Market Update for the Month Ending April 30, 2014

Mark R. Gallagher 

Markets bounce around as economy improves

Financial markets were volatile during April, even as most recovered to show little change. The Dow Jones Industrial Average was up 0.87 percent, and the S&P 500 Index gained 0.74 percent, while the Nasdaq dropped 2.01 percent. The small changes in the Dow and S&P 500 masked two intramonth declines of about 2 percent and 3 percent, respectively, driven by growth fears, which hit technology and momentum-oriented equities. This differential drove the Nasdaq, which has a higher population of these stocks, to a worse performance for the month and into negative territory for the year.

Earnings were also a concern. Early reports actually showed a decline in corporate earnings over the previous quarter. Although data from the end of April moved earnings back into growth territory, the numbers were below what had been initially expected. The uncertainty about earnings growth, combined with bad news about the Chinese economy and the Ukraine situation, made investors nervous. These mid-month losses were recovered, but they prevented further gains.

Technical factors also showed weakness during the month. Several technical support levels were violated, although only for a limited time. The averages remain well above the most worrisome levels, but some damage has been done, and this merits watching.

Developed international markets performed more strongly than U.S. markets, with the MSCI EAFE Index up 1.45 percent, although they continued to trail year-to-date. About half of this came from currency appreciation relative to the dollar. The strong month was in part a bounce back from previous underperformance and also reflected less exposure to technology and momentum stocks. The MSCI Emerging Markets Index was up less—0.06 percent—which reflected the uncertainty surrounding China’s economy.

Once again, longer-duration fixed income securities performed best. High-quality, longer-dated bonds and TIPS posted the strongest returns in April, because of investor demand for certainty and yield. The worst-performing area within bond markets was the floating-rate bank loan space, which was essentially flat for the month. Short-duration bonds also experienced lackluster performance. Overall, the Barclays Capital Aggregate Bond Index returned 0.84 percent.

Spring continues for U.S. economy

After the economic weakness of January and February, statistics for March showed the slowdown to be largely due to weather. The employment numbers for March highlighted much stronger job growth, which was confirmed by even better April employment data. Private jobs touched a new high, breaking the level from before the financial crisis, even as unemployment claims averaged at low levels, despite bouncing around. Overall demand for labor was strong, with the average hours per week at historically high levels.

Better employment led to increased consumer confidence and also to higher spending, a primary driver of the economy. Retail sales were up an unusually robust 1.1 percent, which probably partially reflected pent-up demand from the poor weather months but still was well above expectations. Personal consumption, a wider measure of economic activity, rose at a brisk pace.

The news was not all good. Economic growth was reported as 0.1 percent for the first quarter of 2014, but because this largely reflected bad weather in January and February, it was not a significant concern. More worrisome was an apparent slowdown in the housing recovery. Even as prices continued to increase, activity levels slowed, apparently due partially to the weather, but more due to a lack of supply. Although the slowdown is arguably good news, reflecting a more normal market, it remains an issue worth watching (see chart).

Consumption Was Strong, But Other Factors Slowed First-Quarter Growth

Source: BEA

The Federal Reserve continues to taper

As expected, the Federal Reserve (Fed) continued to reduce its bond-buying program by an additional $10 billion, to $45 billion per month. There was speculation that the weak first quarter might have led to a pause, but the Fed concluded that the economic recovery was strong enough to continue the pace of purchase reductions. Despite the continued taper, rates actually fell during April, which should help the housing market continue its growth, and illustrates that, despite the Fed’s reduction in stimulus, an increase in rates is by no means assured.

International uncertainty remains

There were two major worries from around the world for U.S. investors in April. The situation in Ukraine continued to simmer. Although the expectation was for an eventual resolution, investors still worried that tensions seemed to be escalating. There is a growing conflict between the U.S. and our European allies about how to address the situation; Germany in particular is strongly lobbying against increased sanctions.

The second area of concern is China, where signs of a significant slowdown continue to appear. Chinese manufacturing and exports are showing lower-than-expected growth, and there are hints that China’s leaders realize that slower growth may be necessary to unwind some of the country’s financial imbalances. Keep in mind that in this case, slow growth might mean a still healthy 6 percent or so, but this represents a significant change from recent history. Additionally, the potential for policy errors could damage the world economy, as well as China’s.

Spring is here

As we move into the second quarter, it seems clear that spring is here for the U.S. economy after the weather slowdown of the first quarter. Steady improvements in employment and consumer spending are clearly optimistic signs. Even though worries remain, especially about the pace of wage growth, the trends appear not only favorable but improving for the real economy.

Financial markets are less certain. U.S. market results for the month, while not a concern, showed signs of potential weakness. Company earnings, though beating current expectations, are not particularly impressive. Technical damage was also done to the major indices in April, and therefore markets bear watching.

