Investors Seek Strong Economic Recovery Indicators

OCEAN CITY — Since declining in January, U.S. Treasury yields have been volatile and range bound. The causes of this performance include difficulties investors have experienced interpreting the timing and speed of the Federal Reserve’s (Fed) future interest rate hikes and uncertainty about the strength of the economic recovery.

Recent readings on the economy, from the stronger than expected April employment report to the Purchasing Managers Index, point to stronger growth, but since their release rates have actually drifted downward, contrary to what experience and intuition suggest.

Our view is that despite the more upbeat news on the economy, investors continue to look for stronger evidence of a recovery. In addition, escalation of the conflict in Ukraine and worries about a credit crisis in China, the world’s second-largest economy, have drawn some investors to the quality of U.S. Treasurys, adding to the downside pressure on yields.

Uncertainty regarding the strength of the economic recovery has altered the traditional inverse relationship between equity prices and interest rates before, during the “taper tantrum” in the middle of 2013

Coming into 2014, our BofAML Fund Manager Survey indicated investors were continuing to underweight fixed income. Since that time, most investment strategists have advocated shorter duration fixed income positioning. That positioning worked well in 2013, as within the U.S. Treasury market short-duration issues outperformed long-duration issues. Year-to-date (YTD), however, the market has favored long durations, challenging our view. We maintain our short-duration positioning for 2014. Our shorter-duration view is anchored on improvements in leading indicators of economic activity, accommodative financial conditions and slightly higher but still low inflation.

We see growing evidence that the U.S. economy is strengthening following a weak first-quarter performance. The effects of severe cold weather seem to be fading as we move into spring. Furthermore our colleagues on the BofAML Global Transports Research team recently noted that commentary from UPS on the state of the economy was “the most positive we have heard from UPS in many years” despite a 1Q earnings miss on weather. With the Fed adopting more flexible macroeconomic guidelines, policy should be more responsive to the economic growth we expect. Markets will most likely look toward the Fed’s policy for further confirmation that the recovery is strengthening.

The Fed appears to share this view since it elected to taper its monthly bond purchases by another $10 billion at the April meeting, citing growth in economic activity. The Fed’s tapering signals a slow return to a more normal monetary policy and we view it as accommodative, supporting a strengthening economy.

Investors should not give up on fixed income as it still plays a critical role in a multi-asset portfolio. Our advice at the beginning of the year to keep fixed income durations short in 2014 has been challenged in the first four months of the year. However, we reaffirm it over the medium term. We continue to believe that a strengthening economy in 2014 will lead to higher interest rates.

Within fixed income our preferred segments are municipals and high yield. Municipal bonds remain attractively valued relative to Treasurys, and state and local government finances continue to strengthen. High yield credit metrics remain strong, as corporations have repaired their balance sheets and profit margins continue to be healthy.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)