Markets heat up . . .
After a difficult January, financial markets rebounded in February. The Dow Jones Industrial Average was up 4.34 percent, while the S&P 500 Index climbed 4.57 percent and the Nasdaq rose 3.15 percent. Both the Nasdaq and the S&P 500 are now in positive territory for the year, although the Dow is still down year-to-date.
Several factors drove the strong performance. Corporate earnings were somewhat stronger than expected at the end of the reporting period, with earnings growth rates up to 8.5 percent at the end of February, above the estimate of 6.3 percent at the end of last year, per FactSet (see chart). Eight of ten sectors reported higher-than-expected earnings growth because of some positive earnings surprises.
Earnings Growth Beat Expectations in the Fourth Quarter of 2013
Sales volume was also better than expected, with almost two-thirds of companies beating expectations. Sales data is important because it reflects actual customer demand, and higher sales-growth rates help support the prospect of future earnings growth.
Technically, the markets started February with a decline that broke through both the 50- and 100-day moving averages, but they bounced off a support level at 1,750 and stayed above the key support level of the 200-day average. The current technical challenge is the 1,850 level for the S&P 500. Although the market broke through that figure on the last day of the month, it remains to be seen whether it will be sustained.
Developed international markets also performed well, with the MSCI EAFE Index up 5.56 percent, even more than the U.S. indices, while the MSCI Emerging Markets Index was up by less—3.19 percent. Developed markets are now up for the year, but emerging markets remain below where they started, which reflects both the recovery in Japan and Europe and the ongoing political turmoil in countries like Turkey and Brazil.
Fixed income also did reasonably well for the month, with the Barclays Capital U.S. Aggregate Bond Index up 0.53 percent, continuing a positive streak for the year. The gain was driven by bond yields. Interest rates were relatively stable in February, and the 10-year U.S. Treasury ended the month with a 2.65-percent yield. High-yield bonds returned a respectable 2.02 percent, according to the Barclays Capital U.S. Corporate High Yield Index, and emerging market bonds also staged a comeback. During the month, Janet Yellen, the new chairperson of the Federal Reserve (Fed), stated that she expected to hold the course on current policy, which provided stability in these markets.
. . . Even as economy suffers from severe winter weather
The strength of financial markets stood in contrast to weak recent economic data. Concerns about employment, stoked by a weak December report, continued in January, as only 113,000 jobs were added. Just as with the previous report, though, other data appeared more optimistic. The unemployment rate dropped from 6.7 percent to 6.6 percent, and underemployment fell from 13.1 percent to 12.7 percent. Other areas of concern included weakening manufacturing data, slowing existing home sale volume, and a decline in retail sales.
The question raised by these weak data points is whether they can be explained by poor weather, or whether they point to a slowing of the recovery. So far, economists believe the evidence points mostly to the former—although there may be some of the latter. Indicators that the economy remains on track include strength in consumer confidence, a rise in consumer borrowing, a decline in foreclosures, and surprising strength in new home sales.
At the same time, there are signs that growth has slowed. The gain in the U.S. economy for the fourth quarter of 2013 was revised down at the end of February, from 3.2 percent to 2.3 percent. This negative revision was largely due to lower-than-estimated sales of durable goods, such as cars, as well as reduced exports. Last October's federal government shutdown also appears to have had a significant effect. Still, business investment—one of the missing pieces in the current recovery—was actually adjusted up, which is a positive sign for the future.
Global recovery continues but may be slowing
Economic reports for the rest of the world were mixed. Manufacturing and service PMI surveys indicated a mild slowing of the Chinese economy. Meanwhile, China's exports grew, which supported its economy at the potential risk of political conflict with trade partners such as the United States. China's currency, which is managed by the government, declined against the dollar toward the end of the month, suggesting that China's leaders may be actively trying to support exports. If this is so, it would be contrary to their stated policy and could suggest that they are concerned about economic output.
Europe continued to stabilize, with Germany showing signs of accelerating growth, even as France continued to struggle with government spending cuts. Smaller countries showed general signs of progress. Remaining issues within Europe include continued reductions in government spending, which may negatively impact growth and result in political challenges. Also, European companies need to deliver on the improvement in earnings that investors appear to be expecting.
As for Japan, Abenomics (named for the nation's current prime minister, Shinzo Abe) has been a helpful support behind risk asset prices. Easy monetary policy, fiscal stimulus, and a concerted effort to devalue the yen have boosted investor confidence. But we see a potential headwind coming in the form of consumption tax increases this spring.
Emerging markets appear to have stabilized from the immediate economic impact of the Fed's decision to taper asset purchases, but they continue to struggle to adjust. Currency fluctuations and rising interest rates have hurt trade and caused capital flight. This has disproportionately affected smaller open economies with weak current-account balances and in some cases has led to political confrontations.
Politics threaten markets
Even as economies stabilize and return to growth, politics remains a risk factor. Euroskeptic parties, for example, are increasingly competitive in many European countries and could make significant gains in European Parliament elections this year. These circumstances matter because the political uncertainty created could potentially derail the current fragile recovery. Similarly, major emerging markets, such as Turkey and Brazil, not to mention Venezuela and Argentina, continue to suffer political turmoil.
Most relevant of all, perhaps, is the sudden emergence of the crisis in Ukraine and the move by Russia into the Crimean peninsula. This reminds us that many areas of the world remain much more uncertain than the U.S., and investors have to be aware of that when investing abroad.
Enjoy the gains but don't be surprised by volatility
After a difficult January, the market recovery in February was a relief, and the fact that the S&P 500 hit a new high offered encouragement to investors. Still, the weak U.S. economic reports, along with events in Ukraine, highlight that risks remain in the system.
Although we expect the U.S. economy to continue to grow, recent weak data implies that this is by no means guaranteed. In Europe, the economy continues to mend, but politics could cause a rocky summer. China is trying to spin up its export machine to compensate for weakness in other areas, but this has the potential to spark trade disputes. In short, while markets have celebrated February's very real good news, substantial uncertainty remains.
Therefore, despite the results of this month, we believe it is important to maintain a disciplined investment process. Through good times and bad, this is the key to achieving investors' long-term goals.
Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research analyst, at Commonwealth Financial Network.
All information according to Bloomberg, unless stated otherwise.