Markets heat up...
After a difficult January, financial markets rebounded in February. The Dow Jones Industrial Average was up 6.01 percent, while the S&P 500 Index climbed 5.75 percent and the Nasdaq rose 7.08 percent. All of the major U.S. indices are now in positive territory for the year, a reversal of the situation at the end of January.
Several factors drove the strong performance. Corporate earnings were somewhat stronger than expected in late January. Despite the effects of low oil prices on energy companies and the strong dollar on multinationals, 76 percent of companies in the S&P 500 reported earnings above estimates, with six of ten sectors reporting earnings gains. Moreover, earnings growth rates were up to 3.7 percent at the end of February, above last year's estimated figure of 1.7 percent, per FactSet.
Sales increases were also better than expected, with fourth-quarter 2014 growth up 2.1 percent, as opposed to revenue growth of 1.1 percent as of late December. In addition, eight of ten sectors reported revenue growth for the last quarter of 2014. 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 below their 50- and 100-day moving averages, due to the declines in January, but they bounced off support levels and moved back into technically healthy territory. With improving fundamentals, the more robust technical outlook suggests that market risks may not be at high levels for the near term.
Technically, there are reasons for some concern. Both the Dow and S&P dropped below their 100-day moving averages, although they remain above their 200-day averages. The international indices are still below their 200-day moving averages, despite their recent improved performance, suggesting continued risk. Although none of this is necessarily a red flag, it suggests that investors should exercise caution.
Developed international markets also performed well, with the MSCI EAFE Index up 5.98 percent, in line with the U.S. indices. Meanwhile, the MSCI Emerging Markets Index was up less—2.98 percent. Developed and emerging markets are now up for both months of the year, which reflects the nascent economic recovery in Japan and Europe, as well as the respite in the confrontation between Germany and Greece.
After a strong run, fixed income was down in February, with the Barclays Capital Aggregate Bond Index declining 0.94 percent, giving back some of its January gains. The loss was driven by higher bond yields, with interest rates rising and the 10-year U.S. Treasury ending the month with a 2-percent yield, up 32 basis points. Rates rose on the expectation that the Federal Reserve would likely increase rates soon, but Fed chair Janet Yellen's testimony before Congress at month-end led to some doubt about how soon that increase would come. High-yield bonds returned a respectable 2.41 percent in February, according to the Barclays Capital U.S. Corporate High Yield Index.
. . . Even as economy suffers from severe winter weather
The strength of financial markets stood in contrast to a string of weak recent economic data. Severe winter weather resulted in a slowdown in the housing sector, while economic weakness elsewhere in the world slowed factory orders and manufacturing sentiment, much as we saw in 2014. Unlike 2014, however, employment continued to grow, with an increase of 257,000 jobs, and average hourly earnings increased 0.5 percent—the best rate in some time. The unemployment rate increased slightly in January, from 5.6 percent to 5.7 percent, but this was due to more people moving back into the labor force, which is a positive trend (see chart). Other areas of concern included weak growth in retail sales.
Percentage of Total Working Age U.S. Population Employed,
January 2007–January 2015
The strong employment data was supported by equally strong growth in consumer spending, which is at its highest level since 2006.
At the same time, though, there are signs that growth has slowed from the pace of late 2014. The gain in gross domestic product growth for the U.S. economy during the fourth quarter of 2014 was revised down at the end of February, from 2.6 percent to 2.2 percent. This negative revision was largely due to lower-than-estimated additions to firms' inventory, as well as reduced exports. But, even as private spending growth slowed, many categories of business investment and government spending showed strong growth, 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. China's economy continued to show growth at lower than historical levels, and the Chinese government continued to slowly increase policy stimulus. China's currency, which is managed by the government, has shown patterns of decline, raising concerns about political conflicts—as other nations, including the U.S., protest China's aggressive currency policy—and also concerns of capital flight.
Europe continued to stabilize, with Germany and other major countries showing signs of continuing growth. Smaller countries showed general signs of progress. Remaining issues within Europe include ongoing reductions in government spending, which may negatively impact growth and result in political challenges.
But the big concern in Europe during February was the confrontation between the newly elected Greek government and the financial institutions underwriting the Greek economy. At the end of the month, a temporary agreement had been reached, cheering markets, but implementation of that agreement is likely to be extremely difficult.
Politics threatens markets
Even as economies stabilize and return to growth, politics remains a risk factor. As Greece and Germany continue to bicker, euroskeptic parties are gaining support across the eurozone. The Greek crisis, in many ways, has energized both sides. While euroskeptics are pointing to the increasing costs of preserving the euro, eurozone proponents are moving to stop the Greek exit for fear that removal of one piece of the puzzle will make the whole thing fall apart. These circumstances matter because the political uncertainty created could derail the current fragile recovery. Similarly, major emerging markets, such as Turkey and Brazil, not to mention Venezuela and Argentina, continue to suffer economic and political turmoil.
Most relevant of all, perhaps, is the perpetuation of the crisis in Ukraine and the move by Russia to cement its gains in eastern Ukraine. There are now rumors that Russia may extend its Ukrainian tactics to the Baltics. This reminds us that many areas of the world are much more uncertain than the U.S., and investors must 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, some weak U.S. economic reports, along with events in Greece and 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 is on the 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, although markets have celebrated February's very real good news, substantial uncertainty remains.
Therefore, despite the results of this month, we believe that it is important to maintain a disciplined investment process. Through good times and bad, this is the key to achieving long-term financial goals.
Authored by Brad McMillan, senior vice president, chief investment officer at Commonwealth Financial Network.
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.