Download Market Outlook Letter, July 2015 July 3, 2015 As we prepare to

Market Outlook Letter, July 2015
July 3, 2015
As we prepare to celebrate the signing of the Declaration of Independence 239 years ago, I for one am truly
grateful for the unalienable Rights granted to us. I wish you all the best in Life, Liberty and the Pursuit of
Happiness! I hope you and your family have a wonderful and safe celebration. With the close of the second
quarter, I wanted to provide you with a brief review of the economy and the markets.
The Economy
The U.S. economy, as measured by gross domestic product (GDP), declined 0.2% in the first quarter, from a
previously reported 0.7% decline. The negative print marks the first time that the U.S. economy has
contracted since the first quarter of 2014 (- 2.1%) and follows a 2.2% increase for the fourth quarter of that
same year. While the U.S. economy is growing more slowly than in the past, it is still growing. Real GDP
for this expansion, which – according to the National Bureau of Economic Research – began in June 2009,
has averaged 2.2%. This pace is well below the 2.9% average seen since the 1960s, but it is better than that
seen in Europe or Japan. Looking forward, business confidence as measured by the Institute for Supply
Management (ISM), continued to be positive in June. The index rose to 53.5 from 52.8 in May, suggesting
that the U.S. economy remains in expansion mode (a reading above 50 points to expansion, while a reading
below 50 points to contraction). The June level also marks the 30th consecutive month that the index has
remained above 50 and has historically been consistent with annualized growth of about 3.3% increase in real
GDP over the next six months. The average for the first half of the year (52.6) is consistent with 3.0%
annual GDP growth. The ISM Non-Manufacturing index – which measures the services sector of the
economy – also rose in June, realizing a small increase to 56.0 from 55.7 in May. The less cyclical nature of
the services sector means that this index receives less attention than its manufacturing-oriented sibling, but
nevertheless, the index has been above the 50 expansion/contraction level for 65 consecutive months, and the
June level is consistent with 3.1% GDP growth in the service sector of our economy, on an annualized basis.
Source(s) of data: (U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics, National Bureau of Economic Analysis, Institute for Supply
Management, J.P. Morgan Asset Management, First Trust, Briefing.com, Wall Street Journal)
Employment, Consumer Sentiment & Inflation
While the employment picture vastly improved since the depths of the Great Recession, the slack in the U.S.
labor market remains an issue. At face value, according the U.S. Bureau of Labor Statistics (BLS), the
employment statistics point to a healthier labor market. There were 8.8 million jobs lost in the Great
Recession, but 12.4 million jobs have been added since. The unemployment rate peaked in October 2009 at
10.0%, but it has fallen and is currently at 5.3%, well below the 50-year average of 6.1%. However, the
underlying numbers tell a different story. The significant drop in the unemployment rate following the
October 2009 peak has been largely due to a decline in the labor force participation rate (defined as the
percentage of the population 16 years or older that is employed or seeking employment). The rate has
dropped from approximately 66% before the Great Recession to only 62.6% in June of this year, the lowest
level since October 1977 when women were a much smaller percentage of the workforce. However,
consumer sentiment is pointing to better times ahead. The June readings for both the Conference Board’s
measure and the University of Michigan index (101.4 and 96.1, respectively) continue to point to a U.S.
consumer that is feeling better about the outlook. For perspective, both of these indices plunged into the
depths of despair during the Great Recession, but the current level for the University of Michigan index is
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well above the average going back to the 1970s (84.9). The inflation outlook is also favorable. The silver
lining to lackluster wage growth is that the year-over-year pace of inflation – as measured by the Consumer
Price Index (CPI) and the Personal Consumption Expenditures (PCE) price deflator (the Fed’s preferred
gauge) – remains subdued. As of May 2015, the year-over-over pace for the core CPI (excluding food and
energy) was 1.7%, well below the 50-year average of 4.1%. The core PCE price deflator tells a similar story.
