Natalie Trunow is Senior Vice President and Chief Investment Officer, Equities at Maryland-based Calvert Investment Management.
Harlan Levy: We haven't had a 10 percent correction in the stock market in more than 400 days. What's going on, and is last week's big drop the start of one?
Natalie Trunow: A few things are happening. We had a very extended period of time when equity markets have been posting significant positive returns, because the risk aversion in the marketplace subsided. We also had a significant additional move up in the second half of last year because the Federal Reserve didn't taper in September as many anticipated it might. As a result, expectations for increasing interest rates were lowered, and longer duration assets rallied with pockets of higher beta and higher growth assets outperforming the market. During the second half of last year, the market also seemed to be discounting improvements in macroeconomic data and a potential pick up in GDP growth in 2014. A good earnings season also contributed. However, now that the Fed started tapering, the reality is sinking in that it is now a matter of when, not if interest rates will start to rise. My opinion, however, is that it is likely to be a gradual process with volatility managed by the Fed.
We've had one of the best years ever in the U.S. stock market - a couple of years' returns all in one year: over 30 percent in some of the equity indices. The S&P 500 was up 32 percent. The Russell 1000 was up 33 percent, and the Russell 2000 was up almost 39 percent, and some stocks may have gotten a little ahead of themselves.
A couple of things drove market appreciation last year. Folks have gotten comfortable with the fact that the U.S. economy is recovering and is likely to continue on that path for some time, and we're not going to have a double-dip recession after all. Remember, as recently as the fall of 2012 that was not the case. Things are getting better in the economy and healthier, however slowly. As the economy recovers, the consumer is also recovering. Some of the political stalemates and dysfunctionality in Washington didn't help and have been a drag on the economy, but they have not derailed the economic recovery, and, in fact, some of those tendencies seem to be abating, if not getting better. As economic recovery strengthens, the political landscape is going to matter less.
So the risk-aversion trade dissipated by the end of last year. The P/E multiple has expanded, as market participants were now willing to pay higher prices for a unit of corporate earnings. Also, the macroeconomic reports and corporate earnings reports in the fourth quarter indicated further economic recovery and growth and its extension in 2014, confirming a decrease in probability of recession.
What's happening now is that we had lower-than-expected job numbers come in, some macroeconomic data that were negatively impacted by the bad weather, and we have lower-than-expected numbers coming out of China.
China is always a point of concern when it comes to global economic growth. The Chinese economy continues to be significantly skewed toward exports and benefited the most during the bubble from the over-consumption in the developed economies, particularly the U.S. Some of that demand will likely not come back in the foreseeable future. As we anticipated and commented all along, the decoupling in the emerging markets, including China, never happened, and the middle class is simply not developed enough as yet to support the hyper-growth we observed leading to and during the bubble. If there is a pronounced slowdown in China, given that it's the second largest economy globally, that has the potential of negatively impacting global economic growth. It's always on people's minds. If some long-standing fears of the "hard landing" in China materialize, investor sentiment could suffer. Although I think the U.S. economic recovery, while not immune to potential issues in China, will likely continue on its course.
Also, there hasn't been a pullback in equities in quite some time, which means people have generated very, very healthy returns in the last several quarters. So some folks are probably taking some of the profits off the table and re-balancing their portfolios. It's a natural part of the market action.
But at the moment I don't see a sufficient negative catalyst for a potential correction in the 10 to 15 percent range, although 5 to 10 could happen due to profit taking and seasonal growth issues we're experiencing at the moment, such as reduction in demand in the first quarter because people stay home more because it's cold and the impact on building and housing related projects. Some of that demand and economic activity will be pushed out into the second and third quarter, and the lost economic activity will largely be recovered then.
Q: What do you see in the jobs picture?
A: We had gradual and very slow improvement in employment over the last three or four years which I believe will likely continue. It will be slower than we'd like to see it but likely faster than what we've seen so far. As the pickup in economic growth accelerates, so will employment to match that economic activity.
Q: Will the jobless rate dip below 6.5 percent, the benchmark the Fed set to start raising interest rates?
A: It could by the end of this year. It's possible. But I don't think unemployment alone will trigger the Fed to raise rates even if the unemployment rate goes below 6.5%. The Fed will consider other metrics, inflation and GDP growth. And to the extent that the Fed considers GDP growth as unsatisfactory by the end of the year, even if we get 6.5 percent unemployment, they may want to see more signs of improving economic activity as well as indications that the inflation side of the equation are good.
They do have a dual mandate: inflation and unemployment. They will be watching both, although at the moment I don't think inflation will be a big issue because of the deflationary impact from the emerging markets and slow pace of global economic recovery which drives demand side of the economy.
