U.S. markets bounce back
After a difficult June, U.S. markets bounced back in July. The June decline had been largely due to fears about the Greek crisis, and the subsequent agreement brought confidence and the markets back. The S&P 500 Index closed July up 2.10 percent, and the Nasdaq did even better, gaining 2.84 percent. The Dow Jones Industrial Average did worst among the three, returning just 0.52 percent, the result of weak performance by the energy stocks Chevron and ExxonMobil.
The recovery of U.S. markets was mostly driven by positive earnings news. Per FactSet, as of July 31, almost three-quarters of reporting companies had beaten their earnings estimates, while a little more than half had beaten sales forecasts. Overall earnings were down 1.3 percent. Though certainly not great, that number is much better than the 4.6-percent decline forecast at the start of the month. Thus far, all sectors have reported positive earnings surprises, with the exception of energy, which is still underperforming expectations. Eighty percent of sectors now have higher growth rates than was estimated as recently as June 30.
Sales growth has not been as strong, with fewer companies beating estimates than average. As with earnings, however, actual overall results for the quarter have so far been better than expectations, declining 3.3 percent compared with an expected drop of 4.4 percent anticipated at the end of June. Sixty percent of sectors now show revenue increases, with decliners led by the energy sector. Broad growth in revenue and earnings validates the continuing economic recovery and should provide further fuel for it, despite weakness in the energy sector.
Technical factors were mixed at month-end. Both the S&P 500 and Nasdaq recovered to well above their 200-day moving averages, a sign of longer-term trends, but the Dow remained below that technical level. Even though two of the three averages are still well above problematic levels, the fact that the Dow is stuck in the worry zone suggests potential weakness ahead.
Like their U.S. counterparts, the developed international indices rebounded in July, with the MSCI EAFE Index up 2.08 percent. The strong results came from both a reduction in political uncertainty, as the Greek crisis was resolved for at least the short-term, and continued economic improvement, as the European and Japanese economies still showed growth. This recovery is likely to persist, spurred by improving economies and ongoing stimulus from the European and Japanese central banks. Technical factors have been marginal, with the EAFE bouncing around its 200-day moving average.
Emerging markets, on the other hand, as represented by the MSCI Emerging Market Index, had a very bad July, losing 7.26 percent. The month was something of a perfect storm, with a market crash in China, continued strength in the U.S. dollar, and commodity weakness combining to hit all of the weak points of emerging markets. Although the Chinese markets did show signs of recovery, commodity markets were still weak and the dollar gave no indication of returning to previous lows. Technical signs for emerging markets also remained weak, and, with the Chinese markets still volatile, this looks to be a risky area at this time.
Fixed income also bounced back off of its June losses, due in large part to a decrease in intermediate and long-term rates. The 10-year Treasury rate moved from 2.43 percent at the start of July to 2.20 percent at its end, as concerns over commodity prices and lowered growth forecasts weighed on investors' minds. The Barclays Capital Aggregate Bond Index returned 0.70 percent for July, regaining most of what it had lost during June.
U.S. economic recovery slow but steady
July's economic data indicated continued recovery. At the start of the month, employment reports showed an increase of 223,000 jobs, slightly below expectations but enough to drive the unemployment rate down to 5.3 percent. More good news included the announcement of the highest number of job openings ever—5.363 million—in the JOLTS report, indicating the strongest labor demand since 2000. Moreover, the initial unemployment claims number of 255,000 was the lowest level since 1973.
Even as job growth was good, wage growth—the missing piece of the recovery so far—was disappointing. Average hourly earnings were flat in July, bringing the annual increase down to 2 percent. Worse, the Employment Cost Index report, released at month-end, showed a significant slowdown in compensation growth, from 0.7 percent in the first quarter to 0.2 percent for the quarter ending June 30. This reading represents the lowest quarterly change since the measure was first calculated in 1982 (see Figure 1). Still, the expectation is that wage growth will accelerate, though there are no consistent signs of that happening yet.
Housing remains a bright spot. Prices have continued to rise, with the S&P/Case-Shiller Index showing an average increase of just under 5 percent in June. In addition, housing starts were up 9.8 percent from May to June; including the figure for April, this led to the highest three-month average since December 2007. Existing home sales grew well above expectations, at 3.2 percent for the month of June. Weak signs included a decline in new home sales, which appeared to be due more to supply constraints than market weakness, and a decline in pending home sales after a strong increase in May. Even with that decline, however, the year-over-year increase was 11.1 percent.
Overall, the housing market is considered to be strong. Moreover, industry confidence has increased, with the National Association of Home Builders Confidence Index at its highest level since November 2005.
Not all the news was good. Consumer confidence, after a bump up in early July, appeared to slacken at month-end, with two of three surveys reporting declines. Retail sales growth was also disappointing, declining 0.3 percent in June compared with the May number, which was also revised downward. Core retail sales, excluding autos, building materials, and gas, also decreased for the second month out of the past three. Finally, the Small Business Optimism survey, conducted by the National Federation of Independent Business, indicated a downturn in business confidence, with drops in 9 of 10 regions.
Despite these headwinds, the Federal Reserve appeared to be reasonably positive about the U.S. recovery. The statement issued after the FOMC July meeting made several positive changes in its economic references, and the consensus of many economists was that the expected initial rate increase in September remains on track, which would be an important signal of continued recovery.
International risks recede for the moment
During July, international risks took center stage. The Greek crisis raised the possibility of a eurozone collapse, and Chinese stock markets crashed. Either of these could easily have led to systemic dislocations. The fact that neither did is a good sign of the stability of the current recovery.
The Greek crisis, in particular, was seen as a potential replay of 2011, which shook markets around the world. This time, however, although markets did react, they did so in a measured and rational way. Years of work to reduce risks by European governments and financial institutions, as well as by U.S. and world banks, limited the damage. Likewise, even as the decline in Chinese stocks shook that country's markets, the effect outside of China was very limited.
With a deal in place between Greece and the eurozone and Chinese markets no longer plunging, it appears as if international risks are lower than they have been for some time. Uncertainty remains, but the recent events constituted a stress test, which has had encouraging results. We may well see both Greece and China show up again in the headlines, but, for the moment, both appear to have calmed down.
Good summer weather continues, though storms remain likely
Although U.S. economic growth continues, signs of slowing are apparent, and areas of concern such as missing wage growth remain. Nonetheless, leading indicators are positive, and the second half of the year could likely be stronger than the first. Beyond the improving economy, the better-than-expected results for corporate earnings and revenue are encouraging for the U.S. market. Strong performance in July despite international turbulence also provides confidence.
Even so, we have been reminded that substantial risks remain. Investors have benefited from a just-right mixture of economic acceleration, economic and monetary policies, and geopolitical calm over the past couple of years. Now, however, because Fed policy is likely to change, Europe remains unsettled, and Chinese growth continues to decline, favorable conditions may well become less so.
Moreover, the current high-valuation and low-volatility levels of U.S. markets serve to increase risk. Both factors could lead to significant adjustments if economic and market conditions become less favorable.
In the big picture though, risk is normal, and the U.S. is well positioned to ride out any uncertainty, despite potential volatility. As we have seen in the past month, the U.S. economy and financial markets are among the most solid in the world. We believe that a well-diversified portfolio with regular rebalancing is still the best way to meet long-term financial goals and should be maintained through good times and bad.
Authored by Brad McMillan, senior vice president, chief investment officer at Commonwealth Financial Network.
All information according to Bloomberg, unless stated otherwise.
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 Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. 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.