OUR BLOG

Presented by Mark Gallagher

World markets hit by political uncertainty
June was a difficult month for U.S. equity markets. The S&P 500 Index was down 1.94 percent, and the Dow Jones Industrial Average was down even further, losing 2.06 percent. The Nasdaq did best, though it declined 1.64 percent. Markets were generally flat for most of June but dropped precipitously toward month-end as the Greek crisis worsened.

For the quarter, results were better but still lackluster. The S&P 500 was up slightly, by 0.28 percent, though the Dow lost 0.29 percent. The Nasdaq again performed best, up 1.75 percent. For the Dow, the month-end decline in June erased gains for the quarter and most of the year, while the S&P 500 and Nasdaq continued to post gains for the quarter and year-to-date.

A major contributor to the poor market performance was a further decline in expected corporate earnings. Per FactSet, analysts estimate a 4.5-percent decline in earnings year-over-year for the second quarter, down from an expected decline of 2.2 percent forecast on March 31. The increase in the estimated decline was primarily due to anticipated weakness in foreign markets. There has been a preponderance of negative guidance for the quarter, with 77 negative announcements and only 30 positive. The last time that earnings declined on a year-over-year basis was in the third quarter of 2012.

Technical factors also weakened during June. Even though all three major U.S. indices closed the month above their 200-day moving averages, the sharp decline at month-end brought them closer to that level than they had been for quite a while. In fact, the Dow dropped below its 200-day moving average before recovering.

Developed international markets declined more than U.S. indices for the month but did better for the quarter. The MSCI EAFE Index was down 2.83 percent in June, though it was up 0.62 percent for the quarter and up 5.52 percent year-to-date. The very weak June results came from the significant impact of the Greek crisis on European assets, even as the stimulus action by the European Central Bank had supported previous strong results. Technical factors remained weak, as the index dropped below its 200-day moving average at month-end.

Emerging markets, represented by the MSCI Emerging Markets Index, lost 3.18 percent in June, which led to a small 0.24-percent decline for the quarter. Emerging markets were damaged by a substantial market decline in China, as well as continued fear about the consequences of the Federal Reserve’s pending increases in interest rates. Technical factors, too, were weak, as the index dropped below its 200-day moving average at the end of the month.

Fixed income markets experienced a volatile June, with the Barclays Capital U.S. Aggregate Bond Index reporting a loss of 1.09 percent over the month. Results in other fixed income sectors showed varying levels of weakness, as indicated in Figure 1.

Source: Morningstar® Direct

The notable decline in the Barclays Capital High Yield Municipal Index came after the surprise announcement at month-end by Puerto Rico’s governor, Alejandro Garcia Padilla, that the island could not pay its $72 billion public debt load without dramatic restructuring. Further calls from Padilla to potentially halt payments on the debt for three to five years rattled the relatively small high-yield municipal market and caused much of its dramatic underperformance.

U.S. economic recovery continues despite weak first quarter
U.S. economic news during the second quarter was quite strong, and even the first quarter turned out to be better than initially thought. First-quarter gross domestic product (GDP) growth was revised upward to a decline of 0.2 percent—considerably better than the previous estimate of a 0.7-percent decline. Much of the weakness, as in 2014, was due to extremely harsh winter weather; a strong U.S. dollar, which hurt exports; and a West Coast port strike that disrupted supply chains across the nation.

Both winter and the strike have ended, and second-quarter results have been much more positive, largely dispelling questions of whether the recovery had been faltering. Employment growth continued strong, with annual job growth above 3 million jobs per year for the past six months, a level last seen in May 2000. Strong employment growth has driven the unemployment rate down to 5.3 percent, and wage growth finally seems to be responding. Average hourly earnings grew by 2.3 percent year-over-year in May, which is the highest level since 2009.

The strong labor market is also finally translating into improved consumer confidence and a rise in spending growth. Consumer confidence in May was at the second-highest level since January 2007, and personal spending growth was at its highest level in six years. Other economic indicators at multiyear highs were housing sales—the best numbers since before the crisis for both new and existing homes—and vehicle sales, at a nine-year high.

Not all the news, however, was good. Manufacturing growth remains weak, although positive, and the energy sector continues to downsize in response to low oil prices. Nonetheless, current data indicates that the recovery goes on and is increasingly benefiting the average worker, which may lead to accelerating growth through the rest of the year.

International risks return to the forefront
Despite the strong economic data out of the U.S., markets largely shrugged off the good news. The real risks for the quarter were international. Negotiations between Greece and its creditors had been a concern throughout the quarter, but worries intensified in late June as discussions became more heated. Market concerns peaked when talks broke down entirely on June 27, after Greece’s prime minister, Alexis Tsipras, announced a public referendum on a proposed deal with European lenders. This led to significant market downturns around the world. Figure 2 shows the declines in the U.S., German, French, Spanish, U.K., and Japan stock markets at month-end.

Figure 2. Performance for Leading International Equity Indices, June 2015

Source: Bloomberg

Although the Greek crisis continues, and worries remain, market reaction has been relatively modest thus far. Looking forward, a deal remains quite possible, and even in the event of a Greek exit from the eurozone, the systemic damage will likely be contained.

Beyond Greece, other international issues were on investors’ minds. Chinese stock markets moved into bear territory at the end of June, with substantial declines in Shanghai, in response to a continued slowing of China’s economy. The Chinese government has looked to address the situation with both rate cuts and reduced reserve requirements, a combination last seen in 2008, suggesting both the level of their concern and commitment. This situation remains an area of most concern for global markets.

Concern is appropriate, but the big picture remains positive
The weak results from U.S. equity markets in June and through the second quarter have been concerning, though largely a response to political risks in Europe. Underlying economic fundamentals are strong in the U.S. and improving in Europe, suggesting that any market adjustment may be limited. Moreover, both the U.S. and the world at large are better prepared to weather challenges than they have been in years.

It is quite possible that we will see further turbulence, particularly in international markets, but at this point it appears that it would be more of a normal adjustment to changing conditions. Even a larger correction would be normal in the grand scheme of things and nothing to worry about in the medium to longer term. We remain confident in the U.S. economy, our excellent positioning in the world, and the strength of our financial markets. We believe that a well-diversified portfolio with regular rebalancing is still the best way to meet financial goals over the long run and should be maintained through good times and bad.

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 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 Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip 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 High Yield Municipal Index measures the performance of long-term tax exempt bond market, including high-yield municipal bonds only.

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Mark Gallagher is a financial advisor located at Gallagher Financial Services at 2586 East 7th Avenue #304. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 651-774-8759 or at mark@markgallagher.com.

Authored by Brad McMillan, senior vice president, chief investment officer, at Commonwealth Financial Network.

© 2015 Commonwealth Financial Network®