The tailwind for stocks last week was more evidence of stabilization in the U.S. economy. Looking ahead, while the economic recovery remains uneven, any firming in growth is likely to lend support to the recent advance in two, somewhat different asset classes in particular: Treasury Inflation-Protected Securities (TIPS) and value stocks.
Deflation Worries Return to Europe
Stocks were initially buoyed by a decent manufacturing report. Although the U.S. manufacturing sector remains in contraction territory, the situation appears to be stabilizing as the dollar's appreciation has stalled. Adding to last week's more sanguine tone was February's jobs report. Wage growth slipped, but U.S. job creation remains strong and was well above estimates. The improving tone of economic data have had the predictable effect of pushing rates higher. Bond yields rose to a one-month high on firming inflation expectations.
The situation remains somewhat different in Europe, where deflation remains a bigger threat. Indeed, headline inflation figures are once again negative. While the year-over-year decline in oil prices contributed to the fall, the drop in inflation was not simply a function of weak energy prices, as core inflation fell from 1% to 0.7%.
The drop in inflation in Europe is occurring against a backdrop of generally soft economic data. Retail sales were resilient in January, but in general, euro-zone economic data are disappointing at the fastest pace since mid-2013. Deflationary pressure and tepid growth will add to the pressure at a key meeting of the European Central Bank (ECB) this week. The ECB will need to provide a credible package to stem deflationary forces while taking note of the market's recent aversion to negative deposit rates.
The pressure for additional monetary stimulus in Europe, as well as in Japan and China, is at odds with the Federal Reserve's (Fed's) likely plans. With recession fears abating and inflation expectations starting to lift, admittedly from very low levels, investors are recalibrating their expectations for the Fed. While expectations for a 2016 hike had all but vanished in recent weeks, futures markets now assume the Fed will hike by December, if not sooner. This divergence between the Fed and the rest of the world is likely to provide some support for the U.S. dollar, which has been confined to a trading range in recent months.
TIPS and value stocks worth a look
For investors, less economic anxiety has several implications. First, as we have noted in previous commentaries, the precipitous fall in U.S. inflation expectations seemed overdone absent a recession. In fact, we have seen a recent firming in inflation expectations — 10-year TIPS break-evens have risen by over 30 basis points (0.30%) in less than four weeks — supporting our positive view on the inflation-protected assets.
Turning to equities, should economic conditions continue to stabilize, value stocks may be one of the bigger beneficiaries. Value typically outperforms during periods when economic conditions are improving. The style — currently heavily weighted toward energy and financials — also appears inexpensive. As of the end of February, growth stocks (as measured by the S&P 500 Growth Index) were trading at more than three times the price-to-book value of value stocks (as measured by the S&P 500 Value Index). Based on this metric, the spread between U.S. large-cap value and U.S. large-cap growth is greater than at any time since the bursting of the technology bubble in 2000.
In short, in an environment characterized by more stable growth, value is likely to perform better, as we've already been seeing in recent weeks.
Koesterich is chief global strategist with BlackRock, the largest asset manager in the world.
E-mail: editors@barrons.com[1]
References
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