Global Markets Monthly Update

The major equity indexes reached record highs before pulling back sharply at the end of the month, leaving most with modest gains. As long-term interest rates increased, placing a greater discount on future earnings, investors heavily favored value stocks over growth stocks. In another sign of a market rotation, small- and mid-cap stocks outperformed large-caps. Sector returns also varied widely within the S&P 500 Index, with energy shares surging nearly 23% on a total return (including dividends) basis, while utilities fell over 6%.

The increase in rates took a toll on fixed income investments, although high yield bonds managed a modest positive total return because of their larger coupon payments versus investment-grade issues. Credit spreads in the investment-grade corporate market also narrowed over the month. (Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar-maturity Treasury security.) The yield on the benchmark 10-year U.S. Treasury note jumped 33 basis points (0.33%) and hit its highest level in over a year. (Bond prices and yields move in opposite directions.)

Stimulus Hopes, Vaccine Rollout, and Earnings Beats Push Indexes to Record Highs

The month started out on a strong note, helped by expectations for another round of fiscal stimulus. Senate Democrats rejected a smaller compromise relief package proposed by Republicans and stuck with President Joe Biden’s USD 1.9 trillion plan, approving a budget resolution on February 5 to move forward with the legislation. To pass the bill on a party-line vote, however, Democrats will have to rely on the budget reconciliation process, and the Senate parliamentarian ruled late in the month that it could not be used to pass an increase in the federal minimum wage, a key part of the Democrats’ agenda.

The accelerated vaccine rollout seemed to provide a further boost to confidence. At mid-month, President Biden said in a town hall event that he expected all Americans to have access to a coronavirus vaccine by July, helping life fully return to normal by Christmas. Wall Street also seemed encouraged by declining case reports and hospitalizations, as well as the approval of additional vaccine candidates. Worries about new variants of the virus periodically weighed on sentiment, however.

Better-than-expected fourth-quarter corporate earnings also continued to lift markets. According to FactSet, overall earnings for the S&P 500 rose nearly 4% versus the year before—a large upward revision from the decline of more than 9% that analysts expected before earnings reporting season began. Nearly four out of five companies in the index beat earnings estimates, the third-highest percentage since FactSet began tracking the metric in 2008. Price-to-earnings (P/E) ratios remained well above longer-term averages, however.

Inflation Fears Resurface

Economic signals arguably improved as the month wore on, supporting growth hopes but also pushing up bond yields and deepening inflation fears. Weekly jobless claims rose early in the month but then fell back to their lowest level since November. Retail sales for January exceeded expectations, jumping 5.3%, helped by a 10% surge in personal income that was bolstered by direct payments to individuals as part of the late-December stimulus package. While consumer price inflation remained subdued, producer prices jumped 1.3%. Home prices also saw strong gains, while commodity prices reached multiyear or, in the case of lumber, record highs.

Federal Reserve Chair Jerome Powell seemed to help dampen the impact of rising rates on markets through comments reinforcing the central bank’s dovish monetary stance. Testifying before Congress late in the month, Powell emphasized that inflation remains “soft” and does not show signs of likely experiencing “very large” or “persistent” increases later this year. Powell said that it may take more than three years to reach the central bank’s inflation goals.

Shares in Europe rose with global markets on hopes of a quicker economic recovery, spurred in part by coronavirus vaccination programs and the prospect of more U.S. fiscal stimulus. However, concerns that rising inflation and higher bond yields might prompt central banks to begin tightening monetary policy sooner than expected curbed the gains. Major indexes in the region also advanced, although the FTSE 100 Index’s gains appeared to be restrained by movements in the British pound, which strengthened on the fast rollout of the UK’s vaccination program.

A jump in eurozone sovereign debt yields toward month-end triggered warnings from European Central Bank (ECB) policymakers that they were monitoring financing conditions closely. ECB President Christine Lagarde said that the bank is closely looking at overnight indexed swaps and sovereign bond yields as early indicators of “what happens at downstream stages of monetary policy transmission.”

UK, Denmark, Switzerland Begin to Reopen; EU Faces “Difficult Situation”

The UK, Switzerland, and Denmark announced they would cautiously begin easing lockdown restrictions in March, while European leaders called for an acceleration of the eurozone’s vaccination campaign, which has been hindered by delays and supply constraints. European Council President Charles Michel said, “I think we have to face the truth that there is indeed a difficult situation,” and warned that “the next few weeks will continue to be difficult as far as vaccinations are concerned.” New and more infectious variants of the virus have already been identified across Europe, with the daily number of new coronavirus cases rising again in Germany, France, Italy, the Netherlands, and Austria. German Chancellor Angela Merkel warned of a third wave of infections if the current restrictions are lifted too soon.

