Quiet Week On The Economic Front

The final week of May turned out to be a challenging one for equities, as the S&P 500 Index lost 1.1% and the Dow Jones Industrial Average shed 1.2%. Over the course of May, the S&P and the DJIA gained more than 2.2%.

During the holiday-shortened week, markets were attuned to concerns about the Federal Reserve and its bond-buying program. Economic data was largely mixed.

Most notable last week was data on consumers. Consumer confidence was up in May, but consumer spending remained flat to start the second quarter. For the month of May, personal spending dropped 0.2%, led by a sharp decline in gas prices and weakness in the service sector. On the other side of the ledger, personal income was flat in April after a 0.3% increase in March. To offset weak wage growth, consumers are relying on savings accounts, driving the personal savings rate down to 2.5%, well below the year ago rate of 3.5%.

Source: Econoday

Somewhat surprisingly, however, consumers are feeling better about the pace of recovery. The University of Michigan Consumer Sentiment Index rose from 76.4 in April to 84.5 in May. A combination of current conditions and future expectations led the index higher.

Source: Haver Analytics

Consumers are receiving one benefit this summer – lower gas prices. Early last year, the price for a gallon of gas neared $4, but so far this year, we have not breached the $3.75 mark. Prices dipped below $3.5 in early May, and after a slight increase, are back near $3.64.

Source: Gasbuddy.com

The next several months will be an important period for consumers, particularly as the Federal Reserve looks to move away from interventionist policies and hand the economy back to its own devices. As a gentle reminder, consumers represent more than 70% of gross domestic product.

Source: Sober Look

Outside the consumer sector, news flow was light because of the holiday. The release of the Case-Shiller Home Price Index showed a 1.1% gain in home prices in March and 10.9% in the past year. Additionally, pending home sales moved higher by 0.3% in April, the highest such reading of the index since early 2010.

Source: Haver Analytics

Does Sector Shift Spell A Continued Rally?

Equity markets finished the month of May up 2.3%, as measured by the S&P 500, and are now up more than 15% for the year. Stocks were last up more than 15% through the first five months of the year in 1997.

Unlike most robust equity rallies, however, 2013 performance was initially led by traditionally defensive sectors, such as health care, utilities, and consumer staples. Through the first quarter, those three sectors posted an average return of 14.5%, while traditional cyclicals averaged just 9%. While some speculated this trend was due to investors’ reach for yield amid a frothy fixed income environment, the magnitude of this sector leadership (in an up move) was certainly unusual.

General sentiment entering May was that the current equity rally had exhausted itself, following a 24% tear over the past 11 months. Equity markets had risen in every month but one during that period, while various measures of market momentum and breadth teetered at the high end of historical ranges.

Source: Bespoke Investment Group

Indeed, the “sell in May and go away” phenomenon never materialized. The market experienced just one day of a 1% or more loss, which occurred on the final day of the period. In unusual fashion, lower beta healthcare and telecom stocks sold off the most sharply on May 31, falling 2.2% and 1.8% respectively. The broader S&P 500 declined just 1.4%.

More recently, sector leadership within the S&P 500 changed. Cyclical sectors that severely lagged through the first quarter of the year have suddenly overtaken their defensive counterparts. Financials and industrials led performance in May, while technology – the worst performing sector in the first quarter, jumped more than 4.5% in the month. The four traditional defensive sectors were the weakest performers in May, with three losing money during the period. Telecom and utilities, in fact, suffered shocking losses of 7.4% and 9.1%, respectively.

For many investors, the most important question entering the second half of 2013 is whether cyclical sectors can take the reins and propel equity markets higher. The sudden reversal in sector leadership appears to have been provoked by increasing optimism about the state of the US economy and/or a re-rating of cyclical sectors by less risk averse investors.

For many, the bull case remains a plausible one. To this point, valuations remain reasonable, with the S&P 500 trading at 15x. More importantly, many of the cyclical sectors that could be the engine of further gains are not trading at significant premiums, as one might expect after such a robust market rally.

On the other hand, Federal Reserve policy is clearly having a strong impact on equity markets. The group’s recent intimations of “tapering” on the Fed’s current quantitative easing program rattled markets in the past few weeks, in which the S&P 500 declined in six of nine trading days. How markets will react to the actual implementation of such policy remains to be seen.

While many assume an environment of rising interest rates would be negative for equities, this is not always the case. Research by Deutsche Bank shows that “rising bond yields have mostly been associated with rising equity markets” since 2000. This relationship was especially strong in instances of sharp rises in bond yields. Of course, this relationship was inverted in the 17 years prior to 2000, so drawing a firm conclusion is difficult.

Source: Deutsche Bank

The bottom line is that today’s markets provide a host of new challenges for investors. Unprecedented levels of intervention by central banks and record low interest rates make it much more difficult to interpret traditional signals within the equity markets. One thing appears clear, however: central banks want investors to move out on the risk spectrum, and that appears to be happening. Whether that is a sustainable phenomenon will dictate how the rest of 2013 plays out.

The Week Ahead

In contrast to last week, there is a wealth of information to digest this week. Most important will be the nonfarm payroll report on Friday, with economists expecting a slight pickup from the 165,000 jobs generated in April. Also important will be ISM manufacturing and non-manufacturing reports, as well as consumer credit on Friday. On Thursday, the Federal Reserve releases the latest edition of its Beige Book, which synthesizes the state of affairs across the various Fed Districts.

In the central banking world, seven policy meetings are taking place this week, including those by the European Central Bank, the Bank of England and the Royal Bank of Australia.

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