Stocks fell in July, with the Russell 3000 declining approximately 2% for the month. In our view, more stringent economic sanctions against Russia from both Europe and the U.S. contributed to this decline. Other factors may include a recent pick up in domestic inflation numbers. Some investors may be concerned that should pricing pressures continue to escalate, the Fed might be forced to tighten monetary policy sooner than currently envisioned. That said, there was positive news as well. We were encouraged by the majority of U.S. economic data releases, and note that second quarter earnings season appears to have been quite strong.
Increased economic sanctions on Russia in the aftermath of the downed Malaysian commercial airliner were among the key market moving events for the month in our view. The new measures will impact the Russian finance, energy, and military sectors, and will inhibit the nation’s banks from accessing global markets for financing. Investors fear that these actions could further weaken an already frail European economy. We have written previously that a potential concern of ours was a significant ratcheting up of Russian sanctions, and while these new measures are certainly more stringent, in our view they are not yet sufficiently onerous to have us concerned about their impact on US equities. Of course we are closely monitoring the situation, and stand ready to take action to protect our clients’ portfolios should new information change our position.
In terms of monetary policy, comments out of the Fed were modestly less dovish than we have become accustomed to in recent years. In Chairperson Yellen’s testimony to Congress, she noted that certain labor market metrics have been running ahead of the committee’s expectations, and if this continued they might have to begin raising interest rates sooner than they currently envision. In late July, Federal Open Market Committee meeting officials noted that economic growth and inflation are finally getting closer to their objectives. Still, given a recent increase in inflation data, the tone of the meeting wasn’t as hawkish as some investors feared. Chairperson Yellen also noted that if economic growth cools, it is possible that rates may be held low for longer than her current expectations. Our concern is if inflation rises meaningfully above the Fed’s 2% target, the bond market could have an abrupt reaction, and a resulting sharp rise in interest rates would likely be detrimental to stocks. However, at this point we do not see a sharp rise in inflation as the most likely scenario.
Chairperson Yellen also made some comments about stocks that garnered quite a bit of attention. Specifically, she noted that valuations appear stretched in the social media and biotechnology industries. While we agree that there is some truth to this statement, we do have some exposure to these areas and feel that our specific holdings have very strong fundamentals which adequately justify their valuations. We note that generally our holdings in these industries reported robust second quarter earnings, further strengthening our conviction with regards to these particular stocks.
We were impressed by the majority of the economic data released during the month. While there was some weakness in the housing industry, with new and pending home sales missing expectations, by and large most of the other indicators seemed quite positive. Second quarter GDP surpassed expectations, coming in at an annualized growth rate of 4%. Jobless claims continued to reach their best levels for the current expansion. As did the Conference Board’s measure of consumer sentiment which jumped meaningfully from the prior month’s reading. According to data from the Federal Reserve, U.S. loans and leases increased by 7.7% in the second quarter, marking their best pace in over 5 years.
Consistent with the rebound in economic activity, corporate earnings also fared well in the second quarter. Revenues in particular have been quite healthy. As of this writing, with approximately three-quarters of S&P 500 companies having reported, revenues are on pace to grow over 4%, which would mark the best pace since the first quarter of 2012. Moreover, approximately two-thirds of companies have exceeded expectations on the top line, the best ratio since 2011. Finally, it is noteworthy that estimates did not come down meaningfully in the weeks leading up to second quarter earnings season, as is often the case. This suggests that the expectations bar was set higher for the current period, making the results that much more impressive.
We maintain a constructive view on the market going forward, though we do see the general risk level as having increased modestly in recent weeks.
Positive indicators include an improving U.S. economy, still highly accommodative global central banks, and strong corporate earnings. While the Fed continues to reduce its quantitative easing program, short term rates remain at near zero levels and are expected to remain there for at least the next several months. The ECB has announced new measures in recent months and has also noted that it is working on the framework for an asset purchase program. We believe that should the European economy falter, this program could be expedited. In our view, this combination of positive indicators should bode well for stocks going forward.
As noted, we are not yet overly concerned about the current level of sanctions imposed on Russia. Should new and more onerous measures be taken, however, it is plausible that they could have material ramifications for the European economy and throughout global capital markets. Other risks include the bond market becoming concerned with rising levels of domestic inflation. This could lead to a sharp run up in interest rates, which we believe would adversely impact equity prices. However, in that regard we note that the latest reading of the core price index of personal consumption expenditures rose just 1.5% in June from the prior year, a level still moderately below the Fed’s 2% target.
Consistent with our view that risks have increased somewhat of late, we have raised cash levels to modestly de-risk the portfolio. We also reduced our overweight in the Industrials area, primarily for stock specific reasons. We would characterize these as moderate steps as we still maintain an overall positive outlook on the market. As always, we are closely monitoring the key risk factors that we have identified, and stand ready to take further action should we feel that conditions warrant.
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