Signs of Resilience as Eurozone Economy Falters

Purchasing managers’ surveys from IHS Markit indicated that eurozone business activity fell for a fourth consecutive month in February, suggesting that the economy likely contracted in the first quarter. However, faster manufacturing growth, led by Germany, partly offset the slump in services, and business expectations rose to the highest level in almost three years amid optimism about vaccination campaigns. Gross domestic product (GDP) in the euro area shrank less than initially estimated in the fourth quarter, declining 0.6% sequentially and 5.0% year over year. Employment rose 0.3% on the quarter after a 1.0% increase in the previous three months, despite lockdowns instituted to curb the spread of the coronavirus.

Euro area inflation jumped to 0.9% in January, up from -0.3% in December. Core inflation, which excludes energy and food commodities, rose 1.4% year over year. The price rise was largely attributed to the expiration of Germany’s value-added tax cut.

Italian Parliament Backs Draghi

Mario Draghi, the former president of the ECB, was sworn in as prime minister of Italy. He set about forming a new unity government, which excluded the far right, and received overwhelming support from both houses of Parliament. He pledged to accelerate the vaccination program and outlined plans for structural reforms and investing EUR 210 billion in recovery funds from the European Union.

Japanese stocks rallied early in the month but posted losses in the final week of the period. After setting multiple multi-decade highs, the blue chip Nikkei 225 Average ended the period with a 4.7% gain, while the broad Japanese market recorded more modest returns. Within the Japanese equity market, as measured by the MSCI Japan Index, value stocks outpaced growth shares, and large-caps outperformed small-caps. The yen weakened versus the U.S. dollar and traded above JPY 106 at the end of the month. Japanese government bond yields rose, with the 10-year bond closing the period yielding 0.158%, its highest point in five years.

Business Sentiment Improves

For the first time since mid-2019, Reuters’ monthly Tankan Index recorded a positive reading among manufacturers. The poll, which closely tracks the Bank of Japan’s quarterly Tankan Index, showed that Japan’s manufacturers in aggregate were more positive than negative on business prospects, thanks to improving overseas demand. The sentiment index rose to 3 from -1 in January, reflecting strengthening conditions in chemicals and manufactured foods. The survey also showed that sentiment is expected to continue rising over the next three months, in part due to improving business conditions and a more vibrant global economic environment.

According to Finance Minister Taro Aso, Japan’s GDP growth in the first quarter of 2021 (the final quarter of Japan’s fiscal year) is expected to slow from the torrid pace in the three-month period ended December 31, 2020, when GDP expanded at a 12.7% annualized clip. Despite the economic slowing, the finance minister believes that the government is not currently considering adopting any fresh stimulus measures and that the government will likely maintain its current pace of bond issuance and fiscal stimulus. Bank of Japan Governor Haruhiko Kuroda intends to conduct a policy review in March to ensure that the central bank can continue to provide ultra-loose monetary policy for an extended period.

Central Bank Could Adjust Policy on Bond Yields

According to former Deputy Governor Kazumasa Iwata, the Bank of Japan (BoJ) is likely to continue allowing long-term Japanese government bond yields to rise through a reduction of long-term bond purchases, which should steepen the yield curve. The plan, which Iwata believes will be publicly disseminated in March, should make the BoJ’s policy more sustainable. At the same time, the central bank will also employ loan programs for certain financial institutions.

T. Rowe Price international economist Aadish Kumar believes that the BoJ will also add more flexibility to its exchange-traded fund purchases when the policy review is completed in March. Kumar thinks the yield of the 10-year Japanese government bond could be allowed to trade in a wider band around its 0% interest rate target, which would give the BoJ room to reduce asset purchases when there is upward pressure on yields in the future.

Chinese stocks ended on a mixed note for February and underperformed other Asian markets. The benchmark Shanghai Composite Index edged up 0.75%, after having gained more than 6% on February 19. The CSI 300 Index, which focuses on large-cap growth stocks, fell 0.3%. Looking ahead, some analysts believe that technology-focused China indices will face headwinds from new regulations and investors increasingly favoring value over growth. Sector performance diverged widely, with positive returns for real estate, materials, and energy, while autos, technology, and media posted significant negative returns. In the local currency A shares market, value stocks performed well, while growth stocks fell.

Bond yields continued to grind higher. The yield on the sovereign 10-year bond rose 9 basis points (0.09%) to close at 3.30%. In currency trading, the renminbi shed 0.7% against the U.S. dollar. The renminbi dropped on February 1, following a disappointing manufacturing report from Caixin, subsequently regained some ground, then weakened toward month-end as the dollar broadly strengthened.

Investors Pay Close Attention to Central Bank Policy

After the coronavirus disrupted activity in 2020, analysts expect that 2021 will mark a return to normalcy for China in terms of economic growth, corporate earnings, and policy. Liquidity peaked in momentum terms in the final quarter of 2020, suggesting that economic growth may decelerate later in 2021. The People’s Bank of China (PBOC) is believed to be following a neutral policy with a “bias toward tightening.” Because China is regarded as one of the most policy-sensitive stock markets in Asia, investors pay close attention to possible changes in PBOC policy. Moreover, a weaker liquidity environment has historically been a headwind for A shares.

