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Macro Overview
The Federal Reserve announced the official end of its bond buying stimulus efforts, known as quantitative easing (Q.E). The conclusion comes six years after the initial program was enacted to stimulate economic growth by maintaining low yields on government securities. The end of quantitative easing is seen as a validation that the Fed is confident U.S. economic growth can be sustained.
Improving earnings for U.S. companies helped propel the equity markets to new highs in October, as equity prices rose at month end, recouping a portion of pullbacks earlier in the month.
The Commerce Department reported that the U.S. economy grew at a 3.5% annualized rate in the 3rd quarter, more than expected. Reduced fuel prices, a strong dollar, and an improving job market are helping to excel growth throughout the nation.
Some economists are expecting that low gasoline prices and an improving labor market will help boost consumer sentiment and consumption. A drop in fuel prices is allowing consumers to spend more freely on what they really want to buy.
Labor Department data revealed that this past month had the least amount of jobless benefit claims filed in the past 14 years. Layoffs and firings among U.S. companies are at historic lows as a sustained demand for goods and services is encouraging worker retention.
Greater sensitivity is being paid to the quality of the job market, as more lower-paying jobs are being created rather than higher-paying jobs. The Labor Department reports that lower paying retail and hospitality jobs have climbed nearly 50% since the end of 2011, compared with an 18.6% gain for higher-paying professional jobs. College graduates who find jobs are more likely to end up taking a position that may not require a college degree. The Fed sees this issue as a “significant underutilization of labor resources”, where overqualified workers are taking menial jobs.
Turbulent markets in October almost changed the Fed’s stance on fighting inflation as the St. Louis Federal Reserve Bank President, James Bullard, said that the U.S. central bank considered maintaining its bond buying stimulus given a drop in inflation expectations.
Government sponsored mortgage entities Fannie Mae and Freddie Mac are considering programs that would make it easier for lenders to offer mortgages to more borrowers. Such a move might facilitate the approval process that has been hindering homebuyers since the housing mortgage crisis.
Sanctions have aggravated Russia's economic stability with inflation running at an annual rate of almost 8 percent, the ruble falling sharply this year, and capital flight topping $75 billion in the first half of 2014. The ruble’s 21% tumble against the dollar has resulted in inflation as the cost of imports have increased dramatically.
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Equity Overview
Major stock indices ended October at record highs following a volatile month with dramatic price swings throughout the trading sessions. The markets were roiled in October as Ebola headlines were scattered throughout the news along with global growth concerns becoming more prevalent.
Yet with all of the month’s turbulence, the Dow Jones Industrial Average and the S&P 500 Index both finished an historically volatile October at record highs. The S&P 500 was able to recapture losses suffered earlier in the month, with a 2.32% gain for October. The Dow Jones was also able to minimize the negative effects of October’s storm and edge up 0.89% for the month.
October has historically been known as the single most volatile month for equities, with the crash of 1929 and 1987, and more recently the 2008 crisis stemming throughout September and October of 2008.
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International Overview
Japan’s central bank, the Bank of Japan, lowered its key rate in an effort to combat deflationary pressures. The ECB, Europe’s central bank, in September lowered its key rate to historic lows to help stimulate economic growth and employment throughout the euro zone. By driving down interest rates, the Bank of Japan hopes to also devalue the Japanese yen, thus making Japanese automobiles and products less expensive worldwide. The central bank said that it would shift its portfolio allocation primarily towards equities of domestic and foreign companies. The benefit for U.S. markets is the fact that stocks would be considered as part of the reallocation planned by the Bank of Japan.
Ironically, as Japan and Europe lower rates to all time lows, the Federal Reserve in the U.S. is heading in the opposite direction by starting the process of raising rates in order to fight approaching inflation.
Trying to stem the rise in inflation, Russia’s central bank raised its key rate to 9.5 percent from 8 percent at month end, higher than what economists had expected. The dramatic increase validates the urgency Russian officials have in curtailing the country’s rapidly escalating inflation.
The ruble has lost more than 28% of its value relative to the U.S. dollar since the beginning of the year, primarily due to economic sanctions imposed by Western countries this year as well as lower oil prices.
Dropping oil prices have become a growing concern for various countries. In the Middle East, oil exports account for 85 percent of the Saudi government’s revenue, and the International Monetary Fund (IMF) estimates the kingdom needs an annual average price of at least $83.60 a barrel to balance the national budget. The average for Brent crude this year is $106, still above the Saudi break-even price. The IMF estimates that Saudi Arabia can endure an extended period of low oil prices due to its massive reserve of dollars, currently over $700 billion.
Domestic and foreign investors spurred 187.7 billion euros ($239 billion) of fixed-income outflows from the euro area in the six months through August, the most in ECB data going back to the currency’s debut in 1999. The concern is that outflows risk undermining the euro-region economy if they become too aggressive. The ECB extended its stimulus measures this past month by starting to buy asset-backed bonds, announcing that it bought 1.7 billion euros of covered bonds in the first week of the new plan. The euro sank to a more than two-year low of $1.2501 on October 3rd.
The capital flight encouraged by the ECB’s policies helped push the yield on Germany’s benchmark 10-year bond to a record-low 0.715 percent on October 16th, and Spain’s rate to an all-time low of 2.019 percent. The average yield to maturity on euro-area government debt dropped to 1 percent on October 1st, the lowest ever.
Banking authorities in Europe conducted an industry wide stress test to determine which banks could actually survive a serious financial crisis. In total, 25 out of 123 banks tested failed to meet the requirements. Greek and Italian banks fared the worst, however German and Spanish banks did particularly well.
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Fixed Income Overview
International tensions along with continued fears of deflation in Europe gravitated global assets towards U.S. government and corporate debt in October.
Record low yields on government bonds from Germany to Japan pushed investors to higher paying debt in the U.S., which offers a level transparency and liquidity desired by international investors.
Even though the Fed’s bond buying program is now complete, it still has over $4.5 trillion of bonds on its balance sheet, producing over $100 billion annually in interest income. Additionally, proceeds from interest income and maturing bonds will continue to be reinvested into other bonds, thus indirectly maintaining a “shadow” inventory from the open markets, lending to a continued subdued rate environment.
The Fed’s announcement at the end of October was the first time that it explicitly included sentiment that related to the conditions of a forthcoming rate hike. Many believe that the Fed is gingerly preparing the markets for an earlier than expected increase in its key short-term rate, the Fed Funds.
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