Overall, our stance remains optimistic, but with elements of concern about the financial markets, which remain vulnerable to uncertainty. As always, a diversified portfolio constructed around an investor’s own risk tolerance and time frame should help achieve goals, regardless of what happens in the interim.

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.

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For Registered Representatives: (RR Name) is a financial consultant located at (DBA Name and Registered Branch Office Address). (He/She) offers securities as a Registered Representative of Commonwealth Financial Network^®, Member FINRA/SIPC. (He/She) can be reached at (RR Phone Number) or at (RR E-Mail).

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research analyst, at Commonwealth Financial Network.

© 2014 Commonwealth Financial Network^®

General market news

• Still firmly within the range we’ve been discussing, the yield on the 10-year Treasury bounced off 2.80 percent last Monday and up off 2.60 percent late Friday. Last week’s move was the strongest one-week performance in more than two months. Treasuries sold off early Monday morning, with the 10-year standing at 2.67 percent, in anticipation of the Federal Reserve’s meeting this week.
• International headlines were on investors’ minds last week. Uncertainty over the situation in Ukraine and fear of escalating tension grew throughout the week as a referendum vote approached over the weekend. In addition, weaker-than-expected economic reports from China put further pressure on equity prices.
• The Fed is expected to continue its tapering program at its meeting this week. The announcement will come on Wednesday, and markets seem to be in a “wait and see” mode as economic numbers below Fed targets and events in Crimea raise questions.
• Equity markets slid lower last week, with major indices posting losses between 1.75 percent and 2.50 percent. The S&P 500 split the middle with a drop of 1.91 percent. The best performance was a loss of 1.76 percent for the Russell 1000 Value, while the worst performer for the week was the MSCI Emerging Markets Index, which lost 2.40 percent.

What to look forward to

This week will start off with the release of Industrial Production data. The consensus estimate is an increase of 0.2 percent, which would be quite the rebound from last month’s 0.3-percent decline.

In terms of housing data, we will see the release of Housing Starts and Existing Home Sales. Both data points are expected to have positive results compared with the disappointing results in January.

Finally, the Consumer Price Index will be released on Tuesday, providing some insight into inflation, which is expected to remain under control.

Disclosures: 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. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s. 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 computed by summing the prices of the stocks of 30 large companies and then dividing that total by an adjusted value, one which has been adjusted over the years to account for the effects of stock splits on the prices of the 30 companies. Dividends are reinvested to reflect the actual performance of the underlying securities. 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. The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The Bank of America Merrill Lynch U.S. Broad Market Index tracks the performance of U.S. dollar-denominated investment-grade debt publicly issued in the U.S. domestic market, including U.S. Treasury, quasi-government, corporate, securitized, and collateralized securities. The Bank of America Merrill Lynch U.S. Treasury Index tracks the performance of U.S. dollar-denominated sovereign debt publicly issued by the U.S. government in its domestic market. The Bank of America Merrill Lynch U.S. Mortgage-Backed Securities Index tracks the performance of U.S. dollar-denominated fixed-rate and hybrid residential mortgage pass-through securities publicly issued by U.S. agencies in the U.S. domestic market. The Bank of America Merrill Lynch U.S. Municipal Securities Index tracks the performance of U.S. dollar-denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market.

Markets heat up . . .

After a difficult January, financial markets rebounded in February. The Dow Jones Industrial Average was up 4.34 percent, while the S&P 500 Index climbed 4.57 percent and the Nasdaq rose 3.15 percent. Both the Nasdaq and the S&P 500 are now in positive territory for the year, although the Dow is still down year-to-date.

Several factors drove the strong performance. Corporate earnings were somewhat stronger than expected at the end of the reporting period, with earnings growth rates up to 8.5 percent at the end of February, above the estimate of 6.3 percent at the end of last year, per FactSet (see chart). Eight of ten sectors reported higher-than-expected earnings growth because of some positive earnings surprises.

Earnings Growth Beat Expectations in the Fourth Quarter of 2013

Sales volume was also better than expected, with almost two-thirds of companies beating expectations. Sales data is important because it reflects actual customer demand, and higher sales-growth rates help support the prospect of future earnings growth.

Technically, the markets started February with a decline that broke through both the 50- and 100-day moving averages, but they bounced off a support level at 1,750 and stayed above the key support level of the 200-day average. The current technical challenge is the 1,850 level for the S&P 500. Although the market broke through that figure on the last day of the month, it remains to be seen whether it will be sustained.

Developed international markets also performed well, with the MSCI EAFE Index up 5.56 percent, even more than the U.S. indices, while the MSCI Emerging Markets Index was up by less—3.19 percent. Developed markets are now up for the year, but emerging markets remain below where they started, which reflects both the recovery in Japan and Europe and the ongoing political turmoil in countries like Turkey and Brazil.

