The most recent reading on the broad economy showed that US gross domestic product (GDP) contracted by 0.2% for the first quarter of 2015, continuing the trend of below-average growth since the recession ended in 2009. The first quarter contraction was believed to be caused by transitory issues including harsh winter weather, west-coast port strikes, and a strong US dollar. Most economists project economic growth to resume, albeit at a moderate pace, for the balance of 2015.
Contributing to the negative GPD figure were a decline in business investment and a widening trade gap, where the headwinds from a strong dollar made US goods more expensive overseas. Additionally, manufacturing activity fell from levels seen at the beginning of the year, but remains in expansion territory with the ISM Manufacturing Index at 53.5.
Offsetting the headwinds to GDP was strong consumer spending, which was likely aided by gains in income and lower gasoline prices. Furthermore, housing activity remains strong, with the S&P/Case Shiller 20-city composite index reporting an annual home price increase of 5% coupled with pending home sales continuing to increase year-over-year. Crude oil and other industrial commodities have rebounded in price from the depressed levels a quarter ago, but many agricultural commodities have weakened.
The overall employment picture remains solid with the unemployment rate standing at 5.5%, near its lowest level since the beginning of the 2008 recession. Employment growth has been strong as the economy has added an average of over 200,000 jobs per month so far in 2015, while the number of applications for unemployment insurance benefits has held below 300,000 for 16 consecutive weeks. Wage growth has been largely absent over the jobs recovery of the last several years, although signs of wage inflation are beginning to surface and may impact the overall inflation picture going forward.
International economic data was mixed. The Eurozone continues to show hopeful signs of a gradual recovery from its current state of stagnant growth, however the dire economic condition of Greece continues to dominate headlines in that region. At quarter-end, the country defaulted on a payment to the International Monetary Fund, becoming the first developed country to do so. China and other emerging markets continue to grow at rates well ahead of developed nations, although growth in most emerging economies has been decelerating.
Despite the lack of strong economic growth or readily apparent inflation concerns, bond yields moved higher during the second quarter, with the yield on the 10-year Treasury ended the quarter at 2.35%, higher than where it began the year. The rise in bond yields pushed broad bond market indices into negative territory for the quarter, while shorter-term bond indices were little changed. Inflation appears well contained for the time being, however the stronger jobs market may be beginning to push wage levels higher, a harbinger for future inflation concerns.
The June FOMC meeting contained no significant surprises as the Federal Funds rate was left unchanged at a range of 0-0.25%. Nevertheless rate hikes are expected to begin as early as September. The statement indicated that the FOMC believes the economy is recovering from a first quarter contraction caused by transitory factors, and that the Fed would take a measured, data dependent approach to raising interest rates. As of now, the primary debate among Fed-watchers centers around whether economic data will lead to one or two rate hikes in the second half of 2015.
Given the likelihood of rate hikes coupled with expected economic growth and the potential for inflation to begin to surface, we anticipate longer-term bond yields to eventually rise from today’s paltry levels. Nevertheless, geopolitical uncertainties and a lack of confidence in the economic rebound may continue to keep rates lower than normal in the near-term.
Treasury yields of selected maturities for recent time periods are displayed below.
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
The total return numbers for various fixed income indices over the last twelve months are displayed below (data from Bloomberg).
|52 Week Returns (a of 6/30/15)|
|Barclay Capital US Aggregate||1.86%||Merrill Lunch US High-Yield||-0.55%|
|Merrill Lynch US Treasury Int-Term||1.93%||Merrill Lynch US Municipal Index||3.10%|
|Dow Jones Corporate||-2.09%||JP Morgan Embi Global||0.02%|
Major market averages rose modestly during the quarter, with international indices providing relatively stronger returns. The exception was the Dow Jones Industrial Average which dropped -0.3% for the quarter. The negative performance of the Dow Jones Transportation Index (-7.1%) was worrisome to many investors as the transports are often viewed as leading indicators of the economy. On a more positive note, the NASDAQ Composite gained over 2% for the quarter and set an intraday high above its previous record set during the peak of the tech bubble in 2000. Helping to support the equity markets is increased merger and acquisition (M&A) activity, where 2015 is on pace to break the previous record for deal amounts set back in 2007, according to the Wall Street Journal. For the first six months of 2015, international and small-cap indices have outperformed the S&P 500, which is a reversal of the performance characteristics seen in the prior calendar year.
Below is a table which displays various equity index returns for the past quarter.
|Equity Indices||2nd Qtr. 2015|
|Dow Jones Industrial||-0.29%|
|S&P 500 Growth||0.31%|
|S&P 500 Value||0.24%|
|Russell 2000 (small-cap)||0.42%|
|MSCI/EAFE (developed international)||0.80%|
|MSCI/EM (emerging markets)||0.81%|
US equity markets appear to be trading near fair value versus historical averages, especially after factoring in the low interest rate environment. However, a continued rise in interest rates could prove to be a headwind if higher yielding bonds are seen as an alternative to equities. Perhaps more important to the overall stock market will be the ability of US corporations to deliver revenue growth in a muted economic environment, while maintaining historically high profit margins.
After years of underperformance versus US stock markets, international equities rebounded nicely in the first half of 2015. While economic headlines from the rest of the world have generally been uninspiring, the possibility exists for developed foreign markets to surprise to the upside given reasonable equity valuations and lower expectations. In emerging markets, equities carry an attractive earnings yield, but broad-based outperformance may be challenging as the Chinese economy adjusts to a more consumer-oriented growth profile.
The following table details S&P 500 sector returns for the quarter (price only).
|Return by Stock Sector||2nd Qtr. 2015|
|1. Health Care||2.43%|
|2. Consumer Discretionary||1.56%|
|5. Information Technology||-0.19%|
|7. Consumer Staples||-2.41%|
Despite the relatively unchanged broad market for the second quarter of 2015, the underlying sectors exhibited divergence in their respective returns. Consumer Discretionary and Health Care stocks continued their strong recent performance and were the top performers for the quarter. The general strength of the consumer in addition to increasing M&A activity in Health Care were tailwinds for the better performing sectors. Conversely, Utility stocks were the worst performers for the period, as the rise in bond yields during the quarter caused investors to rotate out of the sector which had been a haven for investors seeking higher yields. Industrials, Energy, and Materials also fared relatively poorly during the quarter, as the uneven global economy pressured more cyclical and commodity-related sectors of the market.