Why So Serious???
The famed line of our title, sadly one of Heath Ledger’s last, encapsulates the mood around last week’s visible crack in US equity markets and more broadly global investing sentiment. Amongst the chaos that is Russia/Ukraine, Israel/Palestine and China/The Balance of Asia – there seemed to be little taken seriously, until last week.
But the reasons things got serious are far more complex.
This morning I am posting James West, Green Squares Chief Investment Officer’s, weekly note that neatly identifies the myriad of issues now crowding investor decision making. With most of the S&P reporting over and most of Europe now on the beach, there’s a lot to think about and not many around thinking.
James West is thinking:
What a week! It was already known that last week was going to be a corker because of a Fed meeting, GDP print, jobs number and last big week of Q2 corporate earnings. Throw in geopolitical tension with Russia, Middle East, Argentina defaulting on its debt, and a Portuguese bank that will now require a government bailout (potentially foreshadowing greater bank problem in Europe?) and it is no wonder that markets moved off of the low volatility environment that most had become accustomed to over the past few years.
So what caused the turmoil? First, the stronger than expected Q2 GDP report (+4% vs. consensus of +2.9%) was a big shock. Q1 GDP was also revised up to -2.1% from -2.9%. A stronger economy brings increased calls from monetary hawks that rates need to go up sooner rather than later, and we saw that with the release of the FOMC decision a few hours after the GD print. The Fed acknowledged the rebound in the economy in their statement and also mentioned that inflation was closer to its 2% goal (long term). Fed governor Charles Plosser dissented from the decision to not raise rates (nothing new), but he was more bold in his remarks about raising sooner (and also took to the airwaves later to discuss his view). All of put markets more on alert of a potential speeding up in the move to raise rates from 0%., still, nothing earth shattering and stock markets ended the day flat.
What sent equity markets down appears to be the employment cost index data released on Thursday, which came the highest since 2008 (+0.7%, vs. +0.3% in Q1). Wages were up from +0.3% to +0.6% (even though YoY they were up 2%, which is in line with hourly earnings and inflation). The report put the fear of higher inflation from wage gains into investor psyche and likely caused the selloff. The key point is that this is off of a low Q1, and that the data needs to show a continuation of the trend for it to be a real concern. Increased inflation is what many investors fear the most, because it would 1) drive the Fed to raise rates quicker and also 2) would pressure company earnings and thus stock prices.
The third major piece of news was the payroll data on Friday. Jobs increased by 209,000 in July, below consensus, but were still strong. Six straight months of +200,000 job growth hasn’t occurred since the 90’s, so it is a good indicator that jobs growth (and thus the economy) is firming. In an interesting counterpoint to the ECI data from the prior day, average hourly earnings and hours worked remained unchanged (not a sign of inflation) and the PCE index (the Fed’s preferred measure of inflation) was unchanged YoY from the prior month (+1.6% and +1.5% core).
The S&P 500 fell 2.69% last week. It was also ended the month down -1.4%, the first negative month since January, although it is still up +5.7% YTD through July 31st. If you read the headlines over the weekend, you would have thought it was Armageddon. This is one of those times it is fun to do a little study into financial media sensationalism. Bloomberg’s headline was “S&P 500 caps worst week since 2012 as Crises offset Data”. True that -2.69% was the worst since June 2012. But amazingly we have had two other weeks in 2014 that lost almost the same amounts: the week of 4/11 (-2.65%), and the week of 1/24 (-2.63%, the beginning of a -5.6% selloff which is the worst so far in 2014). Yes, this time might be the beginning of that long lost market correction that we have all been waiting for as we have not had a loss of -10% (technical definition of a correction) in over two years. The S&P is now down -3.5% off its all-time high set on July 24th. My point is that we need to take a selloff like this in stride, it could definitely continue, but on the surface, it is still not much more than what we have witnessed this year on 2 other occasions this year. Everyone remain calm…
Small cap stocks, not surprisingly, sold off more than large caps, down -6.1% on July and -3.1% YTD. Concerns about higher rates would impact small cap companies (i.e. high yield) more. But what was probably most damaging to small cap stocks was Janet Yellen’s comments before Congress a few weeks ago mentioned small cap stocks as an overvalued area of the markets.
Last week’s selloff also nicked bonds, especially high yield corporate bonds which sold off -1.4% on the week (-1.3% in July). Quite a few articles over the weekend calling out investor unease with high yield on valuation and liquidity concerns and moving back to investment grade (major inflows over the past few weeks compared to outflows from high yield). Of course, investment grade didn’t fare much better. The 10 year treasury yield moved up by 15 basis points in 2 days on the GDP and ECI data, only to drop 10 basis points to settle out the week at 2.51% (-4 bps for the week). For the month, the 10 year vacillated between 2.45% and 2.69% to end the month only 4 basis points higher than where it started.
We are now moving into what should be a decently quiet period on the earnings and macro front. Over 75% of companies in the S&P 500 have reported (83% of market cap) and the next major US macro data will be the release of the July FOMC minutes on August 20th followed by the Fed’s annual Jackson Hole meeting. Remember that the summer months tend to be lightly traded as more people on summer vacation (not just on Wall Street but also individual investors). Of course the low volumes also means that market swings can be exacerbated (Thursday’s 2% drop didn’t have as much volume as one would think). With a dearth of market moving news, it will be interesting to see if investors continue to sell assets or take a breather over the next 3 weeks…
Please note that rather than showing the WTD returns in the charts, I am showing the July monthly returns and the YTD returns through July 31st.
Lincoln S. Ellis
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