Fed Chair Janet Yellen testified before lawmakers last Tuesday and, as expected, she was careful to emphasize that policy accommodation could be withdrawn more rapidly or more slowly than currently expected, depending on incoming data. Market participants looking for any clues that rate hikes could be brought forward in response to recently improved data were largely disappointed, even as several lawmakers focused their questions on the Fed’s exit strategy. Also of note, the Fed’s monetary policy report flagged lower-rated corporate debt as evidence investors may be reaching for yield, and in a very unusual move singled-out small-cap social media and biotech stocks as segments of the equity markets with “substantially stretched” valuations.
All in all, the week’s economic reports indicated some potential loss in momentum from May’s data and added to recent evidence that economic growth heading into the third quarter was steady but not spectacular. However, steady has been plenty good enough for the equity market bulls. The end of the week finally brought the return of some volatility to markets, with the S&P 500 ending its longest streak since 1995 without a 1% daily move by declining 1.18% on Thursday before subsequently recovering virtually all of its loses on Friday.
For the week, the S&P 500 increased +0.54%, the Dow Jones Industrial Average added +0.92%, and the MSCI EAFE (developed international) rose +0.94%.
Here are the 3 stories this week that rose above the noise:
Heading Off the Entitlement Meltdown
This year’s budget deficit of “only” $500 billion has brought some complacency on federal spending and deficits. We believe it shouldn’t. An article from Rob Portman in The Wall Street Journal points out that the Congressional Budget Office’s (CBO) long-term budget outlook released on July 15 shows a $40 trillion increase in debt over the next two decades. While a $500 billion deficit is welcome compared to the $1.4 trillion peak in 2009, the current decline may be only temporary.
The CBO projects new debt of $10 trillion over the next decade, followed by $100 trillion over the subsequent two decades. Consequently the CBO simply stops calculating the national debt after 36 years, as its models apparently cannot conceive of a functioning economy. While the projected ballooning deficits remain a longer-term concern for investors, the article points out that the longer we wait to enact reforms, the more abrupt and painful they may be.
Yellen Wage Gauges Blurred by Boomer-Millennial Shift
A key justification from the Federal Reserve for maintaining its zero interest-rate policy for an extended period after quantitative easing ends has been data indicating very weak wage growth. To many economists, including Fed Chair Janet Yellen, this has been an indication that significant slack remains in the labor market and as a result inflationary pressures are unlikely to sharply increase.
However, a recent Bloomberg article has some interesting data that suggests much of the weakness in wage growth may be attributable to demographics, with high-earning older workers retiring and being replaced with younger workers who earn lower wages. As a result, the labor market may have less slack than the Fed believes and continued strong labor market gains could result in the Fed bringing forward its schedule for increasing rates.
The Single Best Predictor of Equity Returns in 2014?
Since the start of year there has been a significant relationship between a company’s market capitalization and year-to-date returns, as larger size stocks have easily outpaced smaller stocks. This relationship seems to be even more pronounced from the beginning of July, when the small-cap Russell 2000 Index peaked.
This trend represents a stark reversal from 2013 when smaller stocks outperformed. Many analysts point to excessive absolute and relative valuations to explain the recent rotation out of small and micro-cap. Pension Partners warns that this sign of defensive behavior will likely have long-term ramifications that impact the broader market.
Articles chosen and summarized by the First Allied Asset Management, Inc. investment management team.
