U.S. equities made solid gains in January on positive corporate earnings, improving economic data, and the Federal Reserve’s pledge to keep pumping liquidity into markets.

Large cap stocks reversed the trend from 2010 by outperforming mid and small cap stocks.  It’s worth noting, though, that the S&P 400 Mid Cap index quietly broke its all-time record high.  Another reversing trend from 2010 was that value indexes beat growth indexes. 

Growth stocks and small caps are generally favored in the early stages of an economic recovery; but investors may now be shifting toward value stocks and large caps as the prospects for economic and revenue expansion appears more stable.  This trend may also explain the outperformance of developed international markets over emerging markets in January.

Energy led all S&P 500 sectors as the price of oil crossed $100 a barrel for the first time since 2008.  Industrials and technology were the next best performing sectors during the month.  Less cyclical Telecommunications and Consumer Staples were the worst performing sectors as investors favored riskier investments.

After losses in November and December, corporate bonds were the best fixed income investment.  Meanwhile, tax-exempt municipal bonds declined for the fifth straight month, the longest slump in more than 11 years.  Munis have suffered from speculation about state and local defaults as well as rising yields on Treasury debt – the 30-year Treasurys touched a nine month high in January. 

With earnings season underway, the majority of S&P 500 companies are beating profit estimates, with 139 of the 187 companies topping expectations.  For the companies that have reported, fourth quarter profits and sales grew 25% and 8.7%, respectively.  Energy, technology, and materials companies had the biggest improvements.

Economic data points, especially those related to consumers, showed improvement.  Consumer confidence hit eight-month highs and jobless claims continued trending downward.  The holiday shopping season was a success, with retail sales hitting a record $380.9 billion in the month of December.  The explosion in consumer spending during the fourth quarter accounted for a whopping 96.6% of fourth quarter U.S. GDP growth, which grew at a 3.2% rate.

Despite the incremental improvement in the economy, the Fed continues to maintain aggressive, accommodative monetary policy even as price pressures flicker.  Fed Chairman Ben Bernanke predicted the labor market may take “four to five more years” to return to normal.  Accordingly, the Fed reaffirmed their plan to purchase $600 billion of Treasury securities through June and keep the federal funds rate between zero and 0.25% “for an extended period.”

This unprecedented monetary policy should eventually boost prices.  Commodity prices are already on the rise, which threatens to increase inflation and cause global central banks to tighten monetary policy.  Since inflation is starting from such a low level in the U.S., the Fed seems to be in no hurry to address rising price pressures.

But even if higher commodity prices don’t show in the “core” inflation rate used by the Fed, they have real consequences in the economy.  Companies that struggle to pass on higher input (commodity) costs to consumers may see profit margins shrink.  In other cases, consumers take the brunt of higher commodity prices, especially in food, heat, and gasoline prices, leaving less money for discretionary spending.

The threat of inflation is even more apparent in emerging markets, where food makes up a higher proportion of spending than in developed markets.  Lower discretionary spending due to higher food costs and monetary tightening could combine to dramatically slow economic activity. 

Peter Lazaroff, Investment Analyst

St. Louis, MO

www.acrinv.com