January 2014 – Monthly Commentary
The capital markets have vacillated wildly during the first six weeks of 2014. Investors dumped equities in January in what appeared to be a calendar-related attempt to lock in the outsized gains of 2013. As the selling swelled, so did the price of U.S. Treasury bonds. For the month, the yield-to-maturity of the 10-year Treasury note fell to 2.64% from the 3.02% year-end closing yield, reversing a portion of the sharp selloff experienced is the fourth quarter.
Driving capital markets has been the sudden and unexpected weakening in job growth for December and January. As we closed the year, average monthly job growth as measured by the non-farm business survey registered approximately 197,000, which is certainly more robust than the 80,000 monthly average witnessed for December and January. However, a quick inspection of the full labor report indicated that the excessive cold and inclement weather experienced across the country kept a lid on labor growth. The report was “muddied” further by the less referenced Household survey which reported a drop in the unemployment rate to 6.6% from 6.7%. While economist had been expecting a drop in the rate due to an influx of people leaving the workforce, the BLS reported that the reverse occurred. During January the work force actually expanded by 523,000 people while those employed increased by 638,000 people, hence the fall in the unemployment rate.
As equity losses mounted, the media increasingly referenced the adage “as goes January, so goes the year,” suggesting that equity price weakness could continue, exacerbating investor anxiety. However, all was made right by newly sworn-in Federal Reserve Chair Janet Yellen’s testimony before Congress. In it, she made clear that she intended to continue with management of the open market operations in the same manner as her predecessor. With that proclamation, and propelled by a ferocious short-covering rally, the S&P is once again trading above 1800 and just below the previous record close.
Ironically, through both the selloff and subsequent rally, credit spreads have continued to narrow. Credit spreads typically have an inverse relationship to interest rates, widening as rates fall and narrowing as rates rise; at least as rates initially move. Considering the primary driver of interest rates, namely the state of economic health and the forecast for inflation, the correlation makes sense. The relationship has broken down this year because the economic weakness is attributable to the extremely cold, snowy and icy weather. Assuming that weather related weakness will be temporary and recaptured once weather returns to normal, investors have been willing to allocate money to the higher yielding corporate and municipal bond sectors even as rates fall. The narrowing in spread has been beneficial to the fund, adding to performance in January. Looking forward, we expect that the recent spread compression will hold and that interest rates will likely stay at current levels until the impact of foul weather passes. That’s not likely to be evident until at least early April, when March economic data will be released. In the meantime, we will continue to collect coupon income and maintain our hedges.