As the unofficial summer season winds to a close I’d like
to circle back to some of the topics we touched upon earlier in the season.
Economic Growth –
After the challenging first quarter which saw U.S. GDP register a negative 2.1% growth, investors debated the path forward through much of the spring. Stock investors dismissed the weak first quarter as simply weather-related. Bond investors, on the other hand, believed the underlying run rate had truly decelerated from the pace set in the second half of 2013. As of June 30th every major asset class had posted positive total return for the year. Bond investors believed the Federal Reserve would continue to provide monetary policy accommodation to keep the economy from tipping into recession while stock investors believed acceleration in economic growth would drive better revenue and earnings growth. As of today, it is difficult to determine a conclusion. The economic data released over the past two months has been on balance better than expected but there are still a number of key areas, such as housing, that are not convincingly strong. Later this week the U.S. will release the first revision to Q2 GDP. The number first reported in late July was 4.0%. A revision at or above that level would begin to confirm acceleration, something less would refuel the debate. As we stated in our initial discussion of this topic (available here), economic growth at this juncture of the financial market cycle is very critical to sustaining stock market advances. The market is most likely fully valued at current levels, which means that the upside from here may be tied to direct improvement in revenue and earnings.
Pressures – Through much of the first half of 2014 U.S. inflationary pressures, at both the producer and consumer levels, steadily advanced. Beginning the year with an annual pace of 1.4% the consumer price index reached an annualized rate of 2.1% in July. Growing inflationary pressures could put additional pressure on the Federal Reserve to move more rapidly toward normalized monetary policy. Overall investors largely expect the Fed to begin raising the Fed Funds rate in mid-2015. Faster inflation, although a good sign of economic health, could bring that date forward likely – leading to increased volatility and perhaps a sell-off in medium and long term bonds. Although one month does not a trend make, the level of inflation reported through mid-August for both the producer price index and the consumer price index were slightly below levels reported for July. This was welcome news. However, a big drop in commodity prices since June 30th may have helped in this data. The Federal Reserve is clearly focused on wage pressures in the labor market as the leading indicator of accelerating inflation so the trends there in the coming months will be more critical to their policy decisions. With little slack in the US labor markets, there may be little run for error.
Tensions – As we stated in our previous commentary on this topic (available here), geo-political developments are very fluid. The assessment is day-to-day and at times hour-by-hour. The hot spot issues remain the same at this date – Ukraine, Iraq and Syria – but little real progress has been made. Overall it would appear – based on performance in the financial markets – investors’ assessments regarding the risk to global economic growth have not changed much over the past month, with one possible exception. The heightened sanctions against Russia for their aggressive actions in Ukraine have been answered with retaliatory sanctions by Russia against European imports. This action has forced stocks lower in Europe and could threaten what little economic growth the region has experienced to date in 2014. With still high sovereign debt levels and a not fully recovered banking system a move back into recession in the European region would be a strong headwind for growth assets not just regionally but globally. There are talks scheduled in the coming days between key leaders in Russia, the European Union and Ukraine; there is hope for some resolution of the hostilities but the
situation is far from stabilized. The same can also be said for Iraq and Syria. As we look to the final stretch run of 2014 these issues could prove to be the wildcard that leads to heightened market volatility.
Overall with most major asset class – stocks, bonds and real estate – fully valued there is little margin for error. The impact of economic growth, inflationary pressures and geo-political developments will be major drivers of financial market performance in the weeks ahead. As always, we’ll keep you posted on the risks and opportunities as they present themselves.
Jack E. Payne, CFA, CFP
Chief Investment Officer