@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital
The U.S. equity markets hit new all-time highs in July after investors digested the Fed’s plans to taper asset purchases. The S&P 500 Index gained over 5% during the month while the small cap Russell 2000 Index gained 7%. So far 2013 has been a stellar year for U.S. equities with gains of 20%. Second quarter earnings have been decent with 69% of S&P 500 companies beating estimates (as of 8/5); however, revenue growth remains weak at just +1.3% year over year. We will need to see stronger top-line growth for margins to be sustainable at current high levels.
Developed international equity markets also participated in July’s rally, helped by a weaker U.S. dollar. The MSCI EAFE Index gained just over 4% for the month in local terms and gained over 5% in USD terms. Japan’s easing policies have been celebrated by investors, driving Japanese equity markets 17% higher so far in 2013. Emerging markets were able to eke out a gain of just 1% in July as Brazil and India continued to struggle in the face of slowing growth and weaker currencies.
While interest rate volatility overwhelmed the second quarter, the fixed income markets stabilized in July. After moving sharply higher in May and June, the 10-year U.S. Treasury rose only nine basis points during the month and at 2.64% (as of 8/5), remains at levels we experienced as recently as 2011. The Barclays Aggregate Index was relatively flat for the month. Small losses in Treasuries and agency mortgage-backed securities were offset by gains in credit. The high yield sector had a nice rebound in July as credit spreads tightened, gaining 1.9%.
With growth still sluggish and inflation low, we expect interest rates to remain relatively range-bound over the near term; however, the low end of the range has shifted higher. Volatility in the bond market should continue as the Fed begins to taper asset purchases. Negative technical factors, like continued outflows from fixed income funds, could weigh on the asset class. Our portfolios remain positioned in defense of rising interest rates with a shorter duration, an emphasis on spread product, and a healthy allocation to low volatility absolute return strategies.
The pace of U.S. economic growth has continued to be modest, but attractive relative to growth in the rest of the developed world. U.S. GDP growth in the first half of the year has been below expectations; however, there are signs that growth has been picking up in the second quarter, including an increase in both the manufacturing and non-manufacturing purchasing manager’s indices (PMIs) and a decline in unemployment claims. The improvement in the labor markets has been slow but steady. Should the Fed follow through with their plans to reduce monetary policy accommodation, it will do so in the context of an improving economy, which should be a positive for equity markets.
We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we move into the second half of the year. A number of factors should continue to support the economy and markets for the remainder of the year:
- Monetary policy remains accommodative: The Fed remains accommodative (even with the eventual end of asset purchases, short-term interest rates will remain low for the foreseeable future), the ECB has pledged to support the euro, and now the Bank of Japan is embracing an aggressive monetary easing program in an attempt to boost growth and inflation.
- Fiscal policy uncertainty has waned: After resolutions on the fiscal cliff, debt ceiling and sequester, the uncertainty surrounding fiscal policy has faded. The U.S. budget deficit has improved markedly, helped by stronger revenues. Fiscal drag will be much less of an issue in 2014.
- Labor market steadily improving: The recovery in the labor market has been slow, but steady.
- Housing market improvement: The improvement in home prices, typically a consumer’s largest asset, boosts net worth and as a result, consumer confidence. However, a significant move higher in mortgage rates could jeopardize the recovery.
- U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.
However, risks facing the economy and markets remain, including:
- Fed mismanages exit: If the economy has not yet reached escape velocity when the Fed begins to scale back its asset purchases, risk assets could react negatively as they have in the past when monetary stimulus has been withdrawn.
- Significantly higher interest rates: Rates moving significantly higher from here could stifle the economic recovery.
- Europe: While the economic situation appears to be bottoming, the risk of policy error in Europe still exists. The region has still not addressed its debt and growth problems; however, it seems leaders have realized that austerity alone will not solve its problems.
- China: A hard landing in China would have a major impact on global growth.
We continue to seek high conviction opportunities and strategies within asset classes for our client portfolios. Some areas of opportunity currently include:
- Domestic Equity: favor U.S. over international, financial healing (housing, autos), dividend growers
- International Equity: frontier markets, Japan, micro-cap
- Fixed Income: non-Agency mortgage-backed securities, short duration, emerging market corporates, global high yield and distressed
- Real Assets: REIT Preferreds
- Absolute Return: relative value, long/short credit, closed-end funds
- Private Equity: company specific opportunities