Economic and Market Overview: Second Quarter 2015
The following commentary summarizes prior financial market activity and uses data obtained from public sources. This commentary is provided to financial advisors and their clients as a resource for the management of assets and evaluation of investment portfolio performance.
The domestic economic backdrop remained decidedly mixed in the second quarter of 2015 as analysts and investors were concerned over conflicting signals regarding economic growth. The Bureau of Labor Statistics raised its third estimate of first quarter 2015 gross domestic product (GDP) to -0.2%. Although substantially lower than the +2.2% growth generated in the fourth quarter of 2014, it was above the prior estimate of -0.7%. Despite the contraction, economists are quick to point out that the economy is not in a recession, and that temporary factors were at play, including fallout from the decline in oil prices. The employment situation was strong, with an average of about 207,000 jobs added each month. The unemployment rate held steady at 5.5%.
The pace of global economic growth remained constrained due to underinvestment and slack in demand, but similar to the U.S., conditions are expected to improve. Economists anticipate that lower oil prices, waning austerity measures, and Federal Reserve-like liquidity support should be catalysts for accelerated growth. In Europe, the Greece bailout discussions dominated the economic news. By the June 30 deadline, the Greek government and creditors suffered a breakdown in debt negotiations, leaving the country on the precipice of default and a potential exit from the Eurozone. However, in aggregate, Europe, as well as Japan, delivered positive growth, partly because of aggressive monetary stimulus programs enacted by policymakers.
China’s economic growth continues to ease, and slowing demand from foreign countries is offsetting governmental stimulus measures. Emerging markets economies also posted lower growth during the first quarter (the latest period for which data is available), as the decline in commodity prices continues to present headwinds. Brazil and Russia were two of the economies generating negative growth, and are among the most sensitive to commodity prices. India’s economy remains in an uptrend, growing at about 7%.
The Federal Open Market Committee (FOMC) did not make any changes to its interest guidance at its most-recent June meeting, and has a slightly more positive outlook on the economy than after its previous meeting. Seven of the twelve committee members anticipate an interest rate hike before the end of the year, and many analysts expect the first one to occur in September, followed by another by the end of December. The rate hikes are just the first part of the normalization process, and the Fed likely will begin reducing its balance sheet several months after the first interest rate increase.
Highlights and Perspectives
GROSS DOMESTIC PRODUCT (GDP)
The Bureau of Economic Analysis released the third estimate of the first quarter 2015 real GDP, a seasonally adjusted annualized rate of -0.2%, down from the previous quarter’s +2.2% annualized growth, but an increase from the prior estimate of -0.7% growth. Although the results were disappointing, many economists believe the effects were temporary, and that the six-year economic expansion continues to exhibit resiliency. One contributing cause to the contraction was the impact of winding down fiscal austerity. The disappointing first quarter results have not dampened economists’ outlook, however, as the economy remains on track to add an impressive 2.5 million jobs this year. As in recent prior quarters, consumer spending was a positive contributor to growth. However, other major segments detracted from performance. Net exports continued to be a drag on growth due to the strong dollar. Government spending slumped for the second consecutive quarter. Corporate profits fell by -5.2% (not annualized) after declining -1.4% in the prior quarter. Lower energy prices created deflation, and the personal consumption expenditures (PCE) index of prices dropped -2.0%, following a -0.4% decrease in the prior quarter.
Portions of the housing segment advanced. Existing-home sales for May (the latest monthly data available) advanced at an annualized rate of 5.4 million units, about 5% higher than the 5.1 million unit rate reached in April, and up more than +9% from May 2014. Existing-homes inventory loosened somewhat, and now there are about 5.1 months of supply. Existing-home prices in May continued their upward trajectory since February, and are nearly 8.6% higher from year-ago levels. New-home building is rising: the NAHB (National Association of Home Builders) Housing Market Index, a measure of homebuilding activity, rose to 59, up sharply from its previous reading of 52, and its highest level since last September. The increase was broad-based regionally, and homebuilder reports indicate that new-home buyers are committed and enthusiastic. Analysts expect that as the economy emerges from its first quarter doldrums, housing activity will further accelerate through the second half of 2015. However, they caution that the specter of rising interest rates (making mortgages less affordable) is a risk to the housing market.
