February was a rebound month for the markets following January’s sharp sell-off. The S&P 500 Index gained 4.31 percent and is up 0.60 percent this year. The Dow Jones Industrials Average remains in the red though, down 1.54 percent for the year, while the Russell 2000 and NASDAQ are both in positive territory.
Economic data wasn’t terribly supportive of the rebound. There were some strong housing numbers, but more importantly, we learned the 2013 third quarter boost in inventories was not the start of a faster recovery. The Bureau of Labor statistics lowered the 2013 fourth quarter GDP estimate from 3.2 percent down to 2.4 percent, a large drop from the 4.1 percent growth rate in the third quarter. This doesn’t signal a slowdown in the economy though, which is why stocks shrugged off the number. A 2.4 percent annualized rate is the same rate of growth seen in 2010 and it is faster than the growth rate in 2011 and 2012.
Some economists and media outlets have blamed the weakness on weather, but the evidence is strongly against this interpretation. First of all, Hurricane Sandy was undetectable in national GDP statistics and that was a far worse disaster than several snow storms. Second, weather was blamed for weak retail sales numbers, but online sales also suffered. If people did stay home due to snow, this should have increased online sales. Finally, weather was blamed for weak home sales, but a drop in home sales came from the West, where the weather was warmer than usual, while sales were up in the storm battered Northeast.
Even though economic data wasn’t as positive as we had hoped, stocks still pushed higher. Housing, solar, biotechnology, internet, and social media stocks were a few of the sectors benefiting from rising optimism and merger activity. Facebook’s (FB) purchase of WhatsApp for $19 billion was the exclamation point on a very strong month for Internet and social media stocks. The strength in housing stocks is particularly notable because the home builder stocks have pushed to new 52-week highs. Clearly, investors haven’t been deterred by the weaker than expected economic data in 2014.
Still, we cannot overly rely on strong stock prices as a leading indicator for the economy. There are also real concerns that threaten the bull rally and even the economic recovery. The biggest concern is with China, where the government is trying to deflate the credit bubble without bursting it. In January, there were concerns about a default in the trust market and by the end of February the yuan tumbled in value. It wasn’t a big decline for the yuan, but since the currency is tightly controlled and has been steadily appreciating, the sudden drop was surprising. Furthermore, in February, some lenders stopped loaning to property developers due to the growing risk. If it looks like the economy and financial sector are headed for deeper trouble, and a sharp devaluation of the yuan, this will be unnerving news for commodity producers and nearly all emerging markets.
The crisis in Ukraine is weighing on Europe as well. Russian banks have the most exposure to Ukraine, but Austria also has sizable exposure. European banks are exposed to emerging markets more generally, far more than U.S. banks. Already, the crisis is pushing up oil prices, which is bad news for weak emerging market economies. European stocks also opened sharply lower on the first trading day since Russian troops moved into Crimea. It could be a one-day sell-off by panicked traders, and very often these types of events are great buying opportunities as traders panic and assume the worst potential outcome.
By comparison, U.S. markets remain a safe haven and we are likely to see a bid for U.S. Treasuries as long as there is trouble in Europe’s backyard. The Ukraine situation is likely to calm down politically soon, but economic effects could linger. Russian supplies natural gas to Europe and half of that gas flows through the Ukraine. Thus far there’s been no interruption in service. Still, while Ukraine grabs headlines, China is the more worrisome situation as the economic impact of a sudden slowdown would have a greater global impact.
The decline of domestic stocks in January acted to price in some Chinese risk, though losses were recovered over the past month. The headwinds haven’t gone away; in fact, the Chinese situation has shown signs of further deterioration. Manufacturing data still shows a contraction, while services remain strong. Since manufacturing is the leading indicator, there is risk that services will weaken in the coming weeks. On the positive side, although Chinese yuan continues to devalue, the Chinese stock market did not sell-off further. If further depreciation occurs, while bullish for stocks in the long-run, the immediate impact would be fear and volatility.
Finally, U.S. stocks enjoyed a very strong month in February which is unlikely to be duplicated in March. While we may not see any significant long-term market ramifications from Ukraine, China or other unforeseen issues, investors could expect to see greater volatility over the near-term. Interest rates may decrease whether stocks go up or down, due to safe haven buying, which may be good news for home builders, real estate and utilities.