Market Roundup - September 2013
September: A hot fall?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
Many investors experienced a hot summer, both literally, with high temperatures, and figuratively, with market gyrations. With tensions in Syria, a mid-September Federal Reserve (Fed) meeting, a German election, and the end of the U.S. government’s fiscal year, September may prove to be just as hot as August was.
The economyBy Brian Jacobsen
The U.S. economy grew at a 2.5% seasonally adjusted annualized pace in the second quarter, according to the revisions from the Bureau of Economic Analysis. After a mere 1.1% growth rate in the first quarter, the economy looks to be accelerating—except, it is not. Higher interest rates triggered by the Fed’s talk of tapering and higher oil prices due to continued conflict in the Middle East are both likely to weigh on economic growth for the balance of the year. Weak growth, however, is not negative growth; it looks like the economy will once again avert a recession. Weak growth could also be a positive in the perverse world of the markets, as it could lead the Fed to postpone or temper its tapering plans. Thus, as earnings growth slows, the financial backdrop could be supportive.
The September 18 Federal Open Market Committee (FOMC) meeting is perhaps the most anticipated meeting of the year. Economists seem to be split about whether the FOMC will scale back on the expansion of the Fed’s balance sheet. Federal Reserve Bank of Dallas President Richard Fisher was the first to use the term taper to describe how the Fed could eventually stop purchasing $40 billion per month in mortgage-backed securities and $45 billion per month in Treasury securities. The word is appropriate, as whatever the Fed does will likely be drawn out and gradual. The sooner the Fed starts the process, the more gradual it could go, but the key issue is whether labor market improvements are substantial enough and sustainable enough to justify pulling back. Since September 2012, when the Fed started its latest round of asset purchases, the economy has grown. If the Fed determines that the outlook is bright enough to warrant less monetary easing, then investors should take tapering as a positive, not a negative. Much of the correction in the markets—whether in equities or fixed income—that investors fear may have happened already. Remember: Markets are going to anticipate what the Fed does, and the Fed has been transparent about its plans. If the Fed is going to surprise anyone, it’s unlikely that it will do so by tightening too quickly or too much.
Some surprises we should not be surprised to see may come from a different part of Washington, D.C. The federal government’s fiscal year ends at the end of September, and officials need to pass a budget or a continuing resolution (a short-term spending plan). If a compromise can’t be struck, a government shutdown will result. A government shutdown doesn’t have to be disruptive, but it will likely raise the hackles of many constituents, putting the pressure on politicians to pass something. Associated with the budget battle will be a discussion about the debt ceiling. According to the U.S. Treasury, the debt ceiling will need to be raised by the middle of October; otherwise, the Treasury will have to prioritize payments. Yes, this means we will likely hear more fear mongering about the government defaulting on its debts. That, in my opinion, is all bluster. While it’s true that the government might have to slow payments or avoid paying certain bills, it wouldn’t have to miss principal or interest payments on the debt issued by the U.S. Treasury to technically constitute a default by investors. The rest is mere rhetoric and posturing. The likely result of the upcoming debate is another patchwork solution of spending plans that are continued at their current levels as well as a raised debt ceiling. We are anticipating that an actual budget won’t be implemented because the 2014 midterm elections are right around the corner and politicians are going to want to stay in the spotlight.
Speaking of elections…the German election is on September 22, and we expect Chancellor Angela Merkel to retain power. This could trigger a small relief rally in European equities, as she has been one of the biggest proponents of crafting deals to keep the eurozone cobbled together. While her government may be slightly weakened by the election, we believe the results shouldn’t tip the balance of power in Germany or in Europe.The wildcard in the month ahead is Syria. The U.S. and France seem poised to take action, but no one knows right now how involved the action will be or to what extent the spillover will affect the region. Iranian officials have threatened to target Israel if Assad’s regime in Syria is targeted. Russian officials have also protested any attack on Assad’s regime. A short and contained operation would likely lower oil prices and improve investor sentiment. The danger is that involvement is anything but short and contained. This is why we think it is prudent to stay diversified.