I don't think they will raise rates this year. However, tapering in and of itself has an impact on interest rates, whereby interest rates will be rising through market activity and not through direct intervention. Institutional and retail fund flows can also have a significant impact.
Q: Won't that retard the housing recovery?
A: It could. Basically it's about expectations as much as the actual moves in interest rates. When expectations around interest rate increases change, and people expect interest rates to go up, that spills over into mortgage rates. When mortgage rates go up, the housing market tends to react negatively. In fact, this is exactly what we observed in 2013. As a result of the Fed telegraphing in Spring 2013 that tapering might start in September - which didn't happen - there was a pickup in expectations during the summer for interest rate increases, and that impacted mortgage rates, which caused softer housing data and slowing housing activity in the fall. That was a warning sign of what's to come if and when expectations pick up.
Mortgage rates will be one element to watch, but very gradual small increases over time will not derail the recovery in the housing market. A spike will.
Early last year we said that the Fed would likely monitor volatility around interest rate changes as much as the level of change. We believe that's partially why they did not taper in September and pushed it out another quarter. They wanted to manage expectations so there wouldn't be too much volatility in rates causing increase in mortgage rates and spilling over into housing. We believe the Fed's attention to volatility and not just the interest rate level will continue as heightened volatility in rates can impact expectations and economic activity which will put pressure on the Fed for additional stimulus.
It's not just mortgage rates. It's also housing affordability. To the extent we continue to have improvements in the employment picture and to the extent we continue to have economic growth and growth in personal incomes, those elements will also play into housing activity, as household formation and demand for housing continue to be healthy. With economic recovery continuing and U.S. consumers being more prudent with their spending practices, the consumer balance sheet is getting healthier, which helps with consumer credit quality and hence housing affordability.
To the extent those metrics are healthy, increases in mortgage rates can be absorbed, and the housing recovery can continue. It will just be slower. It will not be a V-shaped recovery, just as the economy is not recovering in a V shape but is recovering in a smile shaped pattern.
Q. How's manufacturing doing?
A: It looks good to me. The industrial sector seems to be picking up strength. The earnings seasons in the last couple of quarters were very encouraging, so I think the sector is likely to do well in 2014.
Q: So what's your overall outlook on the U.S. economy?
A: A little bit above consensus is where I will end up. The consensus at the end of December was 2.5 percent growth. I think 3 to 3.5 percent is achievable, perhaps even somewhat above 3.5 if we don't have unexpected shocks to the system.
Some of it has been discounted in the stock market run-up, so I don't know if we will get the kinds of returns we got last year. I think we will get a much lower return in the S&P 500 than last year, but it will still be a positive one, not as robust as last year, but I think we can get a decent year in stocks absent an unexpected shock to the system.
Q: Data showing positive industrial growth in Europe hasn't quelled doubts that Europe is on the rebound. What do you think?
A: The macro data seem to show that the economies there are not deteriorating as much any more and stabilizing. We are not seeing continued contraction. We are seeing some signs of stabilization and recovery, but it looks very nascent. I think the pace of recovery in Europe will be much slower than the one in the States, so markets might be too optimistic and may be disappointed again about Europe, as they have been in the last few years. It's good to see some signs of recovery, however. There will be good investment opportunities as a result.
It's going to be a long road to full recovery, which spells bad news for emerging markets and China in particular because Europe is a big trading partner for China and many other emerging market countries.
Q: What do you most fear about the economy and the stock market?
A: The U. S. economy is much less of a concern than the market because it looks like the market has discounted the economic recovery already to a large degree.
For the economy, a wild card or derailer could be an unexpected spike in interest rates, which could be precipitated by many things like a sell-off of bond holdings by retail investors. They accumulated as much as $1.3 trillion in debt in mutual funds over the past few years. A quick rotation out of these assets could be felt in the marketplace. This could cause a negative impact to the housing market, which could potentially have a slowing effect on the overall economy.
In terms of the equity markets and fixed-income markets, such a spike could also have pronounced effects. In equity land it would be most sharply felt by high-dividend-yielding stocks and higher growth stocks.
Q: What might be the effect of the extreme unrest in the Middle East, Iraq and Afghanistan?
A: The geopolitical risks are always on the table. So any significant event from a geopolitical standpoint could disrupt markets, although I don't think it would in the long run, except for an extreme, sustained spike in oil prices. If the build-out of nuclear capabilities by Iran leads to a preemptive strike by Israel that would be one such event. It hasn't happened so far, so it either won't happen or the probability is higher now, since Iran is much closer to having nuclear weapon capability.