That measure of inflation was at 1.2% year-over-year in May, which compares favorably to the 50-year
average of 3.5%. Source(s) of data: (J.P. Morgan Asset Management, Conference Board, University of Michigan, Briefing.com)
Housing
The ongoing recovery in the U.S. housing market also adds to the more positive outlook. Existing home
sales in May increased to their fastest pace in nearly six years, rising 5.1% to a seasonally adjusted annual
rate of 5.35 million. The strength in May was led by the Northeast region, but all other regions saw increases
as well. Existing home sales have risen year-over-year for eight consecutive months and are now 9.2%
above the 4.9 million pace seen a year ago. This strength in sales is resulting in tighter inventories and
higher prices. Inventories in May fell to a 5.1-month supply at the current sales pace from 5.2 months in
April and have averaged 5.07 months since January. Six month’s supply is considered healthy in a normal
market, and the reduced number of houses for sale caused the median home price in May to rise to $228,700,
up 7.9% from May 2014 and marking the 39th consecutive month of year-over-year price increases. Firsttime home buyers made a large contribution to existing home sales in May. This cohort is seen as the lifeblood of housing demand and it is an “encouraging sign” according to Lawrence Yun, Chief Economist at the
National Association of Realtors, as the increase in first-time buyers is partly due to a stronger labor market.
Low mortgage rates – along with a generally improving economy and a healthier labor market – should help
to keep a fire under existing home sales. According to Freddie Mac, the average commitment rate for a 30year conventional, fixed-rate mortgage has ticked up over the last few months to 3.98% in June, but rates
have been below 4.0% since December 2014 and are averaging 3.77% for 2015. Source(s) of data: (National
Association of Realtors, Briefing.com)
Interest Rates
Now on to the proverbial elephant in the room, the Federal Reserve. Will they raise rates … or won’t they?
Despite the more market-friendly and communicative Federal Reserve we’ve seen in the last several years,
the uncertainty has been keeping both the equity and fixed income markets on edge. At the June 17 meeting,
the Federal Open Market Committee (FOMC) corroborated that the slowing in growth in the first quarter was
transitory by pointing out that the economy had been “expanding moderately” and again reiterated that risks
were “nearly balanced”. Looking forward, perhaps the most significant clue was recently provided by Janet
Yellen, the Federal Reserve Chairwoman. Yellen was quoted as saying, “I expect that it will be appropriate
at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing
monetary policy”. The Chairwoman went on to say that “some tentative hints of a pickup in the pace of
wage gains may indicate that the objective of full employment is coming closer into view”, but couched that
in another statement, saying “while the labor market has improved, it still has not fully recovered”. Yellen’s
comments could be considered important in that they are the first from the Chairwoman since the storms of
Greece and China began to place doubt on whether the Fed would make a move this year. Source(s) of data: (U.S.
Federal Reserve, Wall Street Journal)
International
For the past month, the world’s attention has been focused on Greece and China. Starting with Greece, we
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believe it certainly would be better for all parties if Greece were to stay in the E.U., but at 2% of Eurozone
GDP, we do not believe a “Grexit” is likely to have long-term worldwide economic or financial
ramifications. Setting aside Greece, it is encouraging to see that Europe’s economy grew by 1% on an
annualized basis during the first quarter of this year, accelerating from the 0.9% in the fourth quarter of 2014
and marking the sixth consecutive quarter of positive growth. The unemployment rate held steady at 11.1%
in June 2015, down from 11.6% registered last year. Inflation was positive at 0.2% in June 2015, which –
although below the target level – was still much better than the deflationary numbers seen in the first quarter.
Looking at China, although the economy continues to grow by an estimated 7.0% a year, it is the country’s
stock market that has recently made the news. The Shanghai Composite Index, at a 52-week high in early
June, lost nearly a third of its value in a matter of weeks, and global markets wobbled on the prospect that the
selloff was presaging an economic collapse. Keep in mind, however, that even after the recent rout the
Chinese stock market is still up by about 75% over the last 12 months. Furthermore, the overall investment
exposure to stocks is less than 15% of average household assets. The stock market volatility is likely to
make life difficult for China’s policymakers, but the economy remains on solid footing, with solid growth
and low inflation. In June, China’s National Bureau of Statistics reported that its consumer price index
showed prices up 1.3% year-over-year, giving policymakers plenty of room to maneuver. Japan’s economy
has also resumed growing, with its GDP coming in at 1.0% during the most recent quarter. The
unemployment rate in Japan continues to be the envy of the world at 3.3% in May 2015, while the Japanese
