Back To The Starting Point
Not to be mistaken as a complaint, but the U.S. economy offers few reasons for volatility. We have had to look elsewhere (Greece, China, Puerto Rico) for a directional spark. Our own economic growth rate has a bad case of anemia and anything that might be considered a robust surge in employment is so far on the horizon that we might mistake it for Chimney Rock on the distant plains of western Nebraska. Is this all that bad?
Not really—a slow but steady growth rate combined with low inflation is an optimum combination for appreciation of financial assets. By comparison, our economy has been relatively steady. Our markets have been driven down and up by concerns that originate abroad. Our markets have reacted to the battle of wills between the regretful lenders of the Euro Community and the rebellious borrowers of Greece who have resisted the medicine necessary to get their country's financials back on track. The Euro lenders have poured their liquid assets into a leaky bucket. The Greek saga has continued to zigzag between disaster and hope, having a ripple effect in many corners around the globe.
Another source of concern—also outside our borders—is China. As we mentioned in our last newsletter, China's stock market had been on a roll, having zoomed 100% in 12 months—and was ripe for a correction. Indeed the Shanghai Composite Index—which had advanced 60% in just the first five months of the year—ended the quarter with only a 20% gain for the year—representing a loss of 25% in a single month from their previous highs. How do you say "irrational exuberance" in Chinese?
Let's take a look at how various indices fared for the past quarter and year-to-date:
|Dow Jones Industrials (the Dow)
|S& P 500 Stock Index (S&P 500) ||- 0.2%||+ 0.2%|
|NASDAQ Composite||+ 1.8%||+ 5.3%|
|Russell 2000 Index (small companies)||+ 0.1%||+ 3.2%|
|Dow Jones World (non-US)||+ 0.1%||+ 3.2%|
|10-Year Treasury Bonds||- 3.1%||- 0.5%|
|Commodities: Dow Jones-UBS Index||+ 6.5%||+ 2.0%|
|The U.S. Dollar (WSJ Index)||- 1.5%||+ 4.3%|
All index values come from the Wall Street Journal.Stock indices do not include dividend return.
Stocks offered little in the way of net gains this past quarter. Indices did well for most of the quarter only to return to the starting gate when the resolution of the Greek debt issue hit a roadblock. The Dow Jones Industrial Average (the Dow) slid a percentage point during the quarter, while the S&P 500 ended pretty much where it started. Large tech stocks that dominate the NASDAQ index again did better, gaining nearly 2% for the quarter and over 5% for the year. Small companies fared no better than the broad indices although the head start they gained in the first quarter allowed them to stay ahead for the year. Global stocks were also flat for the quarter as the Euro community struggled with the Greek issue. Investors sold off 10-year bonds in anticipation of an increase in short-term interest rates in June. Commodities prices jumped this quarter, led by a surging recovery in crude oil prices. Having declined over 10% in the first quarter, the price of crude oil jumped a full 25% in the second quarter. The dollar weakened when the Federal Reserve Bank declined to increase short-term interest rates at their June meeting. Currency investors expected increased interest rates in the U.S. to increase demand for our greenback.
Where We Are Now
In late June the Commerce Department revised upward their estimate of the first quarter's economic growth rate from a negative -0.7% to a negative -0.2%—a bit of an improvement, but still a disappointingly negative number. At the end of the quarter optimism was buoyed by the expectation that the second quarter's growth rate was back on track. Economic growth for the second quarter is estimated to have been +2.0%, which would be a nice improvement. Tepid economic growth has weighed on employment. In one respect it sounded positive: June was the 57th straight month of increased hiring and the unemployment rate—the traditional measure of unemployment—declined to 5.3%, the lowest rate since 2008. However, other measures of employment have not been as rosy. The "labor force participation rate"—a measure that includes those who are employable but not looking for work—is at its lowest mark since 1977. Less people are finding meaningful work or are not motivated to work full time—or both.
With this past quarter being the exception, the increased value of the U.S. dollar has slowed the amount of goods we might otherwise export to overseas buyers since these products are more expensive for them. However, the manufacturing sector has been doing very well. Although demand from companies in the oil sector has dried up, overall gains in factory orders and employment within the sector have been solid.
The overall valuation of the market—measured by the price-to-earnings ratio of the S&P 500 index—continues to be higher than historical averages. This implies that stocks are not really a bargain at current levels yet bonds are not compelling either. Indeed, more market opportunities have been presented as a result of reactions to foreign events than by a meaningful direction of our own economy. Consumer confidence has been good but rather than this translating to a jump in retail sales and services, consumers continue to pay down household debt. As financial advisors we would have to say this is a good thing. At some point consumer debt will be reduced to levels that will give consumers enough comfort to resume spending.
It appears that economic growth has resumed to a modest level and inflation remains in check. Most pundits expect the Fed to boost interest rates in September by a small margin. This will have a psychological effect on the market and we may see some short-term volatility in the markets as well as strengthening of the U.S. dollar. The resolution of the Greece issue is not a given. The recent agreement is more akin to kicking the can down the road than arriving at a constructive long-term solution. You can't turn around a citizenry's attitude so easily. The energy sector could experience more challenges should the nuclear/trade agreement with Iran be ratified by Congress. Easing trade restrictions could increase oil production by Iran, thereby increasing worldwide supply and keeping prices low.
It appears we can expect a continuation of a slow recovery with continued low inflation for the foreseeable future. Bonds will be vulnerable to a price decline should the Fed raise short-term interest rates. Likewise, stocks may be volatile in the short term when this occurs. We see no reason to be fearful or excited about the markets given their current valuation. However, the slow growth/low inflation combination has historically offered ideal conditions for the appreciation of financial assets. In these conditions the somewhat elevated valuation of the markets could be maintained without a significant correction.
As always, we will continue to follow the markets closely and take appropriate actions within client accounts to manage risk and return in accordance with each client's Investment Policy Statement.
Please feel free to call with any questions or comments.