Last month, we noted that the markets were off to a rocky start in 2016.  We observed that yields on long duration U.S. government bonds fell sharply, as markets began pricing in a possible U.S. recession and a deeper slowdown in global growth.  This theme continued throughout February; returns on the Standard & Poor’s 500 (“SPX”) and iShares Russell 200 Index (“IWM”) were essentially flat in the month — down 41 basis points (“bps”) and 22 bps, respectively — while iShares Barclays 20+ Year Treasury Bond EFT (“TLT”) increased 300 bps.  The iShares MSCI EAFE Index Fund (“EFA”) declined 330 bps despite negative interest rate policy by Japan and quantitative easing in Europe.

But economic data released recently suggests that fears of a recession in the U.S. could be overblown.  4Q15 Gross Domestic Product (“GDP”) was revised upward to 1% growth – not robust, but not a contraction either.  Oil has stabilized in the low to mid $30s per barrel.  The labor market remains tight.  Higher housing prices are boosting wealth.  These two factors combined suggest that fundamentals for consumer spending remain very strong.  In fact, personal income spending increased 0.5% in January.  Consumer spending comprises two-thirds of the U.S. economy.

On the manufacturing side (12% of the U.S. economy), activity in February shrank less than forecast and contracted at a slower pace than in January.  This could indicate that the manufacturing industry could soon stabilize.  The Institute for Supply Management (“ISM”) manufacturing index registered 49.5, slightly below 50, which is the dividing line between contraction and expansion.  The January reading equaled 48.2.  Half of the industries included in the index expanded for the first time since August; makers of wood products, textiles, furniture, and chemicals were particularly strong.  Domestic demand boosted by consumers could have contributed to strength in these areas.  Both capital equipment orders and factory output increased in January.    Either the headwinds (soft global demand, strong U.S. dollar, inventory overhang, and weakness in the capital-intensive oil industry) that the manufacturing sector faced in late 2014 and in 2015 are receding or the U.S. consumer continues to propel the U.S. economy forward.

In addition, construction spending surged 1.5% in January, reaching the highest level since 2007.  Private residential construction increased 0.5%.  Private non-residential construction increased 1%.  Public construction spending rose 4.5%.  It is possible, though, that mild winter weather could have pushed demand forward.

In short, upbeat data from consumer spending, labor market, industrial production, durable goods and construction spending indicate the U.S. economy may be regaining momentum at this time.

But what does this mean for equity markets and allocation between stocks and bonds?  Earnings have contracted three quarters in a row, pointing to a recession.  However, earnings are a lagging indicator of economic strength.  If economic growth in 2016 remains anemic and if the Federal Reserve continues on a cautious, measured path of rate hikes, then equity markets have no compelling reason to rally and could remain in a trading range.  In the short term, equity markets may continue to have lackluster performances.

While the data may be pointing towards a stabilizing economy, the growth rate it is still nothing to write home about. Looking beyond the S&P 500, virtually all global markets and the US small caps are in a bear market. Meanwhile, the year over year rate of change in NFP (non farm payrolls) is decreasing and that likely means this economic cycle has peaked.  In a world of negative interest rate policies and deflation, the probabilities seem to be against a sustained rally in equities or a spike in interest rates. In the short term, we suspect there will be a fair amount of volatility in both directions.

Based on an investor’s time horizon and risk tolerance, we continue to maintain a cautious posture with an underweight in global equities in our strategic allocation portfolios.  We believe there is little to justify a sustained robust movement upward in equities and if an investor currently has a full or overweight position we recommend using rallies as potential re-balancing opportunities.

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