Financial markets take one step back, two steps forward
July was a volatile month, with both stocks and bonds bouncing around only to end the month up slightly. Uncertainty—economic and political, domestic and international—drove the volatility. Throughout July, the S&P 500 Index moved more than 2 percent up and down, before ending the month up 1.39 percent, while the Nasdaq showed similar volatility and wound up essentially flat, with a small positive move of 0.15 percent. Domestic stocks suffered from announcements of a slowing economy, although earnings results were reasonably robust, with 71 percent of S&P 500 companies beating estimates, as of the last week of July. Still, only 43 percent of companies succeeded in beating top-line revenue estimates, the lowest percentage we’ve seen since the first quarter of 2009.
Technical indicators strengthened over the month, with the 50-day moving average well above the 200-day moving average for both indices. The S&P 500 has traded within a well-defined channel, which began back in early June (see chart). Equities ended July toward the upper bounds of the channel. Technical analysts will likely be watching for a breakout in either direction as a sign of where the market is headed for the remainder of the year.
Source: Bloomberg
International markets showed similar trends. The MSCI EAFE Index was up 1.13 percent, while the MSCI Emerging Markets Index was up 1.61 percent. Despite the improvement, technical indicators remained weak. The dominant influences on these markets were actions by official institutions. On July 5, both the European Central Bank (ECB) and the People’s Bank of China announced rate cuts within minutes of each other. This fueled some speculation of coordinated action, but whether this was agreed upon ahead of time or just a coincidence is unclear.
Central bank speculation also took center stage toward the end of the month, when Mario Draghi, the ECB president, stated that the bank would do whatever it took to support the euro. Although the remarks were made in a meeting not primarily focused on the European debt crisis, investors extrapolated from Mr. Draghi’s comments that he and the ECB might consider ramping up purchases of peripheral European debt. This resulted in a bounce back in the demand for both European equity and debt.
Slowing growth around the world, combined with political uncertainty, benefited fixed income. U.S. Treasury yields declined to all-time lows in July. After breaking below 1.5 percent, yields on the 10-year tumbled to 1.38 percent. This didn’t last long, however, as they rebounded on Mr. Draghi’s pledge to preserve the euro. Despite this setback, the Barclays Capital Aggregate Bond Index returned 1.38 percent over the month. U.S. Treasury yields are now at their historic lows, but they remain higher than yields in Germany, Switzerland, and Japan.
Investors continued to gravitate toward risky bonds as well, causing the Barclays Capital U.S. Corporate High Yield Index to return 1.90 percent in July. Low default rates and reasonably attractive spreads have resulted in the high-yield index outperforming the Barclays Capital Aggregate Bond Index year-to-date. On an absolute basis, yields are very low compared with historical standards, but relative to Treasuries they remain near average levels.
Overall, U.S. markets remain reasonably strong, although valuations are fair to high by historical standards. International markets are weaker on both an absolute and a technical basis and seem to depend significantly on governmental action, but they are more reasonably valued.
Focus on uncertainty from Washington, DC
Washington remained at the center of attention in July. The Supreme Court of the United States ruled that “Obamacare,” formally the Patient Protection and Affordable Care Act, was constitutional, laying the grounds for implementation. Although the ruling did remove uncertainty over the act, it also effectively guaranteed that taxes would increase by at least the amounts written into the bill. The ruling also increased the perceived stakes in the upcoming election, with Republicans vowing to repeal the bill if they take control of the government.
Growing awareness of the consequences of the pending “fiscal cliff” also increased uncertainty. The fiscal cliff—a term used to describe numerous tax increases and spending cuts that will take effect at the end of this year unless explicitly repealed—would likely cut anywhere from 3 percent to 6 percent of gross domestic product (GDP) at the start of 2013. Given current growth levels of under 2 percent, this would likely mean a recession early next year unless Congress acts.
Finally, it is becoming clear that the U.S. will hit the federal debt ceiling again by early fall, well before the election. Given the acrimony and last-minute settlement of the issue last time, many investors expect that this year’s process could be equally disruptive.
All of these factors have acted to increase uncertainty and postpone decision making by both consumers and businesses. This has, without question, been a contributing factor to slower U.S. economic growth.
Europe remains unsettled as well
Hurricane Greece continued to spin, without much effect in July, but Hurricane Spain spun back up in a big way. In the early part of the month, the Spanish banking system was found to be insolvent, and a hurried agreement was reached to recapitalize it. The details were somewhat foggy, but the speed and size of the agreement calmed markets. That calm fell apart later in the month, as the details became clearer, and Spanish government bond yields spiked back above the 7-percent threshold that is considered a red line. At the end of the month, the reaffirmation of support for the euro by Mr. Draghi calmed markets again.
Although markets were soothed at month-end, Spain’s fiscal problems continued to worsen and other countries also disclosed worsening budget problems. France announced measures to increase public spending and lower the retirement age—directly contrary to austerity demands made on other countries. Germany is also showing signs of economic slowing, and political uncertainty is growing there as well. Germany’s Federal Constitutional Court announced that it would not be rushed and would rule on the latest rescue measures on September 12. Should the court rule against the measures, the entire Spanish rescue package could unravel.
Although perceived risk has decreased in Europe, the underlying problems are largely unsolved, and the risk may ratchet up again at any time.
A growing but slowing economy
All of the uncertainty had a slowing effect on the U.S. economy. Although growth continued, the level of growth ticked down to a 1.5-percent annualized rate in the second quarter. This level of growth is weak by historical standards, but it was actually slightly better than some economists had feared. The quality of GDP growth was not as good in the second quarter compared with the first. Spending on durable goods weakened, indicating a reduction in consumer confidence. Reduced government spending continued to be a drag in the second quarter as well.
Job growth in July remained at a relatively low level of 80,000, while the ISM Manufacturing Index dropped to contractionary levels. Consumer confidence showed a drop at the start of the month. Real consumer income continued to rise, although retail spending declined for the third month in a row while the personal savings rate increased.
Although the rate of growth slowed, the fact that growth continued despite all of the uncertainty described above was encouraging. In addition, there were encouraging signs below the surface. In terms of employment, for example, both hours and average earnings increased, which may suggest that employers are choosing to increase overtime for existing employees rather than hire new workers—a trend that will eventually lead to an increase in hiring. Moreover, the housing market continues to show signs of recovery. On a seasonally adjusted basis, July showed the fourth monthly successive rise in prices, according to the Case-Shiller 20-City Home Price Index. Other indices showed improvement as well, and the supply of houses for sale remained below historical levels.
Slow and steady with risks of storms
Overall, the economy and markets have proceeded cautiously in July, with slow growth offset by macro uncertainty. Risks certainly remain at many levels—fiscal, governmental, and international—but the slow improvement of the U.S. economy looks likely to continue and provide the basis for sustained improvement over time, despite short-term volatility. Although it is important to be aware of the risks, it is even more important to remain focused on goals. Investors should seek to match the time frames of their strategies to their goals rather than let short-term concerns override long-term plans.
Authored by Brad McMillan, vice president, chief investment officer, at Commonwealth Financial Network.
Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
