As the Federal Reserve considers its exit . . .
The key news events for June were the Federal Reserve (Fed) meeting and news conference, where Fed Chairman Ben Bernanke announced that he believed the real economy was improving. He also stated that members of the Fed Board of Governors had begun to consider the circumstances under which it would slow the pace of the central bank’s bond purchasing program.
Markets interpreted this as an announcement that the Fed would be no longer be supporting the economy, and they reacted accordingly. Interest rates rose, and stock prices fell. Subsequent announcements that a reduction in stimulus would not occur in the near-term were reassuring to investors. Both interest rates and markets recovered, though rates remained higher and markets lower by month-end.
The downward adjustment and subsequent partial recovery may reflect a growing understanding that the real economy is normalizing and that interest rate policies must do so as well. At the same time, the gradual withdrawal of the Fed from fixed income markets may require further pricing adjustments as overall demand drops.
. . . Volatility returns to markets . . .
The volatility that started in May continued in June. Equity markets ended the month down across the board, with the Dow Jones Industrial Average losing 1.25 percent, the S&P 500 Index losing 1.34 percent, and the Nasdaq losing 1.52 percent. Volatility persisted throughout the month, with multiple moves of more than 1 percent, both up and down. Price movements were particularly high at the end of the month, with a more than 5-percent drop in five days followed by an almost 3-percent recovery.
Even as stock prices have fluctuated recently, investors should feel good about returns this year. This has been the strongest first half for U.S. equity markets since 1998, with the S&P 500 returning 13.82 percent. In the second quarter, it rose 2.91 percent.
Technically, U.S. markets are in a weaker position than they have been recently. Markets closed well below their 50-day moving averages, a sign of weakness, and have shown a downward trend over the past couple weeks. Although they are still above their 200-day averages, it will be important to see whether they recover or remain below their 50-day averages.
The major fundamental factor affecting markets in June was the spike in interest rates following the Fed’s news conference. Income-generating stocks, and those most dependent on lower rates, were significantly affected. The financials sector, which had led markets higher throughout the first and most of the second quarter, lagged in June. In particular, REITs performed poorly, as rising interest rates took away what had been a major tailwind to this asset class’s performance. Investors also shunned cyclical sectors such as materials and energy.
International markets showed similar weakness. The MSCI EAFE Index lost 3.55 percent for the month and 0.99 percent for the quarter, while the MSCI Emerging Markets Index showed even weaker performance, losing 6.79 percent for the month and 8.94 percent for the quarter. International markets were affected not only by the turmoil in U.S. markets, but also by a banking shock in China, where the central bank initially declined to intervene in a liquidity shortage before later relenting. In Europe, ongoing weakness in the real economy continued to weigh on financial market performance.
Bonds were unable to shield against weak stock market performance in June. The Barclays Capital Aggregate Index fell 1.55 percent and slipped 2.32 percent during the quarter. Bond prices were hit across the board, as U.S. rates spiked. Within the realm of fixed income, floating-rate bonds were one of the better-performing areas in June. Investors in short-duration bonds were also largely insulated from rising rates. The worst-hit area over the month was international bonds, which were subjected to the negative currency effect of a rising dollar, as well as generally rising rates. Long-duration bonds, particularly corporates, also underperformed.
Nevertheless, investors should keep the recent sell-off in bonds in perspective. As events in June demonstrated, it is possible to lose money in bonds, but the volatility of high-quality bonds is still significantly lower than that of stocks. Over the longer term, it is important to include bonds in most portfolios as an anchor to counterbalance the risks taken in equities.
The real economy continues to improve in the U.S.
Part of what drove the Fed’s announcement, and the consequent volatility in financial markets, was the improvement in the real economy. During June, and throughout the second quarter, economic indicators showed improvement almost across the board.
The improvement continued despite the negative economic effects of federal government spending cuts known as sequestration. These cuts led in part to a reduced estimate for first-quarter growth, and they intensified during the second quarter, slowing growth in many areas. Despite this, economic growth continued.
Housing pushed the economy forward, with prices and sales levels still increasing. Supply remained at historically low levels, suggesting that home values could continue to rise. Meanwhile, housing construction supported employment growth.
Overall growth in employment slowed but stayed positive in June. Nonetheless, consumer confidence and spending increased. Leading economic indicators ticked up, supported by increases in economic surveys from several of the 12 Fed districts (see chart).
A rise in real Treasury yields and sell-off in bonds have historically coincided
with an improving economy and consumer confidence.
The negative effects of sequestration were set to peak around June and may now begin to subside, suggesting that the current moderate levels of growth may increase. The Fed’s withdrawal of stimulus from the economy could prove a headwind, when it takes effect, but the Fed has made clear that this will not occur immediately.
The rest of the world does less well
Even as the U.S. real economy continued its moderate recovery, other parts of the world showed more weakness. Europe was still mired in a mix of slow growth and recession, depending on the country, with unemployment at very high levels throughout much of the southern eurozone and political uncertainty continuing to affect Greece.
China showed the greatest level of uncertainty, as an apparent liquidity squeeze in the banking system, driven by a shortage of cash, drove interbank interest levels to record highs. The Chinese central bank initially refused to intervene but later had to inject cash to support the system. This, combined with slowing growth in the Chinese economy, drove down Chinese equity prices, which was a large contributor to emerging market weakness.
U.S. remains well positioned for growth
Despite the negative factors impacting the U.S. economy—the drag from sequestration, slowing manufacturing growth driven by economic weakness in Europe and Asia, and rising interest rates—the current recovery appears to be on track. The effects of sequestration should peak and recede in the next couple months, the nonmanufacturing sector is continuing to show strong growth, and interest rates are moderating.
Risk factors remain, principally from abroad, as the eurozone remains very weak and China experiences growing pains. In addition, the actual course of the Fed’s exit will almost certainly create more volatility. Nonetheless, at this point we expect the U.S. economic recovery to remain on track.
For financial markets, more volatility may come, but, although recent events have created weakness, there does not appear to be any obvious reason for significant further declines. External shocks are possible, but at this point it appears that markets may have stabilized. With this in mind, investors should focus less on short-term market gyrations and instead allocate capital in a manner consistent with their long-term goals.