Employment, on average, was not as strong as the first quarter, but it has established a renewed uptrend. Employers added 280,000 jobs during May, outpacing consensus expectations. The three-month moving average of 207,000, although below the average for the period ending in February, nevertheless signals a robust environment. Service industries such as professional/business services, healthcare, and leisure/hospitality led the way, adding 63,000, 58,000 and 57,000 jobs, respectively. The unemployment rate in May was 5.5%, the same level as in February, but above the 5.4% reading in April. The tightening labor market seems to be leading to an uptick in average hourly earnings, which have increased 2.3% in the past 12 months. Analysts expect the recent employment gains to pick up in the coming quarters, and some projections show average monthly payroll additions of 300,000 later in 2015 and into 2016.
The FOMC, which altered the language in its statement following meetings in the first quarter, ended its June meeting with no changes to either its interest rate or balance sheet policies. Neither did the committee modify its forward interest rate guidance. However, it modestly lowered its economic growth projections, a reflection of the first quarter’s soft patch. The committee members’ median estimate of the year-end Fed funds was 0.625%, implying that there may be two interest rate hikes by year-end. However, seven of the twelve members expect just one rate increase. The median estimates for 2016 and 2017 ending Fed funds rates were 1.625% and 2.875%, respectively. Most analysts expect the Fed funds rate “liftoff” to begin in September, and for the Fed to begin reducing its balance sheet several months thereafter.
Fixed-income securities had a difficult time, as investors anticipated the FOMC will soon raise interest rates. The quarter represented somewhat of an inflection point for fixed-income markets. U.S. monetary policy became more restrictive, but many foreign central banks are still in the midst of stimulus programs. Investors wrestled with several dimensions, including signals of mixed economic growth domestically and abroad; determining when and by how much the FOMC will choose to raise interest rates; the continuing Greece bailout negotiations; and the negative impact of declining commodity prices on emerging economies.
In this environment, the shape of the yield curve rose in parallel fashion from the prior three months, rather than flatten as it did in recent prior quarters. Yields climbed steadily, and by the end of the quarter, the yield on the benchmark 10-year U.S. Treasury surged to 2.36% from 1.92% on March 31st.
Yield changes were progressive along the yield curve, except for the very short-term maturities of less than one year, resulting in a fairly parallel upward shift in the yield curve relative to March 31st. The yield on the 3-month T-bill settled at 0.01% at the end of the quarter, down from 0.03% for the previous one. The yield on the five-year Treasury rose, ending the quarter at 1.65%, compared to 1.37% on March 31st, and as mentioned above, the yield on the 10-year Treasury jumped to 2.36% from 1.92% over the same period. The yield on the 30-year Treasury also climbed, to 3.12% from 2.54%. Inflation expectations are fairly well contained, and the Fed’s gauge of five-year forward inflation expectations closed at 2.16% on June 30th, up from 1.83% on March 31st.
Fixed-income securities generally had a difficult time posting total return gains, and almost every segment generated negative returns. The Barclays Treasury 5-7 Yr. Index declined -1.1%, and the Barclays U.S. Corporate 5-10 Yr. Index fell -2.2%. High yield securities were unchanged, with a return of 0.0%. The Barclays U.S. Aggregate Bond Index eased -1.7%. The Barclays Municipal Bond Index was not immune to the fixed-income asset class’s overall troubles: it fell -0.9%. Non-U.S. fixed-income also suffered: the Barclays Global Aggregate ex-U.S. Index declined -0.83%. Emerging market debt posted mixed results, with the JPM EMBI Global Index inching lower by -0.3%.