EquitiesBy John Manley
August was a miserable—but not disastrous—month for the U.S. equity market, as most of the popular indexes gave back more than half of their July gains. Although concerns about tapering bobbed up from time to time, most of the downward pressure on U.S. prices originated in faraway places. India’s market slide and currency plunge clearly cast a pall on domestic investors. However, the open-ended risk of Western intervention in the Syrian revolution exerted the most downward pressure on stock prices, in our opinion. The impossibility of definitively eliminating a series of dire—if unlikely—outcomes in Syria seems to have put a tether on the market’s near-term potential. Still, we think it likely that, in a few weeks, investors will be focused again on what we believe are gradually improving fundamentals, low expectations, and modest valuations.
The S&P 500 Index shed -2.9% in August in a broad-based but shallow sell-off. No industry sectors gained in the period, and 9 of 10 actually declined. More of the damage was done to interest-sensitive areas, while cyclical names fell less severely. Both the financials and utilities sectors declined an even 5% to lead the parade lower. Neither sector is attractive to us. The former has significant regulatory risk, in our opinion, and the latter is too interest-rate sensitive and too highly valued to attract our attention. Other areas of notable weakness were consumer staples (down -4.4%, perhaps on worries about growth in emerging economies) and telecommunication services (down -4.1%, as the sector’s recent role as a bond substitute worked against it). We are neutral on staples and underweight telecom.
The materials sector was unchanged in August, and so it led the market. A flight to precious metals in the face of the Syrian situation probably helped the sector, but we remain only market-weighted in it. Information technology was a close second, with a -0.5% drop. We recently moved to a double overweighting here (our only one) based on our belief that the long-term benefit from a corporate technology upgrade cycle will be augmented by improvements in important European economies. Another outperformer was energy, down only -1.7% in August. We do not believe that oil prices will remain at these fairly high levels, yet we are attracted to the high-quality fundamentals of the large integrated names. The result is an enthusiastic neutral rating on the sector.
The Dow Jones Industrial Average underperformed, declining -4.1%. Some of this underperformance could be attributed to specific shortfalls at a component company. Small caps lagged the S&P 500 slightly: The Value Line Arithmetic Composite Index and the Value Line Geometric Composite Index fell -3.0% and -3.4%, respectively. The relative strength of technology was reflected in the slight (-0.8%) decline in the Nasdaq Composite Index. Growth did better than value, as the Russell indexes tracking them fell -1.7% and -3.8%, respectively.
Overseas markets were case-specific. India grabbed the headlines with a 3.8% decline in local currency terms, which morphed into a -11.4% drop in dollar terms when the depreciation of the rupee was taken into account. However, most foreign markets were not as weak as those in the U.S.
China gained 5.2% in local currency, and its currency slightly appreciated versus the dollar. Brazil was up 3.7% locally, but its currency’s decline translated into a slight loss in dollar terms. European markets all rose in local terms or declined less than the S&P 500. Ireland, Greece, and Italy rose 2.4%, 1.7%, and 1.2%, respectively, but a 0.7% drop in the euro versus the dollar took some of the sting away from American investors. The FTSE 100 Index dropped 2.4%, but a stronger pound sterling cut that loss to 0.5% for Americans. Russia was down 1.7%, probably helped by stronger oil prices.August was a month of worldwide worries. While many may be with us for some time, we believe that international economies are in the process of bottoming. Although it seems early to enter emerging markets, we are impressed by European markets and believe they will continue to draw fresh money. We anticipate that a stronger Europe should eventually have a positive effect on emerging economies. However, we are in no hurry to anticipate this shift.
