Q1 2015: Equity Divergence and King Dollar

History may not repeat but it rhymes. So said Mark Twain a century ago. For U.S. equities, the first quarter the past two years has played out in almost identical fashion. The first quarter was spared by a brilliant February, compensating just enough to make up for a poor January and a very choppy March. In the end, the S&P 500 index, the principal U.S. benchmark, was in the plus column for a ninth consecutive quarter. Not a record, but an impressive winning streak nonetheless.

The first quarter in Europe was quite different, with key bourses surging once European courts approved in principle the central bank’s legal authority to purchase national sovereign bonds. So, from mid-January onward, the path was clear for a record quarter, at least in Euro-terms. Without exception, continental equities rode a wave of optimism. The thinking turned, that not only was the worst in the rear-view mirror, but tangible improvement lies ahead. Local currency returns averaged well into double-digits. To punctuate the point, even in terms of the appreciated U.S. dollar, prices finished in the black.

Japan got into the act. Similar to Europe, the Nikkei took-off early-on, moving up 2,000 points, crossing-over a couple of big round numbers not seen since Y2K! The reasons were similar to Europe’s. Last year’s increase in the national consumption tax, in retrospect deemed a policy mistake, was in the rear-view mirror. Furthermore, with the central bank in the midst of full-blown quantitative easing, including equity purchases, optimism was in the air well before spring’s cherry blossoms. More than a decade of deflation has proven a difficult road to traverse, yet the Bank of Japan’s public signals remain unchanged. Japanese bond purchases in comparison to GDP are far greater than in Europe or past QE’s in the U.S.

On the fixed-income side, Treasuries had a positive quarter. All maturities saw yields decline; by 10 basis points on the short-end, and 20 basis points for the benchmark 10-year note. Why? Inflation remained subdued due to low energy prices, another harsh winter kept consumer spending at bay despite the gas windfall, the global picture was fuzzy (not as in math) but as in geopolitical risks adding to market caution. In uncertain times, Treasuries’ safe-haven appeal tends to prevail.

Meanwhile, across the pond, there were many more bids than offers for debt as yields on peripheral EU debt kept tumbling through most of Q1, reaching their low in March. German bunds, Europe’s benchmark, saw yields continue their relentless march toward zero! Government debt out to 5 years rendered a negative return. Investors paid the Bundesbank for the privilege of owning the country’s sovereign debt. A balanced budget, whether in relative or absolute terms is a modern day feat, one accomplished by the reigning World Cup champions.

Commodities had an uneventful quarter, up in spurts, then down just as quickly. In the case of gold, the Midas metal started quickly, higher by more than $100 in the opening month before giving it all back, to close unchanged. WTI prices (domestic crude oil), stayed in the news all quarter long. Again, the jumps were short-lived and prompted immediate sell-offs. The New Year opened at $53 a barrel, fell, then recovered, but was unable to move beyond its breakeven point. At one point, the price dropped to a new 6-year low, and remained choppy throughout. Q1 closed down $6 at $47. Brent fared better. The differential between the two blends narrowed significantly in January before widening to double-digits a good portion of the quarter. The international blend closed Q1 at $55.
On to the highlight story of Q1, the U.S. Dollar. The greenback’s sharp revaluation versus a basket of currencies, especially against the Euro, surprised markets. What started as a gradual descent of the European currency unit turned into a rout. The first 25 days saw the Dollar appreciate 10 numbers, and 16 numbers the first 75 days of the calendar year. Way too fast in the market’s mind. Alarm bells sounded as to unintended consequences of a strong dollar. Namely, U.S. corporate earnings, which are expected to decline for the first time in 3 years when first quarter reports are released. Investment decisions over the better part of 2015 may hinge on the market’s expectations for the dollar. Not only in the States, but abroad. It may affect the timing of any potential rise in U.S. rates, not only dampening inflation, but perhaps lowering potential GDP.

Emerging Markets had their own turbulence – equities more so than debt. However, both asset classes were on the upswing as the quarter came to an end. In particular, equities received a lift from China’s markets. Though the economic data still shows the 2nd largest economy sputtering and pockets still experiencing a slowdown, China’s main index powered ahead in March, closing the quarter at its highest point since 2008. That said, it was not smooth sailing even in China, even for equities. A swoon before the Lunar New Year caused a fallback in prices, before buying resumed in earnest. In March, the Shanghai index was up better than 15%.

For EM, the underlying concern is the U.S. Dollar. The greenback’s rapid rise jolted many investment strategies, as the possibility of further strength began to be factored-in assumptions for the year. It was a good part of the reason why fund flows were inconsistent and unsteady. Will the Fed move by mid-year? Or continue to be patient despite removing the word from its statement? And, how will that decision impact the Dollar’s value going forward after what was a historic quarter? In short, the value of the U.S. Dollar is once again front and center on investors’ minds.

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