Central banks help fuel global stock-market breakouts

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Published November 19, 2013

| Covestor

After a volatile second quarter, the U.S. stock market reached a new all-time high in the third quarter. The S&P 500 Index (SPX) reached 1729 points on September 19. Although the index has since pulled back a bit, for the quarter, the index was up 5.2%. Since the beginning of the year, the index is up 19.8% (through 9/30).

International markets have started to show signs of recovery with the Eurozone officially pulling out of a 1-1/2 year-long recession. The Asian markets have also shown signs of strength. China has exhibited strong economic data in the last six months, while Japan, the world’s third-largest economy, is seeing recovery as well.

The Emerging Markets broke out of their downward trend with MSCI Emerging Market Index (EEM) up 5.9% for the quarter. Third quarter fixed income results were less volatile than in the preceding quarter. As of September 30, the 10-year Treasury yield stood at 2.64% (a 0.1% increase from 2nd quarter).

Decisions by the Federal Reserve have continued to contribute to market uncertainty. While the start of gradual tapering of the $85 billion-per-month bond-buying program was highly anticipated, the Fed’s decision to continue the programmed purchases surprised investors.

On the geopolitical front, neither the conflict in Syria nor the uncertain political situation in Egypt seemed to have much effect on the financial markets.

During September’s Federal Reserve Bank meeting, the Fed unexpectedly refrained from beginning its widely anticipated reductions in its $85 billion monthly bond-buying program.

They said they needed more evidence of lasting improvement in the economy and warned that an increase in interest rates could curb the expansion. The central bank left unchanged the outlook that its target interest rate will remain near zero “at least as long as” unemployment exceeds 6.5 percent and so long as the outlook for inflation is no higher than 2.5 percent.

Their announcement helped send the Standard & Poor’s 500 Stock Index to its record high, while Treasuries and gold also rallied.

At the same time, Fed officials reduced their forecasts for economic growth for 2013 and 2014. U.S. gross domestic product has been forecast to increase 2 to 2.3% this year, down from a June projection of 2.3 to 2.6% growth. In fact, analysts suggest that growth so far this year has only been about 1.7%.

U.S. companies created 169,000 jobs in August. This is fewer than economists projected. Job numbers from the prior two months were also revised downward. While the unemployment rate declined to 7.3%, it is believed this reflects the impact of discouraged workers leaving the labor force rather than a real improvement in unemployment.

July and August were the year’s weakest back-to-back months for employment/payroll gains. Faster employment gains may be needed to spur consumer spending (which accounts for 70 percent of the U.S. economy).

An improving housing market helps bolster both consumer confidence and net worth. Housing starts this quarter rose 0.9% to an annual rate of 891,000 new homes—slightly below estimates. Permits for new homes were also below forecast.

Despite lower-than-expected housing numbers, homebuilding and manufacturing remain bright spots for the economy. U.S. consumer sentiment slid in September to its lowest level in five months, as consumers appeared concerned about higher interest rates and the continued sluggishness of the economy.

Some Federal Reserve policy makers are citing the lowest inflation rate in at least five decades as a potential concern for the economy. While these analysts may be concerned about the possibility of deflation, low inflation typically creates a stable environment that supports growing corporate profits.

This, in turn, often leads to a rising stock market. Over the last 12 months, the Consumer Price Index rose a very low 1.0%, compared to an average of 4.1% over the last 50 years–this year it may not rebound as quickly as hoped.

Unlike the recent past, the Chinese government appears to be reluctant to implement strong stimulus policies for fear they might create longer-term problems.

The stunning stock rally of 2013 continued its torrid pace during the 3rd quarter with both the Standard & Poor’s 500 and Dow Industrials achieving new all- time highs on September 19th (they did fall back a bit afterward). The S&P 500 rose 5.2% in the quarter. Its renewed rise followed the Federal Reserve’s surprise announcement that it will continue its market-friendly bond-buying program.

The S&P 500 index has now risen more than 174% from its March 2009 lows (including dividends) and at the end of the quarter was 22.6% above its prior peak on October 9, 2007.

The U.S. Dollar continued to weaken throughout the much of the third quarter, trading at near to its lowest level since February. The MSCI EAFE index, the most widely-used international index, gained 7.5% in local currency, which U.S. investors saw boosted by another 4.1% thanks to the falling dollar. Japanese markets rose 5.4% for local investors, but 6.7% in dollar terms. In dollar terms, year-to-date, the MSCI EAFE index is up 16.6% vs. 19.8% for S&P 500.

As is usual, the state of the world’s economies varied this quarter. The Eurozone appears to have emerged from its recession after a record 18 months of economic contraction. The bloc’s GDP grew by 0.3% in the second quarter of 2013, slightly ahead of forecasts.

While the global economy shows signs of revival, the emerging markets’ dependence on global commodity prices continued to negatively impact their economic growth. Year-to-date returns for China and Russia are largely flat, with Brazil and India down 10.9% and 12.8% respectively.

After a difficult second quarter, the fixed income sector, as measured by the Barclays Aggregate Bond Index, finished the 3rd quarter with a modest gain of 0.6%. Bond values fall when interest rates rise.

With the Fed announcing it will continue to hold rates low, fears of rising rates declined and bond prices stabilized during the quarter. As of September 30th, the 10-year Treasury yield stood at 2.64% (an 0.1% increase from last quarter). With the core CPI inflation rate currently at 1.8%, the “real” inflation-adjusted returns of the 10-year Treasury note stands at 0.84%, well below the 2.5% historical real returns of the last 50 years.

Emerging market debt posted a modest gain during the last quarter. Dollar-denominated emerging market bonds gained 0.51% for the quarter but have declined by 8.9% year-to-date.

The Alerian Master Limited Partnership Infrastructure Index, which tracks energy transportation and storage facilities, gained 0.4% during the third quarter and has risen 24.9% year to date.

US equity markets have experienced double digit returns this year. With three more months remaining until the year-end, the question is whether these gains will hold.

While the economy is still vulnerable to various economic factors, we’ve seen employment numbers improving, the housing market recovering to the pre- crisis levels and consumers are gradually shaking off the last signs of the economic downturn.

Fed policy is unquestionably playing a big role in this recovery by keeping the interest rates at historic lows and providing liquidity to the financial markets.

Some analysts could say that the bull has run its course and higher volatility is around the corner. However, so far, the reaction to such negative news as Federal government shut down and uncertainty with the next Fed chairman policy has not caused major reactions from the investors.

Disclaimer:  Any index comparisons provided in the article are for informational purposes only and should not be used as the basis for making an investment decision. There are significant differences between client accounts and the indices referenced including, but not limited to, risk profile, liquidity, volatility and asset composition. The S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry, among other factors. Past performance is no guarantee of future results.

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