Market Update for the Month Ending August 31, 2012

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Sep 6, 2012 4:42:03 AM

and tagged Fiscal Cliff, Debt Crisis, Market Updates

Leave a comment

No news is good news

Despite rumblings of bad news throughout the month, nothing really materialized and equities had a very good August. U.S. markets were strong, with the S&P 500 Index up 2.25 percent for the month and the Nasdaq doing even better, up 4.34 percent. Most of the gains came early, in response to word from the head of the European Central Bank (ECB) that it would do whatever it took to support the euro. Although the bank backed off its statement later in the month, markets largely held their gains, even in the face of slowing growth in the real economy. U.S. markets ended August close to four-year highs, with the VIX, known as the market’s fear gauge, at very low levels.

Technical factors were positive as well. The moving averages continued supportive of the markets, with the 50-day moving average well above the 200-day for both the S&P 500 and the Nasdaq. The S&P 500 remained within its trading channel, as discussed last month, with no breakout in either direction.

International markets showed a divergence in August. Developed markets performed strongly, with the MSCI EAFE Index up 2.69 percent, even better than the U.S.—largely a result of the ECB statement. Emerging markets, however, performed worse, with the MSCI Emerging Markets Index posting a loss for the month of 0.54 percent. The slowdown in the global economy—particularly in the major importers, such as the U.S. and Europe—hit China and other manufacturing hubs hard.

To the surprise of many fixed income analysts, the U.S. 10-year Treasury yield spiked up above 1.8 percent in mid-August, later retrenching below 1.6 percent. The reasons for this were unclear, with some observers speculating that sales of U.S. Treasuries by China were a catalyst. Generally, a lack of major changes in the economic picture may have caused interest in safe assets to wane slightly over the month, as the Barclays Capital Aggregate Bond Index returned 0.07 percent. High-yield followed equities, with the Barclays Capital U.S. Corporate High Yield Indexreturning 1.17 percent in August.

The strong performance of risk assets in developed markets depended largely on the expectation of continued government support. That support appears likely to continue in the U.S., with the speech by Federal Reserve Chairman Ben Bernanke apparently setting the stage for more quantitative easing. The effects of government support may not extend to Europe, however, with several events coming in early September that could spell trouble for the eurozone.

Euro divergence

The strong performance of the European markets has been in contrast to the continued weakening of the real economies there. Headlines throughout the month focused on the ongoing decay of Spain and growing weakness in the core economies of France and Germany. The eurozone as a whole is at least on the brink of another recession, although it has not been officially recognized yet. Spain has moved toward a full bailout, with several of its regions also requiring individual bailouts. The gap between the policy prescriptions of the ECB and the German central bank has grown wider and more public. Social decay has also been evident, with rioting in French cities and a Spanish mayor ordering the occupation of some supermarkets.

Three significant events over the next two weeks will reveal whether the markets were right to have been optimistic. First is the ECB meeting, where the bank will announce what measures, if any, it will take to stabilize fixed income markets. The market clearly expects the bank to step up and buy government bonds. When the bank’s head said early in the month that the ECB would do whatever it took, that’s what he was widely assumed to have meant. Even though the ECB has since walked back from that commitment, there remains an expectation that it will provide support. If this meeting falls short of that expectation, markets will certainly be affected.

Next, we have a decision by the German constitutional court that will define whether and how Germany can participate in the already planned European Stability Mechanism, a permanent financial bailout fund. If the court voids the plan—which is not expected—it is back to the drawing board, with very significant negative effects for the markets. If, as is more likely, the court allows the plan but tacks on additional conditions, it could vastly complicate the process.

Finally, the upcoming Dutch elections have a significant chance of changing the existing government. Again, this could force renegotiation of deals already made and set back any plans significantly.

Right now, markets appear to be operating on the perception that Europe largely has its problems under control. Anything that damages that perception, which any of the three events described above could easily do, will have a negative effect on financial markets. There is no reasonable way to determine the outcomes in advance, so we will just have to wait and see.

Problems in other parts of the world

China continued its slowdown, with reports of refused deliveries of commodities such as iron ore and growing stockpiles of unsold goods. The Chinese government was widely expected to announce stimulus measures, but as of month-end it had not done so. India also had problems, with a widespread power failure in its north and a weak monsoon, which may lead to food supply problems. Beyond the economic realm, potential conflicts in the South and East China seas made the news, with mounting tensions between China and multiple other countries, including Japan, Vietnam, and the Philippines, as well as diplomatic and sometimes military clashes. The possibility of an Israeli strike on Iran’s nuclear facilities also reemerged, raising the risk premium built into oil prices.

The U.S. as a safe haven

In contrast to other areas of the world, the U.S. market appeared to be better supported. Although mixed, the tone of the economic reports here was generally positive. Employment figures came in better than expected, at 163,000 jobs, up from 64,000 the previous month, and showed wide breadth in employment gains as well, with 90 percent of sectors creating jobs. Personal income came in strongly, which supported a strong retail sales report, the first in three months. Most important, the housing market continued its recovery, with indices showing strong gains and the Case-Shiller 20-City Home Price Index showing a positive year-over-year change for the first time in two years. Overall, the U.S. economy appears poised to continue on a growth path, albeit at a slow rate.

The reason for the slow rate is uncertainty, derived from the rest of the world but also and primarily from the deadlock in Washington, DC. The fiscal cliff—the pending mix of tax increases and spending cuts scheduled to take effect at year-end—is edging closer, while the political environment is getting tenser as elections approach. The debt ceiling face-off is also on the horizon and will most probably hit before the election. Finally, the selection of Paul Ryan as Mitt Romney’s running mate has sharpened the distinction between the two parties, enhancing the uncertainty about what the government will do after November 6.

Nonetheless, the strong fundamentals of the real economy, combined with the general political stability, have reaffirmed the U.S. as the safe haven, which has benefited all U.S. assets.

Hurricane season continues

Despite a quiet August, we are still in hurricane season. As market participants return from the beach and reengage with the markets, we can expect renewed volatility. Hurricane Spain in particular looks to be spinning up, followed close behind by others.

So, the U.S. means safety, even with our pending difficulties. Our real advantage is that our problems can be solved and that we still control our own destiny, a statement that many other countries cannot make. The base case now is for continued slow growth in the absence of external shocks, the most likely of which could come from Europe or China.

Our primary internal risk is governmental inaction, although it is worth noting that our potential risks have upside potential. For example, problems in China could lead to cheaper raw materials worldwide, including oil, and the fiscal cliff will certainly reduce the deficit significantly, even as it creates other problems.

In short, although we expect volatility to increase in the next month, the long-term picture is one of growth. When planning for the future, we will therefore build out portfolios to both ride out the short term and benefit from the longer term.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

Upcoming Appearances

Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®