Presented by Joe Smalley, Accredited Investment Fiduciary®

Markets return to gains . . .

After a turbulent June, July marked a return to positive territory for U.S. equity markets. With the Federal Reserve reassuring investors that low interest rates would continue into the indefinite future, buyers moved back into the market, resulting in strong gains for U.S. markets. The S&P 500 Index was up 5.09 percent, while the Dow Jones Industrial Average gained 4.12 percent, and the Nasdaq Composite climbed an even stronger 6.56 percent.

The big news during the month was corporate earnings. As of the end of July, 73 percent of companies had beaten earnings estimates—in line with the four-year average. At the same time, earnings growth has clearly slowed, with the current rate likely to wind up as the third lowest in the past four years. Moreover, although earnings growth has been positive—1.8 percent so far—it has been dependent on the financial sector’s very strong results. Excluding financials, earnings have declined 2.9 percent.

Meanwhile, corporate revenue grew 1.2 percent in July, though it would have increased 2.8 percent if the energy sector had been excluded. With 8 of 10 sectors reporting higher revenues, U.S. companies appear to have experienced an improving business climate last month.

From a technical perspective, U.S. equity markets still look strong; all indices are well above their relevant moving averages, and there is apparent strong demand and investment flows. A potentially worrying sign in July was a brief break downward, but the markets recovered rapidly, keeping the damage to a minimum.

International developed markets also did well in July. The MSCI EAFE Index was up 5.28 percent, based on continued central bank support for economies throughout Europe and gradually improving economic conditions. Although Europe remains weak, there has been a general sense that things have been improving, with better manufacturing and consumer confidence reports from major countries. Developing markets did not fare as well last month, as reflected in the MSCI Emerging Markets Index, which eked out a gain of 0.77 percent.

Fixed income markets appear to have stabilized. U.S. interest rates moved very little in July, following a substantial increase in June. Risky bonds engaged in a relief rally in July, after suffering losses in the second quarter. Global bonds outperformed U.S. bonds and were the best-performing fixed income asset class. Although they struggled in the second quarter, high-yield bonds, as tracked by the Barclays Capital U.S. Corporate High Yield Index, returned 1.9 percent in July. Yields rose significantly, and demand for the asset class returned, as Treasury rates stabilized. Bank loans also continued to perform well over the same period.

Commodity prices turned around in July, with the Dow Jones-UBS Commodity Index rising 1.36 percent. Year-to-date, commodity prices are off 9.25 percent, as investor bearishness on the Chinese economy has held back the prices of raw materials. Given concerns about China, commodity price weakness may well continue.

. . . as the real economy continues to recover

Economic statistics were mixed during July. Although manufacturing showed strong improvement, retail sales were disappointing. Consumer confidence bounced around but stayed at about its highest level of the past five years, even as mortgage applications dropped. Jobless claims ticked up and then back down.

The big economic news was the release of gross domestic product (GDP) data at the end of the month. Defying expectations, GDP grew 1.7 percent last quarter, well above the consensus of 1 percent. But this was not an unmixed gain, as growth in the first quarter was revised down from 1.8 percent to 1.1 percent. Still, this was seen as a positive because the trend remains upward.

Consumer spending in the second quarter grew faster than had been expected as well, by 1.8 percent, according to the U.S. Bureau of Economic Analysis, although this was lower than the 2.3-percent gain for the first quarter. Also according to the bureau, business investment was up 4.6 percent, reversing a similar decline in the first quarter. In addition, federal government spending fell less than expected, by 1.5 percent, which is much better than its 8.4-percent decline in the first quarter. Finally, state and local spending actually ticked up 0.3 percent. The chart below demonstrates how each of these components contributed to GDP growth.

Consumption and investments were primary drivers of GDP growth
in the second quarter of 2013.

 

Source: U.S. Bureau of Economic Analysis

Revisions to data for previous years also supported the notion of an accelerating recovery. Growth in 2012 was revised upward, though most of this came in the early part of last year. The second half of last year was weaker than had been initially reported, which implies that the first half of 2013 was better than the end of 2012. 

Overall, although tax increases and spending cuts have slowed the economy, their impact seems to have been largely absorbed. The most recent employment numbers show continued growth, with positive job creation in all sectors but two. Total job creation was 668,000 in the second quarter, the most in three quarters. Worker incomes have also been growing faster than spending, suggesting that consumers may be able to continue their purchasing in the future.

Europe is looking better, but China looks weak

News from Europe was surprisingly upbeat. Although most European economies are still in recession, the mood appears to be shifting, as the situation seems to be stabilizing. Spain, for example, experienced a 0.1-percent drop in GDP in the second quarter, but this was a much smaller decline than in past quarters. Consumer confidence for the eurozone as a whole increased to the highest levels since April 2012, and confidence improved in most of the bloc’s biggest economies, with the notable exception of the Netherlands. European Union-wide unemployment also improved modestly. None of this means that the outstanding problems have been solved, but the perception both in Europe and outside is that progress has been made.

China, on the other hand, has shown signs of slowing growth. After declining sharply in June, the Shanghai Stock Exchange Composite Index stabilized in July, but a weak manufacturing sector report caused the month to end on a sour note. Speculation has risen that the Chinese government may unleash more stimulus to boost growth, but it has refused to do so.

The Chinese government’s decision to implement “Likonomics”—named after Li Keqiang, its premier—has not been popular among investors. These policies shun fiscal and monetary stimulus in favor of market reforms and deleveraging. In the long run, this move may represent a healthy transition, but shorter term it has caused market skittishness and slowed down economic growth. The combination of this policy shift and emerging local government finance problems, as highlighted in an International Monetary Fund report released at the end of July, suggests that troubles in China’s equity markets may not be over.

Overall, an encouraging month

Evidence of increased economic growth has supported the strong performance in U.S. equity markets, with the potential for more ahead. Home values have been appreciating, despite increases in mortgage rates, and employment has continued to grow. Overall, the signs for the U.S. economy have been increasingly positive, as consumers have shaken off tax increases and the economy has adjusted to sequestration. Financial markets have been rallying, and interest rates, although higher, have been trading in a range and have not spiked to unreasonable levels.

Risks remain, in the form of political tension in Washington, DC and economic worries in Europe and China, but the U.S. still appears to be on the right track. The appropriate stance is cautious optimism, with a focus on the long term, as we wait to see whether the economy can transform its current slow but steady growth into something more robust.

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 Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip 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 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. The Dow Jones-UBS Commodity Index is composed of commodities traded on U.S. exchanges, with the exception of aluminum, nickel, and zinc, which trade on the London Metal Exchange (LME). The index is calculated on an excess return basis. The Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A shares and B shares listed on the Shanghai Stock Exchange. The index was developed on December 19, 1990, with a base value of 100. Index trade volume on Q is scaled down by a factor of 1,000.

Joe Smalley is a financial advisor located at Smalley Investments.  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, and Sean Fullerton, investment research analyst, at Commonwealth Financial Network.

© 2013 Commonwealth Financial Network®