Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital
After a mild 4% pull-back from July 24 through August 7, the equity markets continued to grind higher while global bond yields fell. The S&P 500 Index gained 4% in August and crossed the 2000 level for the first time. Markets shook off elevated geopolitical tensions in Ukraine and the Middle East, and focused on stronger earnings from U.S. companies, better U.S. macroeconomic data, and the anticipation that central banks globally will remain supportive.
In the U.S., small cap stocks outpaced large caps in August, but large caps have a lead of more than 800 basis points on small caps year-to-date. Growth was ahead of value in August. In both large cap and small cap, growth has closed the gap and now lags value by only 50 basis points year-to-date; however, mid cap value still has a significant advantage over mid cap growth due to the very strong performance of REITs so far this year.
Developed international equity markets meaningfully lagged the U.S. in August, in part due to weaker currencies. Europe was slightly positive, but Japan declined more than -2%. Year-to-date, U.S. equities are almost 700 basis points ahead of the MSCI EAFE Index. However, emerging market equities posted another solid month and, after a very weak start to the year, are now ahead of U.S. equities. Brazil and India have each rallied more than 25% so far this year, while China has lagged with a gain of only 8%.
Global fixed income rallied along with equities in August. The yield on the 10-year U.S. Treasury Note fell 22 basis points to 2.34%, which still looks attractive relative to yields in the rest of the world.
All fixed income sectors positive for the month, led by credit and Treasuries. After high yield spreads widened in July and the asset class experienced significant redemptions, investors saw relative value and moved back into high yield in mid-August. The sector gained 1.6% for the month, and spreads still remain 40 basis points above the low reached in June.
We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds, and as a result our strategic portfolios, are positioned with a modest overweight to overall risk. A number of factors should support the economy and markets over the intermediate term.
- Global monetary policy remains accommodative: Even as we approach the end of quantitative easing, U.S. short-term interest rates should remain near-zero until 2015 if inflation remains contained. The ECB has taken more aggressive action to support the European economy by lowering interest rates even further and announcing the purchases of covered bonds and asset-backed securities. The Bank of Japan continues its aggressive easing program.
- Pickup in U.S. Growth: U.S. economic growth rebounded in the second quarter. Capital spending appears to be recovering. The improvement in the labor market continues and job openings are surging. Leading economic indicators suggest the recovery has momentum.
- U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash. M&A deal activity has picked up this year. Earnings growth has been ahead of expectations and margins have been resilient.
- Less Drag from Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year. Fiscal drag will not have a major impact on growth this year, and the budget deficit has also declined significantly.
Risks facing the economy and markets remain, including:
- Fed’s Withdrawal of Stimulus: Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, tapering is more gradual and the economy appears to be on more solid footing this time. Should inflation pick up, market participants will quickly shift to concern over the timing of the Fed’s first interest rate hike. However, the core Personal Consumption Expenditure Price (PCE) Index, the Fed’s preferred inflation measure, is up only +1.5% over the last 12 months and we have not yet seen the improvement in the labor market translate into a level of wage growth that is worrisome.
- Election Year/Seasonality: While we noted there has been some progress in Washington, we could see market volatility pick up in the next two months in response to the mid-term elections. In addition, September tends to be a weaker month for the equity markets.
- Geopolitical Risks: The events in the Middle East and Ukraine could have a transitory impact on markets.
Risk assets should continue to perform over the intermediate term as we expect continued economic growth; however, we see the potential for increased volatility and a shallow correction as markets digest the end of the Federal Reserve’s quantitative easing program. Economic data, especially inflation data, will be watched closely for signs that could lead the Fed to tighten monetary policy earlier than expected. Equity market valuations look elevated, but not overly rich relative to history, and maybe even reasonable when considering the level of interest rates and inflation. Investor sentiment, while down from excessive optimism territory, is still elevated, but the market trend remains positive. In addition, credit conditions still provide a positive backdrop for the markets.
Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.
Source: Brinker Capital
Brinker Capital, Inc., a Registered Investment Advisor. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index.