Economic Update 7-25-2016

• In a slow week for economic news, home sales and housing starts surprised on the upside, while the index of leading economic indicators has shown some flattening of momentum as of late.

• Stocks gained for the fourth straight week, as a flurry of earnings reports came in better than expected, with U.S. equities outperforming foreign due to a strengthening of the dollar.  Bonds ended up with generally tempered returns, as interest rate volatility calmed down from prior weeks.  Commodity prices slipped across the board, with oil ticking down a few dollars upon higher inventories.

Equity markets experienced another positive week, with earnings results coming in better than expected and continued M&A activity.  From a sector basis, technology and utilities led the way with the best returns, while energy lost over a percent, followed by industrials.

So far with 125 companies in the S&P having reported for the 2^nd quarter, 80% have beaten earnings estimates (which were admittedly quite tempered in many cases).  This still doesn’t mean earnings are in great shape, as absolute results show flat to even slightly negative growth on a year-over-year basis, which would be the 5^th straight quarter of declines—a pattern last seen during late 2008-early 2009.  Of course, the largest negative impact has come from the energy and materials sectors, for which earnings suffered dramatically in the wake of extreme commodity price declines.  However, such impacts are expected to ‘trail off’ and normalize in coming quarters assuming recent price gains hold.  Other sectors are nowhere near in as bad a shape, with mid-single digit earnings growth seen in a variety of areas, such as healthcare, industrials and consumer stocks.  Higher stock P/E ratios as of late are a factor of both the low interest rate environment, but also market expectations that better earnings ‘E’ in coming quarters will catch up to the price ‘P’, and bring the ratio back in line to lower levels.  However, this process rarely seems to happen smoothly.

Internationally, developed markets earned gains in line with domestic equities last week in local terms, but a stronger dollar created a headwind, resulting in flattish performance on net.  Economic data in Europe tended to be on the weak side, particularly in the U.K., where PMI fell into contractionary territory.  The ECB took no policy action last week, but alluded to further stimulus if needed.  The post-Brexit topic of the hour is the Italian banking system, which is facing solvency issues due to a growth in nonperforming loans and general high levels of debt.  While a bailout is likely required, concerns continue regarding populist sentiments there especially due to elections there later this year.

Emerging markets outperformed developed, with the strongest gains in Latin America, with Brazil taking no central bank action.  Turkey was pummeled with nearly a -20% loss in the aftermath of the prior weekend’s coup attempt and subsequent crackdown on citizenry in a variety of areas, from waivers of unreasonable detentions to closures of schools, charities and other institutions as part of a broader state of emergency.  The fear in Turkey is that President Erdoganis using the coup attempt as an excuse to consolidate power, punish opponents and/or move from a traditionally secular mindset to one that appeals increasingly to the Islamic side—a move that naturally concerns global politicians as well as investors.  At the same time, even leaders in less stable nations understand the importance of keeping access to financial markets; a perception of lessened liquidity or asset safety could cause a dramatic spike in credit spreads, or cut of needed external capital flows completely, restricting a nation’s borrowing capability for years to come.

U.S. bonds were relatively flat on net with interest rates moving very little, in contrast to recent weeks.  In addition to longer-term treasuries, corporate bonds, especially high yield and bank loans, earned the strongest returns as investors continued to seek yield wherever they could find it.

The dollar strengthened by almost a percent on the week, affecting foreign bonds as much as any other asset class.  This was the most substantial factor, as results in local currency terms were generally flat to slightly positive—emerging market debt was the most affected to the downside.  From a practical standpoint, such move favors USD-hedged and USD-denominated strategies and penalizes locally-denominated ones; ETFs and some active foreign bond strategies can be targeted to either extreme, but many of the more well-known active managers tend to ‘cross-hedge’ strategically, ending up somewhere in the middle.  Such activity with currencies can cause performance differentials to be somewhat larger than one would expect in the short term compared to other asset classes.

Real estate experienced sharp gains globally, outperforming broader equity markets.  In the U.S., cyclical lodging and healthcare REITs led the way, while Asia and Europe lagged, albeit will still-positive returns.  Year-to-date, the +15% gain for the domestic REIT group remains one of the better asset class performances thus far, due to lessened fears about rising interest rates, as well as continued strong tenant demand and low vacancy activity.

Commodities lost several percent during the week, with no help from a stronger dollar, and weaker energy prices as inventories were reported to be a bit larger than expected.  Accordingly, West Texas crude declined from just over $46 to $44.  Other groups also lost ground, including metals and agriculture, but to a lesser degree than did oil.  Unsurprisingly, the U.S. oil rig count has picked up in recent months, in keeping with higher prices—on the order of about 10 additions per week (twice the rate expected)—which could put U.S. production levels back into positive growth levels by next year.

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.