Second-Quarter Market Update & Outlook
Author: Jeff Layman
Similar to last year’s start, the U.S. economy experienced a slight contraction during the first quarter of 2015, declining 0.2 percent in real terms. Severe winter weather, particularly in the Northeast, once again contributed to the decline in output.
However, growth this year also was dampened by the strengthening U.S. dollar. When the dollar is strong and all other things are equal, U.S. goods become more expensive to foreign buyers. The result is a drop in U.S. exports to other countries, which was a negative influence in the first quarter. That same dollar strength created a more favorable environment for U.S. consumers buying foreign goods. This factor, in addition to the resolution of the West Coast port labor disputes, caused a surge in imports. More imports and less exports translated into a sizeable increase in the U.S. trade deficit during the quarter, according to Capital Economics.
Many of the factors contributing to poor economic results in the first quarter are considered “transitory” and not likely to repeat in future periods. Therefore, most economists expect growth to return to the post-recession trend of roughly 2.5 percent in the second quarter.
Although this recovery has been subpar by historical standards, the slow but steady pace of growth has been sufficient to pull the unemployment rate down to 5.3 percent as of the end of June—the lowest level in seven years, according to Bloomberg Inc. While wage growth has been modest, at around 2 percent, consumer purchasing power is still improving due to lack of inflationary pressure. For the 12 months ended June 30, the Consumer Price Index (CPI) was actually down 0.28 percent. Given these conditions, the capacity of the U.S. consumer to increase spending is strong—an important factor influencing the pace of economic growth going forward.
The Federal Reserve is expected to raise the short-term Fed funds rate at its September meeting. The central bank continues to emphasize that this decision will be “data dependent,” leading most observers to believe rates will rise slowly and remain lower for longer. Since inflation is well in check, the Fed has flexibility to increase rates gradually to avoid jeopardizing economic improvement.
Global stock markets declined at the end of the quarter, primarily on concern over Greece’s continued financial struggles. Although Greece’s contribution to the European economy is insignificant—about 2 percent of total output—a Greek exit from the Eurozone likely would create short-term turmoil.
Despite this development, both U.S. and international stocks made further progress during the quarter and for the year-to-date, according to Morningstar Inc.:
International stocks continue to lead the way in 2015. Both the Eurozone and Japan have benefited from central bank stimulus in the form of quantitative easing. Expectations for both economic and earnings growth are rising. This tailwind is boosted by weakness in the euro and yen, which has helped exports from each region. Improving profit expectations set a solid backdrop for further stock price appreciation.
An appropriate way to describe U.S. stock market trading in the first half of 2015 is a “period of consolidation.” Although there have been no large, anxiety-causing downward movements, the major indexes haven’t made much progress either. Partially because of the stronger dollar, earnings expectations in the U.S. are only slightly positive for 2015, and these expectations have been moving lower over the last few quarters; significant energy sector profit declines have added to the weakness. With current price-to-earnings multiples at the high end of normal, the likelihood of additional multiple expansion is limited. These factors have kept U.S. stocks in a sideways trading pattern, with 47 percent of trading days up and 53 percent down so far in 2015, according to BTN Research.
Results have not only varied significantly by region, but also by economic sector in 2015. Health care stocks are up about 10 percent for the year, while the utility sector has dropped by 9 percent. The underlying range of returns is significantly wider than the marginally positive index returns would suggest.
Interest rates rose during the second quarter in anticipation of Fed rate hikes later this year. The benchmark 10-year Treasury note yield increased to 2.34 percent from 2.05 percent. Given the inverse relationship between changes in interest rates and bond prices, this caused negative total returns for bonds. For the quarter, the taxable Barclay’s Aggregate Government/Credit index lost 2.1 percent, while the Barclay’s Municipal Bond index declined 0.89 percent. The second quarter results essentially offset first-quarter gains to take both taxable and tax-free bonds back to even for the year, with year-to-date total returns of -0.3 percent and 0.11 percent, respectively.
Given the advantages of higher cash-flow yield and a relatively stable credit environment, satellite bond categories have produced better results than core bonds so far this year. Corporate high-yield bonds have gained 2.49 percent, while emerging markets debt has risen 1.76 percent in 2015. These bond market segments don’t offer the same degree of protection against stock market risk as core bonds, but they have the potential to provide a return boost as a portion of the overall allocation.
In the near term, expectations regarding Fed policy will be the primary factor driving bond market returns. A gradual interest rate increase is more favorable for investors than a rapid escalation, and various structural factors in the global rate environment suggest the former is the most likely scenario.
Global stock markets face several challenges in the second half of 2015. Fed policy is changing, and interest rates should begin to rise in the current quarter. This could cause increased volatility. Debt concerns in Greece have escalated and the country may exit the Eurozone, which is already causing market anxiety and could result in additional near-term volatility. China’s stock market has significantly corrected after a major rally fueled by the speculative purchases of individual investors. A further share price collapse could lead to a more protracted economic slowdown there.
A long list of worries and concerns like these has accompanied this market advance since its beginnings in early 2009, yet U.S. stocks have gone nearly four years without experiencing a “run of the mill” 10 percent correction. This sort of drawdown normally occurs about every two years and often sets the stage for the next leg upward. Although we’re statistically overdue for a normal market correction, several indicators suggest fears of a more significant decline are unwarranted, including the following:
- Significant market downside events normally coincide with recessions, but current economic data and leading indicators continue to improve.
- Even with an initial interest rate increase this fall, Fed policy is still extremely accommodative; meanwhile, foreign central banks continue to apply significant stimulus.
- Excessive optimism or speculation on the part of individual investors, which often occurs in the final stages of a bull market, is not apparent.
U.S. stocks have been stuck in a narrow trading range this year. From a valuation standpoint, they are neither compellingly cheap nor exorbitantly expensive. The erosion of earnings caused by the strong dollar is being partially offset by a more financially fit U.S. consumer, with the net result being slow profit growth. All things considered, our base case for U.S. stocks is that they continue to slowly grind higher in 2015, offering more modest returns than investors have realized in recent years.
Looking beyond the tumultuous happenings in Greece, the investment opportunity in Europe and other foreign markets is more favorable. Accommodative monetary policy and weak local currencies are driving economic and profit growth higher, which ultimately benefits stock prices. Yet the opportunity for U.S. investors has been tempered in the short run by the strengthening trend in the dollar, which has offset a portion of the strong local market returns.
From a risk management standpoint, owning assets that mitigate stock market risk—bonds and alternative investments—often seems unappealing when the trend in stocks is up. However, when volatility increases and stock returns become more modest, the benefit of these investments is more fully realized. Maintaining appropriate diversification is essential to achieving investment success throughout market cycles. This is particularly true in periods when conditions are changing, as they appear to be in 2015.
Jeffrey A. Layman, CFA®
Chief Investment Officer
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