Mark Luschini, Chief Investment Strategist

Economic activity in the Eurozone is weak. GDP for the whole year expanded just 0.4%, with the bloc’s largest economy, Germany, narrowly avoiding recession, and the hard data so far this year is not evidencing a material change for the better. To be sure, inflation has decelerated meaningfully, but it remains above the European Central Bank’s (the ECB) target of 2.0%.

Additionally, wages (a prime driver of consumption-driven demand) are falling, but from a very high level, and with the unemployment rate at a historic low of 6.4%, they could remain sticky and keep inflation elevated. Inherently, that combination complicates the picture for monetary officials. While the underlying economy is growing at an anemic pace, which probably warranted a rate cut already, if not soon, the ECB fears inflation may not subside sufficiently if it loosens policy too far in advance of its amelioration. Nonetheless, market participants are looking ahead to a possible reduction in the overnight rate, and ECB President Christine Lagarde has strongly hinted that one may occur at the central bank’s June meeting.

Interestingly, surveys of the business and investor communities point toward expectations that business activity is poised to improve. Indeed, the Euro Stoxx 50, an index comprised of 50 blue chip stocks representing 11 different Eurozone countries, is up smartly this year and pacing the similarly robust gains generated by the large-cap U.S. equity indices. Since it is reputed that stocks discount future expectations, the rally in European equities may very well be foreshadowing an improving fundamental backdrop in the future quarters.

The Eurozone’s COVID-induced fiscal stimulus program, which helped maintain employment during the pandemic, boosted household assets considerably. While the services sector has benefited from a normalizing resumption in consumer spending, it has yet to be depleted. Now, with the economy recovered, tight labor markets have led to rapid wage gains that are only now subsiding. Collectively, that has aided in supporting the Eurozone’s economy even as the beleaguered manufacturing sector remains feeble.

On the latter, the Eurozone’s outsized industrial base makes the economy subject to the cyclicality of not only domestic conditions but also, importantly, trade with the U.S. and China. The post-COVID spurt of buying goods, consisting of apparel, home furnishings, sporting goods, computer equipment, and more, has waned as spending shifted to travel and leisure activities. That has weighed on manufacturing, as has China’s sluggish economy.

Additionally, the spike in energy prices following Russia’s invasion of Ukraine hit consumer confidence as households had to bear the spike in gas and heating costs. Confidence has rebounded but remains fragile as interest rates are restrictive and geopolitical risks lurk along Europe’s border.

Investors have welcomed lower headline inflation and the prospects of the ECB’s pivot toward a more accommodative monetary setting. Widely followed investor surveys regarding future economic conditions have improved markedly; along the way, they have beaten consensus forecasts. Meanwhile, while the underlying economic activity has mostly been mixed, the Citigroup Economic Surprise Index, which tracks data releases and compares them to market expectations, has been positive and in an upward trend for months.

The mood swing has clearly shifted to a degree of optimism hearty enough to hoist risk assets rewarding those who allocated capital to European equities this year. However, the appeal of European equities has spawned many calls over the past 15 years to invest. For periods of time, it has proven fruitful only to see conditions reverse and U.S. equities reestablish dominance. However, the valuation disparity between European and U.S. stocks today stands near a historic discount. While that alone is not a rationale for an investment decision, the potential narrowing of that valuation gap, plus any tangible signs that the Eurozone’s economic blight is improving, could make this an appealing area to farm for opportunities.

Volatility Finally Declining

Guy LeBas, Chief Fixed Income Strategist

Interest rate volatility is one of those under-the-hood aspects of the bond market that seem irrelevant but end up mattering a great deal for markets. We typically write an Investment Perspectives note on volatility about once every two years—and apparently, the markets are keeping us to that schedule. In 2022, the last time we focused on the topic, our attention was on rapidly spiking volatility measures into an unpredictable Federal Reserve (Fed) rate hike cycle. Today, the reverse is true. Measures of volatility are receding as the outlook for the economy and Fed policy becomes at least a little clearer. Falling volatility has implications for demand in the bond markets and returns in fixed-income assets that are directly sensitive to volatility.

