Market Review – February 2015

Rumors of Deflation

February saw a shift in investors’ thinking. With bond yields at record lows in Europe and with the US Federal Reserve considering a rate increase, bonds started to look less attractive. It is unclear how long this perspective will last, but there was a significant movement from bonds to stocks in February. The US stock market saw strong returns, and investors showed a willingness to invest in comparably cheap stocks in Europe and in emerging markets.

The theme this month was inflation, or lack thereof, in the US, Europe, and China. When the inflation report was released at the end of the month in the US, the figures showed that prices fell 0.1% in January and the US was following Europe into deflation. Usually, deflation is a strong indicator of poor economic health and investors react accordingly, but the US markets stayed relatively calm. The reason for this was buried deeper in the inflation report, which showed that the headline inflation figure was largely driven by the declining price of oil and that most prices were still increasing slowly.

This reading of the report was confirmed by Janet Yellen, the chair of the Federal Reserve, when she blamed the price of oil for the disappointing inflation figure and told Congress that the Federal Reserve would not allow a single component of the inflation report to delay its actions. Yellen seemed to indicate that the Federal Reserve is optimistic about the US economy and it might consider an increase to its interest rate in June. As a rise in interest rates approaches, interest rate risk becomes a larger concern and investors will need to consider the impact of rising rates on their investments.

Meanwhile, deflation remains a significant concern in Europe. Even the recent actions of the European Central Bank (ECB) have done little to control declining prices in the Eurozone. As in the US, the price of oil is pushing European deflation even lower, but prices are falling throughout the Eurozone. European investors are legitimately concerned about the possibility of yet another recession. The fears of another Eurozone recession are not only tied to continuing deflation, but also the continuing negotiations with Greece about its bailout package. Representatives from Greece and the ECB reached a short-term agreement that allows Greece to bolster its case for relaxing its bailout requirements, but Germany is still opposed to any changes to the terms of the bailout. Investors and analysts fear that Greece will exit the Eurozone and blaze a trail for other dissatisfied countries to do the same.

For the second time in three months, the People’s Bank of China (PBoC) cut its lending rate. Unlike in the US and Europe, China is not yet seeing deflation. Instead inflation has fallen to a five year low, and the PBoC is attempting to prevent the destructive effects of deflation before it arrives. As China resolves its credit crisis, it is harder for corporations and consumers to borrow. This encourages them to save, rather than spend, which means that demand for goods falls and price increases slow in accordance with that falling demand. There are also other indicators that China’s economy is slowing. Its manufacturing sector shrank for the second month in a row, and the real estate market is struggling. While the Chinese economy is now the largest in the world, it appears that it will see slower growth for a time as it adjusts to the effects of the credit crisis.