The equity market seemed to climb a “wall of worry,” as broad-based indices continued to post gains in the face of perceived headwinds. Investors had a fair amount to digest: lackluster economic data, looming interest rate hikes, unsettled negotiations over Greece’s status in the European Union, and the psychological hurdle of beginning the seventh consecutive year of positive performance. But after January’s initial drop, equities have been resilient in posting steady, albeit unremarkable, gains. The S&P 500 Index finished the quarter with a gain of +0.28%, and is now up +1.23% on a year-to-date basis. The index has advanced for 10 consecutive quarters, the longest streak since 1994-1998, and has gained more than 250% since the bull market began in March 2009.
The ten primary economic sectors generated varied performance, and created a more favorable environment for active managers. The health care sector was the best performer, as it was in the first quarter, posting a gain of +2.84%. Financials and telecommunications services also fared well, gaining +1.72% and +1.59%, respectively. The utilities and industrials sectors were the poorest performers, declining -5.80% and -2.23%, respectively.
The Russell 1000 Index of large capitalization stocks generated a +0.11% total return. Within the large cap segment, growth and value stocks performed in line with one another. Small cap stocks, as represented by the Russell 2000 Index, performed well relative to large caps, ending with a total return of +0.42%. Until the fourth quarter of 2014, small caps had an extended period of underperformance, but have staged a nice recovery relative to large caps over the past three quarters. Growth also significantly outperformed value within the small cap universe. The Nasdaq Composite, dominated by information technology stocks, again delivered solid gains, advancing +2.03%, and the Dow Jones Industrial Average of 30 large industrial companies eased slightly, by -0.29%.
A streak of strong gains in Real Estate Investment Trusts (REITs) came to an abrupt end as interest rates rose sharply. The DJ US Select REIT Index slumped -10.00%, and the index is now down -5.75% on a year-to-date basis. Commodities finally stabilized, as energy prices recovered somewhat, and the Bloomberg Commodity Index tacked on +4.66%, but is still down -23.71% over the past 12 months.
International stocks outpaced U.S. equities, and investors began adding to positions after years of underperformance. The economic environment in the eurozone has improved steadily in recent months as the European Central Bank’s asset purchase program of €60 billion (about $69 billion) per month seems to be having its intended effects. As a result, European stock indices again produced strong gains. On balance, as with the first quarter, equity market performance outside the U.S. was positive. The MSCI ACWI ex-USA Index, which measures performance of world markets outside the U.S., advanced +0.72%, fueled by both developed and emerging markets. The MSCI EAFE Index of developed markets stocks rose by +0.62% during the same period. Regional performance remained strong, and almost every region advanced. Eastern Europe and China were the strongest relative performers, and the MSCI EM Eastern Europe and MSCI China indices posted returns of +5.18% and +4.18%, respectively. Emerging markets performance was moderate, as these economies continue to struggle with lower commodity prices. The MSCI Emerging Markets Index posted a gain of +0.69% for the three months.
Despite the slight contraction in U.S. economic growth, economists generally are upbeat about the economy’s prospects heading into the second half of this year and into 2016. The lackluster economic data may have been a result of various temporary effects, and recent reports suggest more robust growth lies ahead, with some economists estimating underlying real GDP growth closer to 3%. Continued improvement in employment will help, and employers are on pace to add approximately 2.5 million jobs to their payrolls this year, putting the economy on track to reach full employment sometime in 2016. Although inflation will become more of a concern going forward as the tightening labor market results in wage gains, it should not be an issue for several quarters. Consumers have been a key growth driver in the past, and although they have contributed to recent gains, future growth depends on their accelerated spending. Lower oil prices have not yet translated to increased consumer spending, but economists are looking for it in the second half of the year. Global economies are beginning to firm and produce meaningful recoveries, and Europe appears to lead the way. Weaker currencies and lower energy prices are important potential catalysts for further gains. From a market perspective, fixed-income securities now may be encountering the long-awaited end of the secular bull market, but only time will tell. Even though equities are in the midst of a seventh consecutive year of gains, valuations do not appear excessive, and could potentially benefit from any asset allocation rebalancing that occurs.