While we think about volatility as a historical measure, there are two ways to view the topic: realized historical and implied future volatility. In the first quarter of 2024, the yield on the 10-year Treasury note has spanned a 0.5% range, which is much narrower than in the back half of 2023. More statistically robust measures of realized volatility, such as standard deviation, are also trending down.

Implied volatility (IV) is a measure of the expected future volatility of an underlying asset’s price, as implied by the price(s) of its options. In one sense, IV reflects market participants’ expectations of potential price fluctuations, but in another sense, it just reflects supply and demand for options. When there are options buyers, IV rises, and when there are more options sellers, IV falls. The fixedincome options market is overwhelmingly institutional in nature, but billions of dollars of notional value trade in those markets every hour of the day. Arguably, the most accessible measure of implied volatility is the MOVE index, which extracts volatility from traded options on Treasury notes and bonds.

Chart 1: MOVE Index Declining as Fed Policy Path Stabilizes

The MOVE index is declining for the first time in a long time. After peaking last year at the highest since the Global Financial Crisis, the MOVE index has fallen below 100. Essentially, when the economic outlook was especially cloudy and the Federal Reserve policy outlook highly uncertain, market participants used options to position for or hedge sharp interest rate moves. There was net demand for interest rate options, which pushed volatility higher. Today, the MOVE index signals that market participants view the Fed policy outlook as more certain. In “normal” times, the MOVE index trends in the 40-70 range. So, while volatility has fallen far from the peak, it likely has further to go.

Lower bond market volatility does a few things. First, for the large number of institutional investment strategies that scale by the degree of volatility, lower volatility means these strategies can add leverage. All else equal, that trend alone creates demand for bonds and will push down interest rates on the margin. Second, a wide range of vanilla fixed-income instruments are directly sensitive to volatility. The quintessential example is agency mortgage-backed securities (MBS). Since mortgage loans can get refinanced, MBS can get “called away” from owners when interest rates fall sharply. In other words, MBS are exposed to big swings in interest rates, and accordingly, mortgage bonds perform well when volatility is falling. Note that this is a general rule and that individual mortgage bonds vary widely in characteristics and their sensitivity to interest rate changes.

Overall, we should view declining interest rate volatility— both realized and implied—as a sign of confidence that future economic conditions will prove stable and that the Fed’s interest rate hikes and cuts will trace a predictable path. Moreover, there are reasons to believe that lower implied volatility will lead to marginally greater demand for fixed income assets as well as help options-sensitive sectors of the bond markets, like MBS, to perform well in the near future.

The Best Is Ending — or Not

Gregory M. Drahuschak, Market Strategist

April will have the usual list of economic reports but will also bring the initial run of first-quarter earnings reports.

With the final reading of fourth-quarter Gross Domestic Product growth at 3.4%, the Atlanta Fed GDPNow tracker pointing to first-quarter GDP growth of 2.15%, and personal consumption expenditure growth still solid, first-quarter results are expected to be good. Despite being down moderately from earlier estimates, led by the Technology, Communication Services, Healthcare, and Discretionary sectors, earnings expectations for 2024 still point to a 9% year-over-year increase.

Aside from stretched technical conditions, the most formidable market concern centers on valuation. At nearly 22 times the 2024 S&P earnings estimate, the S&P is relatively richly valued. However, minus the high valuations for the largest weighted stocks in the S&P 500, the remaining S&P is valued at about 20% less. This valuation difference is another reason the broad market could advance, even as the biggest stocks languish or even slip modestly. Continued improvement in the Energy, Financials, Industrials, and Materials sectors, which together comprise 26.7% of the S&P 500, could go a long way in supporting or helping to advance the overall S&P 500. In addition, the initial estimate of potential 2025 S&P 500 earnings suggests a possible 13.7% year-over-year earnings increase.

Expectations that the market must endure a pullback stem largely from what many technical analysts believe is an overbought market condition. We would note, however, this argument could have been made at almost any time in the last two months, which did not stop the market from posting a solid year-to-date gain.

If the S&P 500 does experience a pullback, we think it is likely to be well-contained. The task during a pullback will be to avoid ill-timed selling and to focus instead on additions to equity exposure.