Fixed incomeBy James Kochan
Fixed-income investors will not be sorry to see this summer end. Total returns have been almost uniformly negative since early May. In addition, yields began rising in May, as the markets adjusted to the prospect of a reduction in asset purchases by the Fed, and they remained under pressure through most of the next three months. The yield on the benchmark 10-year Treasury note rose from 1.60% in early May to 2.90% in mid-August. As a result, Treasury market returns have been negative for each of the past four months.
In addition to rising Treasury yields, the municipal market confronted the Detroit bankruptcy petition and, more recently, renewed concerns about Puerto Rico. These developments prompted investors to withdraw a record volume of funds from tax-exempt mutual funds and exchange-traded funds. Yields on 10-year and longer municipal maturities have increased by as much as 130 basis points (bps; 100 bps equals 1.00%) since late April. The -7.0% cumulative total return for the municipal market over the past four months is worse than the -5.5% return over the October 2010 through January 2011 market sell-off. In a reversal from prior years, the BBB credits have recorded the poorest returns thus far this year. Because yield curves are exceptionally steep, yields on the longer maturities are now as high as they were in January 2011 and much higher than in 2006, when the federal funds rate was at 5.25%.
Concerns over credit quality have apparently not increased in the corporate bond market. In the investment-grade sector, returns have been quite uniform across the ratings spectrum. Within high yield, the CCC credits continued to perform best in August. Year to date, the CCC market index has a return of 7.6%, while the return for the BB index is only 0.9%. For corporations, the combination of strong cash flows and a receptive market for their debt has contributed to improving credit fundamentals.This four-month period of rising yields has been the most severe sell-off since 2010–2011. The yield increases in these two periods are almost identical. That earlier market correction proved to be an excellent buying opportunity, as yields fell sharply in 2011–2012. A similar decline in yields is probably unlikely now, as Fed policy suggests a less simulative approach in the months ahead. Nevertheless, with yields now adjusted to that prospect, the potential for coupon-like total returns is probably much better than it was four months ago.
Table 1: Year-to-date bond market total returns (%)
Asset allocationBy Brian Jacobsen
For investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Short-term, over the next three months, we think investors may still be rewarded by looking at higher-yielding fixed-income investments as well as growth-oriented equities.
EquitiesGlobal equities still look attractive from a valuation perspective. There are risks, as the economic recovery is still middling at best. But pessimism is already priced into stocks, especially European equities. Emerging markets are attractively valued, but the sector is likely going to tell two different tales: Commodity-oriented emerging markets could get cheaper, while manufacturing-oriented emerging markets could begin to recover.
Value versus growth
Choosing between value and growth is like choosing between walking to the store and breathing. Why not both? We think pessimism about the future—of which there is plenty—has contributed to mispriced growth opportunities that blend value and growth characteristics.
Large caps versus small caps
Large-cap companies are probably better positioned for global growth than small-cap companies. That doesn’t mean small- and mid-cap companies should be ignored. However, we think it’s more important to be discerning about the economic exposure of a company rather than judge it solely on its size.
Fixed incomeBased on our economic outlook, we believe interest rates are likely to remain low for the balance of the year. This presents an opportunity for investors to take on additional duration and credit risk, but we prefer more credit risk to more duration risk. Provided the economy doesn’t dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues would.
Asset allocation summary table*Neutral positioning for equities is the percentage of market capitalization meeting the classification criteria of a broad market index. Because the fixed-income market tends to be dominated by sovereign debt, we chose to represent the neutral weight as 50%. The strategic positioning represents our guidance for investors with a time frame of three years or longer. The tactical positioning in the pie charts below represents our guidance for investors with a time horizon of less than one quarter.
The bottom line
It was a long, hot summer. As things heat up in Syria, The fall might not be much cooler. Also, while the U.S. economy cools, political rhetoric could heat up, with the federal government’s fiscal year coming to an end, the debt ceiling needing to be raised, and the midterm elections just around the corner. If there were ever a time to have a diversified portfolio, the balance of the year could be that time.