Fixed income also did reasonably well for the month, with the Barclays Capital U.S. Aggregate Bond Index up 0.53 percent, continuing a positive streak for the year. The gain was driven by bond yields. Interest rates were relatively stable in February, and the 10-year U.S. Treasury ended the month with a 2.65-percent yield. High-yield bonds returned a respectable 2.02 percent, according to the Barclays Capital U.S. Corporate High Yield Index, and emerging market bonds also staged a comeback. During the month, Janet Yellen, the new chairperson of the Federal Reserve (Fed), stated that she expected to hold the course on current policy, which provided stability in these markets.

. . . Even as economy suffers from severe winter weather

The strength of financial markets stood in contrast to weak recent economic data. Concerns about employment, stoked by a weak December report, continued in January, as only 113,000 jobs were added. Just as with the previous report, though, other data appeared more optimistic. The unemployment rate dropped from 6.7 percent to 6.6 percent, and underemployment fell from 13.1 percent to 12.7 percent. Other areas of concern included weakening manufacturing data, slowing existing home sale volume, and a decline in retail sales.

The question raised by these weak data points is whether they can be explained by poor weather, or whether they point to a slowing of the recovery. So far, economists believe the evidence points mostly to the former—although there may be some of the latter. Indicators that the economy remains on track include strength in consumer confidence, a rise in consumer borrowing, a decline in foreclosures, and surprising strength in new home sales.

At the same time, there are signs that growth has slowed. The gain in the U.S. economy for the fourth quarter of 2013 was revised down at the end of February, from 3.2 percent to 2.3 percent. This negative revision was largely due to lower-than-estimated sales of durable goods, such as cars, as well as reduced exports. Last October’s federal government shutdown also appears to have had a significant effect. Still, business investment—one of the missing pieces in the current recovery—was actually adjusted up, which is a positive sign for the future.

Global recovery continues but may be slowing

Economic reports for the rest of the world were mixed. Manufacturing and service PMI surveys indicated a mild slowing of the Chinese economy. Meanwhile, China’s exports grew, which supported its economy at the potential risk of political conflict with trade partners such as the United States. China’s currency, which is managed by the government, declined against the dollar toward the end of the month, suggesting that China’s leaders may be actively trying to support exports. If this is so, it would be contrary to their stated policy and could suggest that they are concerned about economic output.

Europe continued to stabilize, with Germany showing signs of accelerating growth, even as France continued to struggle with government spending cuts. Smaller countries showed general signs of progress. Remaining issues within Europe include continued reductions in government spending, which may negatively impact growth and result in political challenges. Also, European companies need to deliver on the improvement in earnings that investors appear to be expecting.

As for Japan, Abenomics (named for the nation’s current prime minister, Shinzo Abe) has been a helpful support behind risk asset prices. Easy monetary policy, fiscal stimulus, and a concerted effort to devalue the yen have boosted investor confidence. But we see a potential headwind coming in the form of consumption tax increases this spring.

Emerging markets appear to have stabilized from the immediate economic impact of the Fed’s decision to taper asset purchases, but they continue to struggle to adjust. Currency fluctuations and rising interest rates have hurt trade and caused capital flight. This has disproportionately affected smaller open economies with weak current-account balances and in some cases has led to political confrontations.

Politics threaten markets

Even as economies stabilize and return to growth, politics remains a risk factor. Euroskeptic parties, for example, are increasingly competitive in many European countries and could make significant gains in European Parliament elections this year. These circumstances matter because the political uncertainty created could potentially derail the current fragile recovery. Similarly, major emerging markets, such as Turkey and Brazil, not to mention Venezuela and Argentina, continue to suffer political turmoil.

Most relevant of all, perhaps, is the sudden emergence of the crisis in Ukraine and the move by Russia into the Crimean peninsula. This reminds us that many areas of the world remain much more uncertain than the U.S., and investors have to be aware of that when investing abroad.

Enjoy the gains but don’t be surprised by volatility

After a difficult January, the market recovery in February was a relief, and the fact that the S&P 500 hit a new high offered encouragement to investors. Still, the weak U.S. economic reports, along with events in Ukraine, highlight that risks remain in the system.

Although we expect the U.S. economy to continue to grow, recent weak data implies that this is by no means guaranteed. In Europe, the economy continues to mend, but politics could cause a rocky summer. China is trying to spin up its export machine to compensate for weakness in other areas, but this has the potential to spark trade disputes. In short, while markets have celebrated February’s very real good news, substantial uncertainty remains.

Therefore, despite the results of this month, we believe it is important to maintain a disciplined investment process. Through good times and bad, this is the key to achieving investors’ long-term goals.

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. 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.