting with sales, and removing cost of goods sold, R&D, administrative expenses, depreciation/amortization and other costs, as well as owed interest and taxes, you get a final ‘bottom line,’ which is net income.

Are net profits sustainable at such a high level?  Probably not forever, but they could hover here for a while.  We’ve seen a steady increase in margins since the 1970’s, which, when you think about trends towards automation and associated efficiencies, this isn’t entirely surprising.  However, in the most recent business cycle recovery, there has been debate about how much cost-cutting can be accomplished without higher revenues on the other end.  So, just like last quarter, eyes will be focused on top-line revenues and guidance commentary as well as bottom-line earnings.  As the business cycle matures and firms become increasingly confident in their prospects for profitability, we may start to see increasing amounts of leverage used (from today’s much lower post-crisis levels), which may act as another lever to aid corporate returns.

In developed foreign equity markets, the U.K. fell by just over a half-percent, while the Eurozone fell -2%.  Japan suffered a -5% loss following a BOJ announcement that rates/stimulus will remain unchanged, as policy appears to be on track for 2% inflation at present.  The BRIC emerging market nations gained several percent, and have experienced a bit of a comeback in recent weeks, as EM equity is the leading equity group so far in 2014 (who would have guessed at the end of last year?) as sentiment is perhaps reaching a bottom.

Bonds generally performed well in a risk-off week, with yields falling about 10 bps across the curve—so, long bonds outperformed short bonds.  Intermediate credit and MBS gained between one-half and one percent, while high yield bond indexes lost ground with widened spreads.

High yield bonds and bank loans have experienced strong cash inflows over the past year.  There continues to appear to be some room to run here—spreads are just below long-term average levels, but aren’t near their all-time ‘tights.’  In high yield, default rates have remained below 1% (compared to a historical average of 4%) and have generally stayed at lower levels until a year or two after the Fed begins to raise rates.  Relative to the fewer opportunities seen in intermediate-term investment grade debt, a spread that stays somewhat stable continues to provide ample absolute return for waiting by clipping the coupon.  Floating rate bank loans are in a similar situation, although pricing is closer to ‘fair value.’  Then again, these types of securities have historically performed well when rates rise, due to their resetting nature—all other fundamental factors aside, continued economic improvement could be a technical positive for that market.

In broader foreign markets, a weaker dollar on the week created positive performance in both developed and emerging markets; otherwise, local currency returns appeared to be roughly flat.  Non-U.S. markets were highlighted by the return of Greece for the first time in four years, raising €3 billion for a 5-year bond with a 4.75% coupon.  Perhaps the amazing part is that the deal was eight times oversubscribed, implying huge interest in the paper.  Conditions have certainly improved in Greece—their deficit-to-GDP ratio is only about a fifth of what it was in 2010 (on a lower GDP base than pre-crisis).  No doubt this improvement added to the success of the bond offering, but the rate appears low considering the ongoing challenges.

With the exception of Europe, most real estate segments were negative on the week, along with general equity markets, but better than the financial sector as a whole.  U.S. industrial/office lost a percent as the worst performing group; however, year-to-date numbers from the real estate sector are extremely strong (up in the 5-10% range), representing the best performance from any asset class and demonstrating its diversification characteristics.

Commodity indexes generally gained about a percent overall, with strength in coffee (worst drought in Brazilian history has affected this and other products), natural gas and some industrial metals such as nickel and aluminum.  West Texas crude also gained a few percentage points from $100 to $103.  On the negative side, sugar and cotton correct a few percent on the week.