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The first quarter of 2014 was characterized by a surprisingly smooth transition at the Federal Reserve Bank with Janet Yellen now presiding as Chairwoman. The market’s reaction was subdued; tapering of the U.S. stimulus will continue, the economy continues to improve, and the Fed’s focus is now squarely on the jobless rate. The drag on the economy from lower federal and local government spending is flattening out on a year-on-year basis; while it is still negative, the impact is becoming less negative, and as the economy continues to improve, public sector GDP growth will begin converging in a positive sense toward the current private sector U.S. growth level of 3%.

Some common sense is returning to the stock market’s fundamentals, as investors focus on value rather than fast moving “momentum stocks”. The latter have indeed experienced a pullback in the first quarter as rotation is taking place out of momentum stocks and into “slow and steady” value stocks. Sectors whose multiples are less than those of the market are outperforming, as are those with higher dividend yields such as utilities, REIT’s, MLP’s and energy stocks. While capital expenditure in the U.S. has been slow, it is rising in certain key areas of the economy like technology, oil equipment, and oil services. In the case of energy stocks, the positive effect of shale oil and gas continues with huge capital inflows being experienced in the sector.

There is still debate about profit margins in the U.S. and their sustainability. Given the combination of productivity growth as well as the number of job seekers keeping a ceiling on wages, profit margins are likely to continue rising, or at worst stabilize at their current high levels. If the Obama administration is successful in raising the Federal minimum wage, its impact will affect companies which have relatively low sales per employee, primarily small businesses which are not publically quoted.

The Ukraine has proven to be a storm in a teacup in Wall Street’s view. What is more important in the emerging markets is China. Chinese government policy is attempting to shift the economy away from investment and toward domestic consumption, with some salutary steps toward releasing genuine market forces. The Yuan has been "depegged" somewhat to the dollar in a sign of movement toward liberalization. The first corporate bond default in China, albeit a small one, was "permitted" to take place in January. The market remains wary about massive levels of local government debt, which remain over-reliant on property taxes. Economists are slashing their growth forecasts to levels well below China’s own growth forecast of 7 1/2%, while profits at some of China’s biggest companies are shrinking. Accordingly, the Chinese stock market is down this year, while China's neighboring economies in India, South Korea, and Taiwan are doing better than expected and are hitting new highs.

Deflation in Europe is exacerbating the need for further stimulus by the ECB, which is likely to boost European stocks and provide tailwinds to the global economy. There is upside risk in Europe that the European Central Bank will attempt to engender some inflation and more stimuli to the European economy.

For the first quarter of 2014, The Dow was up 0.8%, the S&P 500 was up 0.8%; and the Nasdaq was up 1%.

Grant Rogers

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