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Dow or DJIA (Dow Jones Industrial Average) is an unmanaged index of 30 common stocks comprised of 30 actively traded blue chip stocks, primarily industrials and assumes reinvestment of dividends. The Nasdaq Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market. The S&P 500 Index is an unmanaged index comprised of 500 widely held securities considered to be representative of the stock market in general. The DJ U.S. Select REIT Index is a subset of the Dow Jones Americas Select RESI and includes only REITs and REIT-like securities (The Dow Jones U.S. Select Real Estate Securities Index (RESI) represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S.). The Bloomberg Commodity Index is a broadly diversified commodity price index that tracks prices of futures contracts on physical commodities on the commodity markets. The index is designed to minimize concentration in any one commodity or sector.
The MSCI EAFE Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises the MSCI country indices that represent developed markets outside of North America: Europe, Australasia and the Far East. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI Japan Index is designed to measure the performance of the large and mid-cap segments of the Japanese market. With 320 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes. The MSCI Emerging Markets (EM) Eastern Europe Index captures large- and mid-cap representation across 4 Emerging Markets (the Czech Republic, Hungary, Poland and Russia) countries in Eastern Europe. With 52 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The Barclays U.S. Aggregate Bond Index is a market capitalization-weighted index of investment-grade, fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of at least one year. The Barclays Municipal Bond Index is an unmanaged index comprised of investment-grade, fixed-rate municipal securities representative of the tax-exempt bond market in general. The Barclays Global Aggregate ex-U.S. Index is a market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most U.S. traded investment grade bonds are represented. Municipal bonds, and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury securities, Government agency bonds, Mortgage-backed bonds, Corporate bonds, and a small amount of foreign bonds traded in U.S. The Barclays U.S. 5-10 Year Corporate Bond Index measures the investment return of U.S. dollar denominated, investment-grade, fixed rate, taxable securities issued by industrial, utility, and financial companies with maturities between 5 and 10 years. Treasury securities, mortgage-backed securities (MBS) foreign bonds, government agency bonds and corporate bonds are some of the categories included in the index. The Barclays Capital US 5-7 Year Treasury Bond Index is a market capitalization weighted index and includes treasury bonds issued by the US with a time to maturity of at least 5 years, but no more than 7 years.
The Russell 1000 Index is a market capitalization-weighted benchmark index made up of the 1000 largest U.S. companies in the Russell 3000 Index (which comprises the 3000 largest U.S. companies). The Russell 2000 Index is an unmanaged index considered representative of small-cap stocks. The Russell 2000 Growth Index is an unmanaged index considered representative of small-cap growth stocks. The Russell 3000 Index is an unmanaged index considered representative of the US stock market and measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market. The Russell Midcap Index is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership.
Fed, The Fed or FED refers to the Federal Reserve System, the central bank of the United States. The Federal Open Market Committee (FOMC) is the monetary policymaking body of the Federal Reserve System. Fed Funds Rate, the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. The ECB is the central bank for Europe's single currency, the euro. The ECB’s main task is to maintain the euro's purchasing power and thus price stability in the euro area. The euro area comprises the 19 European Union countries that have introduced the euro since 1999. The Consumer Price Index (CPI) measures the change in the cost of a fixed basket of products and services. The Gross Domestic Product (GDP) rate is a measurement of the output of goods and services produced by labor and property located in the United States. The personal consumption expenditure (PCE) measure is the component statistic for consumption in GDP collected by the Bureau of Economic Analysis. It consists of the actual and imputed expenditures of households and includes data pertaining to durable and non-durable goods and services. It is essentially a measure of goods and services targeted towards individuals and consumed by individuals. The Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse of the single-family housing market. The survey asks respondents to rate market conditions for the sale of new homes at the present time and in the next six months as well as the traffic of prospective buyers of new homes.