Insights / 07.01.2017
Equity markets ended June modestly higher with the most notable exception being the technology sector, which finally saw a long overdue pull back during the month. Developed and emerging markets saw continued strength as the euro rallied following hawkish comments by the ECB president regarding inflation in Europe and further evidence of strength in the European and global economy. The following table contains a summary of June’s market performance:
|S&P 500 (Total Return)||+0.62%||+9.34%||All Country World Index (Net)||+0.45%||+11.48%|
|MSCI EAFE (Net)||-0.18%||+13.81%||Barclays Aggregate||-0.10%||+2.27%|
|MSCI Emerging Markets (Net)||+1.01%||+18.43%||60/40 Blend*||+0.26%||+8.00%|
The S&P 500 index finished June within a few points of where it started, but that outcome hides the significant rotation across sectors that took place during the month. After gaining 25% and contributing nearly 30% of the S&P 500’s year-todate rally, technology stocks fell by almost 5% during the month. Financial sector stocks gained nearly 10% during the month, and small-cap stocks finished the month 3.5% higher. Investors’ decision to sell growth stocks that had exhibited price momentum and buy value stocks that benefit from a cyclical recovery was driven by the market’s changing expectations about corporate earnings and interest rates.
After climbing by nearly 14% in the first quarter, second-quarter earnings growth is predicted to slow to 10% for technology stocks. With the prices of technology stocks rallying as much as they did in the first half of the year, valuations as measured by the forward price-to-earnings ratio had climbed to 18, above their ten-year average. As investors weighed slowing earnings growth for technology stocks against their rising valuations, interest rates climbed, raising the attractiveness of financial sector stocks that benefit from rising rates.
Technology and Financial sector stocks were not the only sectors to experience significant volatility during the month. Energy sector stocks tracked the price of oil, falling for much of the month before rallying in June to finish about where they started. The price of a barrel of oil fell from $54 to $42 on concerns of over-supply before rallying to finish the month at $46. Oil markets have to come to realize that U.S. shale producers and other non-OPEC nations are adding oil to world stocks at a rate that exceeds the amount that OPEC nations agreed to withdraw in late 2016. Expected earnings for companies within the Energy sector have been revised downward and the market has responded by driving their prices down by over 7% during the second quarter. MLPs, which benefit from the expansion of U.S. oil production, lost value during the month as markets continue to associate the prospects for MLPs with the direction of oil prices.
Interest rates rose sharply to end the month on rising expectations that not only is the Fed undertaking a normalization of interest rates, but global central banks are closer to falling in line than previously thought. The 10-year U.S. Treasury yield, which reached a year-to-date low of 2.13% earlier in June, jumped sharply the final week of the month to finish at 2.3%. The rise began following comments from a number of central bank heads around the world. Fed chief Janet Yellen stated that despite U.S. inflation falling below the Fed’s target rate of 2%, the central bank would maintain its stated normalization policies. The ECB’s Mario Draghi, emphasizing the strength of the European recovery, stated that reflationary forces had replaced concerns over the possibility of deflation. His comments were “a hawkish surprise” to the market and “set up expectations of an ECB tapering announcement in the fall.” With Japan’ economy growing for a fifth straight quarter, its longest expansion in a decade, there is a thought by many market strategists that the Bank of Japan will be pressured to announce its plans for winding down quantitative easing by year’s end. Markets are also beginning to assume that the Bank of England and the Bank of Canada are likely to fall in line based on rising rates for those countries.
European stocks sold off sharply in the days following Mario Draghi’s statement, losing nearly 2% of their value. However, the near-term response to Draghi’s unexpected comments have not diminished the market’s longer-term expectations for economic and earnings growth. The MSCI EAFE index produced modest returns in June, but is up nearly 15% year-to-date, reflecting expectations that Europe and Japan’s recoveries are in their early stages, with significant room to expand before full employment and inflationary conditions are reached.
Not to be overlooked, emerging market equities are up over 18% year-to-date following another gain in June as markets recognize the sustainability of economic recovery and corporate earnings growth. Chinese growth in the second quarter showed up in improved corporate profits and employment as well as improving retail sales.
Market volatility remains near historical lows. Investors appear to have accepted the conventional wisdom that is largely priced into asset values: expectations of low inflation, tightening monetary policy, and slow but sustained economic and corporate earnings growth in the U.S and most of the developed world and emerging markets. To the extent that these expectations are met as the second half of the year unfolds, equity markets should deliver positive returns. Within the U.S., despite high equity valuations, the enactment of Trump administration growth policies could have a positive impact on equity prices.
This communication is not an offer or solicitation with respect to the purchase or sale of any security and is for informational purposes only. Information contained herein has been derived from sources believed to be reliable, but CAPROCK makes no representations as to its accuracy or completeness. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns.