The Standard & Poor’s 500 finished the quarter with a modestly positive return of 1.1%, ending just 39 points below its all-time high set on September 18. This is the seventh straight quarterly gain for the index, the longest since the 14-quarter bull run that ended in 1998. Even though the S&P 500 managed to post another quarterly gain, investors were reminded of the volatility inherent in owning stocks. We experienced a sell-off in July, a recovery in August, and more selling later in September. Small company stocks, measured by the Russell 2000, tend to be more volatile than large stocks and this quarter was no exception. Small stocks did not fare as well as large stocks, declining 8.8% from the index’s record high reached on July 3. Both small and small value stocks ended the quarter with negative year-to-date returns.
Developed-economy foreign stocks, measured by the MSCI EAFE, also declined during the quarter due to slowing economic growth and a surging U.S. dollar. Most notably, the Eurozone continues to struggle. German gross domestic product (GDP) is all but flat, the French economy is stagnant, and Italy entered its third recession in six years. August Eurozone inflation was measured at a meager 0.4%, largely due to declines in energy and food prices. While most of us would cheer declining prices for everyday staples, this is a less-than-encouraging sign of fragile economic conditions and lackluster demand in Europe and many other parts of the world. The European Central Bank has promised to keep interest rates low until inflation nears its target of 2%. With a long way to go, accommodative monetary policy is expected for the foreseeable future. The slow growth conundrum lingers in Japan, as well.
Emerging markets provided a mixed bag of worries, from pro-democracy protests in Hong Kong to a continuing crisis between Russia and Ukraine. Even though foreign stocks have more attractive valuations when compared to the U.S. markets, investors fled to the relative safety of U.S. assets.
Bonds rose modestly during the quarter as the yield curve flattened. Investors paid careful attention to the Federal Reserve’s messaging about tapering and upcoming rate increases. Municipal bonds did better than taxable bonds as fewer tax-exempt issues came to market, constraining supply. Bond markets also made headlines late in the quarter as Bill Gross, the founder of PIMCO, left the firm to manage a bond fund at Janus. Bond market dislocations were predicted as a result of his unexpected departure.
The U.S. dollar was among the world’s best performing currencies during the third quarter, gaining 7% against the euro and 8% against the Japanese yen. In the past, a strong currency was a sign of economic might and global leadership. Ironically, it has been many years since any political leader spoke about achieving and maintaining a strong local currency. Since the financial crisis, governments have been more interested in pursuing a policy of relative currency devaluation.
In the third quarter, economic and political turmoil worsened around the globe. Even though the U.S. has had an uneven recovery since the financial crisis, we have been somewhat insulated – both economically and geographically – from many of these conflicts. There are reasons to be cautiously optimistic about the U.S. economy. Employment is steadily improving, even though we have many long- term unemployed and a low labor participation rate. Corporate operating earnings continue to rise. On average, GDP has continued on a path of slow but steady growth.
A rising dollar has implications. Relative currency valuations are a mechanism that can shift fortunes among economies over time. On the plus side, U.S. consumers can buy imported goods that are less expensive because of the relative strength of the dollar. We can travel overseas on the cheap because the dollar buys more goods abroad. At the same time, U.S. goods become more expensive to consumers overseas, who may decide to buy a new cell phone from Samsung instead of Apple. Some may forego a trip to the U.S. because it is just too expensive. This type of consumer behavior reduces the competitiveness of U.S. corporations on a global scale and, in theory, earnings decline as a result. To complete the cycle, as corporate earnings decline, stock prices would be expected to follow and the vibrancy of the U.S. economy could also slow. Eventually, a new currency appreciates relative to the dollar.
Relative currency valuations can also impact rates of inflation. Even though U.S. consumers enjoy inexpensive foreign-produced goods, declining prices on imports can contribute to disinflation. At the same time, European consumers who buy U.S. goods import inflation as they pay more euros to buy dollar-denominated goods. With a recent inflation measure of 0.4%, this is not a current worry for the European Central Bank; however, for a country like India that has struggled to contain inflation, importing goods denominated in highly-valued U.S dollars contributes to rising prices.
A strong U.S. dollar has implications for investing, too. Most directly, foreign bonds provide exposure to a large group of foreign issuers and are a tool to diversify among currencies, protecting an investor from a declining U.S. dollar. For our clients who own foreign bonds, we have hedged most of the foreign currency exposure while still diversifying among the foreign issuers. The foreign stocks our clients own are always denominated in the companies’ local currencies. For example, if investors own Samsung stock, they have exposure to the profitability of the company’s operations and the Korean won. If the dollar appreciates relative to the won, the currency component of return from the investment is negative. Because of this extra volatility, we carefully consider and control the foreign stock exposure in our clients’ portfolios.
While a rising dollar can be considered a vote of confidence in the U.S. economy, it can act as a headwind to U.S. economic growth if it appreciates too much. To date, U.S. policymakers have had little to say about the appreciating dollar. Expect this to change if the dollar continues its recent ascent.
Written by Colleen S. Supran, CFA, Principal; [email protected]
|Index||Market||Last 3 Months (7/1/2014 – 6/30/14)||Year-to-Date as of 09/30/14|
|Standard & Poor’s 500||Large Co. U.S. Stocks||1.13%||8.34%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||-0.19%||8.07%|
|Russell 2000||Small Co. U.S. Stocks||-7.36%||-4.41%|
|Russell 2000 Value||Small Co. Value U.S. Stocks||-8.57%||-4.74%|
|FTSE NAREIT Equity||Real Estate Investment Trusts||-2.48%||13.37%|
|NASDAQ 100||Technology Stocks||5.19%||12.74%|
|MSCI EAFE1||Foreign Stocks||-5.87%||-1.38%|
|Barclays Aggregate||U.S. Dollar Bonds||0.17%||4.10%|
|Barclays Municipal||Municipal Bonds||1.49%||7.58%|
|BofA Merrill Global||Global Bonds||-3.26%||1.15%|
Key economic indicators compiled by Barbara A. Ziontz, CFP®, Portfolio Manager; [email protected] Data Sources: The Wall Street Journal; U.S. Dept. of Commerce – Bureau of Economic Analysis; U.S. Dept. of Labor; Bloomberg.com;
Live.Lehman.com; MSCI.com; REIT.com; NYTimes.com; StandardandPoors.com; Vanguard.com; Dimensional Fund Advisors
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