Tug of War Continues Between Fundamentals and Geopolitics
- Important progress in the global recovery, U.S. labor market and corporate earnings has been masked by geopolitical tensions.
- The conflict involving Russia could have a significant impact on the eurozone and global growth.
- Market volatility is likely to increase in the short term, causing headwinds for risk assets.
U.S. equities finished higher last week with the S&P 500 increasing 1.3%.1 A relatively steady tone continued in spite of the weakness in global economic data. Fed dynamics were viewed as somewhat supportive. The geopolitical backdrop seemed more favorable for global risk appetite, however, renewed volatility surrounding the crisis in Ukraine reversed an early rally on Friday, fueling a bond rally. Health care and technology were among the best performers. Energy was the only sector to finish negative, as oil fell for a fourth straight week.1
Favorable Environment Offset by Areas of Caution
The overall environment is largely represented by strengthening global economic growth, improving corporate earnings and profits, as well as relatively reasonable equity valuations. Officials have recently become concerned about pockets of illiquidity in the repurchase agreement (repo) market. Repos are equivalent to the plumbing of the global financial system, and holders of government securities use repos as a source of overnight borrowing. Liquidity questions are a headwind for the Fed, and possible turbulence could result once the fed funds rate moves beyond 0%.
The turmoil involving Russia and escalating sanctions are weighing on the eurozone economy, placing global growth at risk. Eurozone business confidence has declined, which to us indicates early signs of a slowdown. Japan reported extremely weak GDP data, signaling a slide back into recession.2 Other countries in recession include Italy, Portugal, Russia and Ukraine. Countries at risk are France, Brazil, much of Latin America and potentially Germany.
Weekly Top Themes
1. Industrial production increased in July, exceeding expectations. Production increased 0.4% and manufacturing output expanded 1.0% for the month.3
2. Initial unemployment claims increased. Weekly claims rose by 21,000, which was a disappointment compared to expectations.4
3. Wage growth typically accelerates in the second half of a business cycle. U.S. wage growth appears to have developed momentum, indicating tighter monetary policy should be on the way.
4. The large budget deficit reductions in recent years are starting to slow. This is occurring as the Fed is exiting its asset purchase program.
5. The equity market continues to emphasize stock selection as not all stocks are rising together. Technology holds the leadership position.
Risk Assets Prepare for a Bumpy Ride
Equities have cooled off after a strong spring rally. The strengthening labor market has reintroduced an element of monetary policy uncertainty, despite the Fed’s plans to keep rates lower for longer. While interest rate hikes are not imminent, debate about the timing of the first move will probably intensify as the labor market expands. As a result, risk tolerance has waned somewhat, and high levels of leverage virtually assure increased volatility. So far, this has manifested itself in outflows in the high yield corporate market, pushing spreads wider. The U.S. dollar is under upward pressure due not only to heightened geopolitical risks and investor inflows resulting from perceived safe haven potential, but also from U.S. economic and interest rate expectations breaking out relative to the rest of the world.
U.S. equities were primarily driven by valuation expansion throughout 2012 and 2013. Now, profits are showing signs of renewed vigor, however, we expect additional stock market volatility over the next few months as the appetite for risk assets diminishes. Concerns have escalated that the eurozone could move back into recession because of uncertainty around the standoff with Russia and the potential for increased sanctions. Euro-area equities led on the downside and the euro has weakened, although fortunately global contagion has not yet been meaningful.
1 Source: Morningstar Direct, as of 8/15/14. 2 Source: Bloomberg. 3 Source: Federal Reserve. 4 Source: U.S. Department of Labor.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Euro STOXX 50 Index is Europe’s leading Blue-chip index for the Eurozone and covers 50 stocks from 12 Eurozone countries. FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. Deutsche Borse AG German Stock Index (DAX Index) is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange. FTSE MIB Index is an index of the 40 most liquid and capitalized stocks listed on the Borsa Italiana. Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. Hong Kong Hang Seng Index is a free-float capitalization-weighted index of selection of companies from the Stock Exchange of Hong Kong. Shanghai Stock Exchange Composite is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The MSCI World Index ex-U.S. is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets minus the United States. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
RISKS AND OTHER IMPORTANT CONSIDERATIONS
The views and opinions expressed are for informational and educational purposes only as of the date of writing and may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Noninvestment-grade bonds involve heightened credit risk, liquidity risk, and potential for default. Foreign investing involves additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. Past performance is no guarantee of future results.
Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc.
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