In political news, China’s annual meeting of the National People’s Congress (NPC) starts March 5. Despite the event’s high-profile nature, most investors have low expectations for any significant policy changes. A partial withdrawal of fiscal stimulus with reduced infrastructure bond sales and a lower budget deficit target of 3.0% of GDP are among the expected announcements. This year’s NPC marks the first year of China’s 14th Five-Year Plan, in which legislators are expected to lay out a road map for doubling GDP, decarbonizing the economy, and achieving other key objectives in the coming decades.

Post-Lunar New Year Data to Be in Focus

The release of combined January/February economic data, delayed due to the weeklong Lunar New Year holiday, will be in focus for China economists. Strong export demand, rising domestic consumption, and increasing vaccination rates are some of the near-term drivers of China’s economy despite a pair of disappointing Purchasing Managers’ Indexes (PMIs) at month-end. However, some analysts believe that the recent PMI weakness reflects China’s status as the first major economy to return to growth after the pandemic and point out that business expectations in services are at multiyear highs.

Turkish Stocks Decline

Stocks in Turkey, as measured by MSCI, returned -2.45% versus 0.77% for the MSCI Emerging Markets Index. Shares were pressured in part by rising U.S. Treasury yields and a stronger U.S. dollar versus the lira.

On February 18, Turkey’s central bank decided to keep its one-week repo auction rate at 17.0%, even though inflation is still rising, propelled by food prices and the effects of lira weakness. T. Rowe Price sovereign analyst Peter Botoucharov believes that year-over-year inflation will peak around 16.5% during the spring and that headline inflation should decline over the course of 2021, finishing the year around 11% to 12%.

Toward the end of the month, Turkey’s central bank raised its requirements for Turkish lira reserves and decreased them for foreign exchange (FX) reserves. Botoucharov believes that the central bank’s objective is to tighten lira liquidity and improve U.S. dollar liquidity in the Turkish financial system. While he believes this is the right policy action, he also believes that the central bank has sent the wrong message—that it has resumed managing the country’s liquidity conditions and is willing to pursue less orthodox policy measures. This is contrary to investors’ expectations for the new, politically untested, economic management team.

If the central bank’s intent is to fortify the lira, Botoucharov believes that policymakers need to do more than adjust reserve requirements. Demand for non-Turkish currencies remains strong—reflecting a lack of confidence in the lira—while the dollarization trend has temporarily stabilized, not reversed. Also, the current account deficit, which is about 5% of GDP, and the central bank’s plans to replenish reserves are other sources of FX demand. Unfortunately, policymakers continue to prefer supporting growth with spending rather than making more difficult fiscal adjustments. At the very least, Botoucharov believes that the central bank is likely to resume raising rates in an attempt to keep the Turkish lira relatively stable and achieve some disinflation, rebuild its reserves, and increase confidence among investors.

Mexico’s Central Bank Cuts Rates

Mexican stocks, as measured by MSCI, returned 0.42% but slightly lagged the MSCI Emerging Markets Index. Returns in U.S. dollar terms were hurt by the peso’s 3% drop versus the greenback.

On February 11, the Mexican central bank held its first monetary policy meeting of the new year, and, after remaining on hold since September 2020, policymakers unanimously decided to cut the overnight interbank interest rate from 4.25% to 4.00%. While the rate cut was not unexpected, T. Rowe Price emerging markets sovereign analyst Aaron Gifford believes that some analysts may have had doubts about a rate cut, due in part to recent upward surprises in inflation data and comments from certain central bank officials. In terms of forward guidance, the central bank’s post-meeting statement indicated only that policymakers “will take the necessary actions based on incoming information.”

Toward the end of the month, Gifford determined from the meeting minutes that policymakers were not as dovish as investors initially believed them to be. The input from each of the five board members varied quite a bit regarding the rate cut decision:

• One dovish opinion is that monetary policy is still too tight and that there’s plenty of space to keep easing.
• Another dovish stance is that the upward inflation readings are temporary and that policymakers should be willing to look beyond them.
• A neutral opinion is that policymakers should focus on Mexico’s financial conditions and the peso exchange rate.
• One of the hawkish opinions among policymakers is that there’s a limit to monetary policy and that it’s important for policymakers’ actions to generate confidence.
• Another hawkish perspective is that there’s still plenty of uncertainty, that core inflation hasn’t declined, and that policymakers may need to pause their rate cuts.

Judging from these statements, Gifford believes that the rate cut decision should have been mixed rather than unanimous. Given the more difficult external backdrop stemming from rising U.S. Treasury yields and a stronger U.S. dollar, it will be important to see how board sentiment shifts. He still thinks, however, that central bank officials are biased toward at least one more rate cut.

Total returns unless noted
As of 02/28/2021
Figures shown in U.S. dollars