are very happy to report inflation of 0.5% during the same month. It looks like Japan might finally be
winning the battle against deflation, but it could be too early to call at this point. Source(s) of data: (European
Commission, Eurostat, European Central Bank, Bank of Japan, International Monetary Fund, Peoples Bank of China, China Bank of
Communications, Chinese General Administration of Customs, China’s National Bureau of Statistics, Tradingeconomics.com, Financial Times, Wall
Street Journal, The Economist)
Energy & Commodities
Commodities markets experienced a great deal of volatility in the second quarter. The Commodity Research
Bureau index, a broad measure of commodities prices, rallied nearly 9.5% in the first half, but then fell back
in the last half and into early July, all but erasing the gains realized in the first half. Oil was not immune to
the volatility and followed the same profile, rallying as the U.S. dollar weakened early in the quarter and
falling back as the dollar recovered. The supply and demand dynamics for oil have changed somewhat since
our last missive. The Organization of the Petroleum Exporting Countries (OPEC) revised up slightly their
forecast for world demand in 2015 and now sees total global demand weighing in at 92.6 million barrels a
day (MBD). Global growth is expected to improve further in 2016, and OPEC is forecasting another 1.34
MBD in demand growth for that year, leaving total demand at an expected 93.94 MBD. On the supply side,
the International Energy Agency (IEA) expects non-OPEC supply growth to “grind to a halt” in 2016, while
OPEC supply growth should slow to a 1 MBD pace to 30.3 MBD. Until the current supply/demand
imbalance is worked out, the global market will remain awash with oil as reflected by record-high inventories
that have been driven by record-high production from Iraq, the technology-enhanced U.S. shale boom and an
OPEC that is trying to crush that shale boom by opening up the spigots. A lifting of oil sanctions in Iran is
expected to bring even more supply online. In its July 2015 report, the U.S. Energy Information Agency
(EIA) was forecasting $60 per barrel in 2015 and $67 in 2016, but added that an Iranian re-entry into the
market might mean a $5 to $15 per barrel drop in the price. The price of a barrel of oil has been hovering in
the low 50s since December 2014, down about 50% from $103 in July 2014. As with other commodities, the
supply of oil will either need to be cut back or demand will need to recover to soak up the excess supply. We
believe it will be the latter. China, the swing consumer, needs to maintain its growth trajectory and will
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continue to consume more resources – including oil – over time as its economy grows. And don’t forget that
China’s population continues to grow by approximately 6 to 7 million people a year, about three times
thenumber that the U.S. population has been growing. Source(s) of data: (Organization of the Petroleum Exporting Countries,
U.S. Energy Information Administration, International Energy Agency, J.P. Morgan Asset Management, StockCharts.com, SeekingAlpha.com,
Goldman Sachs, Wall Street Journal)
The Equity & Fixed Income Markets
The second quarter results are in. The S&P 500 (S&P) was up a small .028% and the Dow Jones Industrial
Average (DJIA) lost .29% in the second quarter. Combined with the first quarter, year-to-date performance
of these two closely watched indexes is 1.23% and .003%, respectively. The developed international
markets, as measured by the MSCI EAFE index, had a slightly more definitive move of .62% for the quarter,
bringing year-to-date performance to 5.53%. The MSCI Emerging Market index was up .69% for the
quarter, bringing its year-to-date performance to 2.95%. The Nasdaq Composite index surpassed 5,000
during the second quarter, fifteen years after initially reaching that milestone, and was up 1.74% for the
quarter. Its year-to-date performance is 4.42%. Medium-sized companies, as measured by the S&P Mid Cap
400 Index, are up 4.2% year to date. Small companies, as measured by the Russell 2000 Index, are up 4.75%
for the first half of 2015. Looking at returns in the fixed income market, the broad-based Barclays U.S.
Aggregate Bond Index was down 1.68% in the second quarter. The higher quality and shorter duration
Barclays 1-5 Year Government/Credit Index was down a slight 0.02%. At the lower-end of the credit
spectrum, the Markit iBoxx High-Yield Index was down 0.65%. For individuals investing in tax-free
municipal bonds, the Barclays National AMT-Free Municipal Bond index was down 1.02% in the quarter.
Investors in short-term bonds are treading water at this time, with the Barclays Short Treasury index up and
the Barclays 1-3 Year credit index up 0.05% and 0.11%, respectively, in Q2. Source(s) of data: (Standard & Poor’s,
Dow Jones, Barclay’s Capital, Russell Investments, Nasdaq, MSCI, BlackRock, Financial Times, Wall Street Journal, Factset, Federal Reserve, and
U.S. Treasury)
I hope you have found this economic and market review informative and useful. I wish you and your family
a very happy and safe Fourth! As always, if you have any questions about the market, economy or your
accounts, please do not hesitate to contact me.
Sincerely,
Andrew Rand, CFA, CFP®
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