Market Update for the Month Ending May 31, 2014

A strong close to a quiet month U.S. financial markets had a relatively quiet month, except for the Nasdaq, which was down close to 2 percent mid-month. Still, all U.S. equity markets finished May strongly, with the Dow Jones Industrial Average up 1.19 percent, the S&P 500 Index up 2.35 percent, and the Nasdaq up 3.11 percent, despite its mid-month drop.

The weak start to May was driven largely by earnings growth, which was down significantly from fourth-quarter 2013. In addition, guidance from companies for the second quarter was much more negative than usual. On top of these factors, the economy suffered from severe weather. The strong close for the month owed a lot to much stronger economic reports, available toward the end of the period.

The MSCI EAFE Index, reflecting developed international markets, was up 1.62 percent in May, and the MSCI Emerging Markets Index gained 3.26 percent for the month. Fixed income markets showed surprising strength at month’s end. Yields on 10-year U.S. Treasury bonds, dropped from 2.63 percent at the start of May to 2.48 percent at the end, with the Barclays Capital Aggregate Bond Index gaining 1.14 percent for the month.

Winter’s last gasp as U.S. economy thaws Although the economy suffered from severe weather in the first quarter, shrinking 1 percent, more recent numbers have been substantially better. April showed a gain of 288,000 jobs, much higher than expected. Initial unemployment claims dropped to a seven-year low in April—another good sign—and average hours worked recovered to normal levels. Housing prices continued to increase at double-digit rates. Consumer confidence also improved, leading to gains in consumer spending and increases in lending. Because of these factors, most economists expect second-quarter growth to be quite strong—and to accelerate for the rest of 2014.

The Federal Reserve and interest rates The Federal Reserve (Fed) reportedly remains confident about a strengthening recovery. A surprising drop in interest rates at the end of May could call that view into question, but analysis of the supply-and-demand balance for Treasury securities suggests that the drop is market-driven. The reduction in the federal deficit means that, even with the taper, the Fed is buying a large proportion of the total debt issuance—and that sustained Fed purchasing, combined with growing demand from other buyers, is pushing rates down.

International risk remains Recent elections for the European parliament resulted in a much higher number of parliamentarians representing anti-European Union parties, indicating that Europeans are running out of patience with austerity policies. Expect to see more uncertainty around Europe through year-end.

China has become much more aggressive with respect to other countries. This is leading Japan, for example, to consider a more aggressive defensive stance, raising the geopolitical risk level.

Finally, even as Russia has seemed to pull back on Ukraine, it signed a multibillion dollar natural gas supply deal with China. This should benefit both sides but was designed to strengthen both countries in dealings with the West.

Back to the old normal With the U.S. economy continuing to mend, and because the bulk of the risk is in international issues, it seems as if we’re moving back to the old normal. Could the markets become complacent?

It would be a mistake to take the current improvement in the real economy and appreciating financial markets as a sign that risk has disappeared. Though we expect the recovery to continue, markets remain richly valued and subject to correction. Further, Europe and China retain the ability to generate negative surprises. And, although the U.S. recovery seems strong, it could weaken.

We certainly acknowledge the positive changes, but we aren’t complacent and remain on the lookout for risk. With that said, we believe that a properly diversified portfolio should allow investors to achieve their goals over time.

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.

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

© 2014 Commonwealth Financial Network®