WILLIAM RIEGEL, CHIEF INVESTMENT OFFICER
July 31, 2015
U.S. stocks started to display the volatility that usually precedes the first interest-rate hike in a Fed tightening cycle. After falling on July 27, the S&P 500 Index meandered higher to return about 1.2% for the week through afternoon trading on July 31. Some better-than-expected corporate earnings releases underpinned the advance, as earnings from S&P 500 companies who have reported so far have topped estimates by more than 5%. Some solid economic reports also supported the market. Cyclical stocks, strong performers during economic upswings, have begun to outpace growth shares, which tend to lag as interest rates rise.
Chinese stocks suffered their sharpest one-day decline in eight years on July 27 and finished with their worst month since August 2009 even as Shanghai stepped up efforts to stem the decline in domestic share prices. While some have equated China’s equity weakness with a slowdown in its economy, we see signs of economic firming—a decidedly minority position—amid an uptick in positive data surprises.
In Europe, the STOXX 600 Index weathered the China-led sell-off to gain 0.4% for the week, boosted by a slew of acquisition announcements and encouraging company earnings results. The index also rose 4% in July, its best month since February.
Long-dated U.S. Treasuries traded within a narrow range for most of the week. On July 31, however, the yield on the bellwether 10-year note dropped to 2.21% after the government reported the smallest quarterly gain in wages (+0.2%) since 1982. This is a clear sign that the diminishing slack in labor markets has yet to build wage pressure.
Returns for most “spread” products (higher-yielding, non-U.S. Treasury securities) were modest for the week through July 30. Meanwhile, flows were negative for emerging-market debt along with investment-grade and high-yield bonds, which continue to feel the pain from commodity weakness.
Second-quarter GDP grew at a 2.3% annual pace, according to the government’s advance estimate—precisely in line with our forecast. Consumer and business spending were a bit soft, but exports perked up as expected, reflecting the end of the West Coast port shutdown. Additionally, first-quarter GDP was revised upward to 0.6% from a 0.2% contraction, as the government has taken steps to refine seasonal adjustments for some components of GDP. Other releases were mixed but leaned positive, including:
Although the second-quarter GDP report was solid, the lack of consumer and business spending growth revealed some weakness. That said, with the upward revision to first-quarter growth, the U.S. economy is on slightly stronger footing and poised to accelerate modestly in the second half of the year. This suggests steady momentum that brings us closer to a Fed rate hike.
In terms of the Fed, we still believe that the odds favor a December rate “liftoff.” A comparison of June’s and July’s policy statements shows that the Fed’s overall view of the economy hasn’t changed, which we believe is a sign that the central bank isn’t ready to pull the trigger. Moreover, the Fed failed to suggest that a change of policy is in the works. Given the Fed’s desire for transparency in order to avoid surprising markets, we would expect Chair Yellen to clearly signal an intention to raise rates before actually doing so.
Beneath the S&P 500’s move toward recent highs is a sharp rotation across sectors and individual equities. A majority of stocks have fallen more than 10% from their recent peaks, and as of mid-week, only 36% of the index was above its 200-day moving average. This occurred last in October 2014, just prior to a sharp market rally.
Continued negative investor sentiment, a contrarian indicator that often precedes rising stock prices, also supports our view that stocks could move higher through year-end. While a correction of 5% to 10% is still possible, we may instead see wide price swings, as past Fed tightening has introduced heightened volatility. In fixed-income markets, credit-sector spreads may widen further until the first rate hike occurs.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc. is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). Past performance is no guarantee of future results.
Foreign stock market returns are stated in U.S. dollars unless noted otherwise.
Please note that equity and fixed income investing involve risk.
© 2015 Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY 10017