Presented by Joe Smalley, Accredited Investment Fiduciary®

A strong close to a quiet month

 Joe Smalley at Kentucky Derby party.  Photo by Jena McShane

Joe Smalley at Kentucky Derby party.

Photo by Jena McShane

U.S. financial markets had a relatively quiet month, with little volatility, except for the Nasdaq, which was down close to 2 percent mid-month. All U.S. equity markets finished May strongly, however, with the Dow Jones Industrial Average up 1.19 percent, the S&P 500 Index up 2.35 percent, and the Nasdaq up an even stronger 3.11 percent, despite the mid-month drop.

The weak start to May was driven largely by earnings. Despite a 2.1-percent increase over the previous year, earnings growth for the first quarter was down significantly from the fourth quarter of 2013. In addition, earnings guidance from companies for the second quarter was much more negative than usual. On top of these factors, the U.S. economy suffered from severe weather, with poor data points reported during the first part of the month.

The strong close to the month owed a lot to the much stronger economic reports that became available toward the end of the period, which supported investor hopes for faster earnings growth later in the year despite the corporate warnings.

Technical factors remained supportive for the Dow and the S&P 500 after the weakness of April, but the Nasdaq broke below both its 50- and 100-day moving averages before recovering. In the broader context, this is not too worrisome, but the development is worth noting.

Developed international markets performed very similarly to the S&P 500, with the MSCI EAFE Index up 1.62 percent, partially closing the gap between international and U.S. returns year-to-date. Emerging markets showed very strong performance, with the MSCI Emerging Markets Index up 3.26 percent for the month, although earlier weakness this year means total performance for 2014 still trails developed and U.S. markets. Technical factors were supportive for both.

Fixed income markets showed surprising strength at the end of May, with an unexpected decline in interest rates. Yields on 10-year U.S. Treasury bonds dropped from 2.63 percent at the start of the month to 2.48 percent at the end, driving gains in the long end of the curve while causing underperformance in spread-based and shorter-duration products. The Barclays Capital Aggregate Bond Index was up 1.14 percent for the month.

Winter’s last gasp as U.S. economy thaws

The revised gross domestic product (GDP) number released at the end of May showing that the U.S. economy had actually shrunk by 1 percent in the first quarter of 2014, rather than growing slightly, highlighted the difference between the first quarter and the past two months. While the economy suffered from severe weather in January through March, more recent reports have been substantially better.

April showed a gain of 288,000 jobs, the highest since January 2012 and much higher than expected. This gain was partially fueled by a rise in the number of private employees, which reached a new all-time high. Initial unemployment claims dropped to a seven-year low in April—another good sign of the strength of the employment market—and average hours worked recovered to normal levels following a drop in the first quarter. Housing prices continued to increase at double-digit rates, despite predictions of a slowdown. Construction did slow in the first quarter but showed signs of a recovery as weather warmed.

Given the strength of the employment and housing markets, consumer confidence unsurprisingly also continued to improve, with the significant result that confidence for those under age 35 recovered to precrisis levels for the first time. Rising confidence and employment led to further gains in consumer spending and increases in lending.

Because of all these positive factors, most economists expect growth in the second quarter to be quite strong—and to accelerate for the rest of 2014.

The Federal Reserve and interest rates

No news was good news from the Federal Reserve (Fed) in May. As the normalization process of the taper continues, the Fed reportedly remains confident in a strengthening recovery. A surprising drop in interest rates at the end of the month may call that view into question, but analysis of the supply-and-demand balance for Treasury securities suggests the drop is market-driven, rather than a sign of economic weakness to come. Even with the taper, the reduction in the federal deficit means that the Fed is still buying a large proportion of the total debt issuance—and that sustained Fed purchasing, combined with growing demand from other buyers, is pushing rates down (see chart).

Even with the Taper, the Fed Is Buying a Large Percentage of Total Debt Issuance

In fact, rather than a sign of impending economic slowdown, the rate drop could actually accelerate the recovery, particularly in housing, where lower mortgage rates could spur activity.

International risk remains

Even as conditions in the U.S. improve, risk remains substantial at the international level. The recent elections for the European parliament led to a much higher number of parliamentarians representing explicitly anti-European Union parties, with results in both England and France described as political earthquakes. Although the slow European recovery continues, unemployment remains at depression levels in many countries, and the election results suggest that Europeans are running out of patience with current austerity policies. Expect to see considerably more uncertainty around Europe through the rest of the year.

China seems to be stabilizing and lowering perceived economic risks, but domestic terrorism has become much more prevalent, or at least reported, in the country. Perhaps in response to domestic concerns, China has become much more aggressive with respect to other nations, placing an oil rig in waters contested with Vietnam, which has led to direct naval confrontation. China’s rise, which is leading Japan to consider a more aggressive defensive stance, continues to raise the geopolitical risk level.

Finally, even as Russia has seemed to pull back on Ukraine, it signed a multibillion dollar natural gas supply deal with China. This deal should benefit both sides but was explicitly designed to strengthen both countries in their dealings with the West. This could ratchet up uncertainty even further.

Back to the old normal

With the U.S. economy continuing to mend, and with the bulk of the risk coming from international issues, it almost seems as if we are moving back to the old normal. We are not quite there yet, but the absence of many of the crisis issues of the past several years seems to be leading the market to a potentially unhealthy degree of complacency.

It would be a mistake to take the current improvement in the real economy and appreciating financial markets as a sign that risk has disappeared. Although we expect the recovery to continue, financial markets remain richly valued and subject to correction risk. Further, both Europe and China retain the ability to generate negative surprises. Finally, even though the recovery seems to be strong, it could certainly weaken again.

We certainly acknowledge the positive changes—which are many and substantial—but we are not complacent and remain on the lookout for risk, as you should too. With that said, we believe that a properly diversified portfolio should allow investors to achieve their goals over time.

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 Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. 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.

Joe Smalley is a financial advisor located at 213 East Saint Joseph Street, Lansing, MI 48933.  He offers securities   and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member   FINRA/SIPC, a Registered Investment Adviser. He can be reached at 517.487.4850 or at www.smalleyinvestments.com.

         Authored by Brad McMillan, vice president, chief investment officer, at Commonwealth Financial Network.

©     2014 Commonwealth Financial Network®