WILLIAM RIEGEL, CHIEF INVESTMENT OFFICER, TIAA-CREF ASSET MANAGEMENT
August 29, 2014
U.S. equities gained in a quiet trading week ahead of Labor Day weekend. On August 26, the S&P 500 Index closed above the 2,000 threshold for the first time but retreated two days later amid escalating geopolitical fears related to the Russia-Ukraine conflict.
Small-cap stocks continued their recovery and were poised to outpace both large caps and the broader S&P 500 for the month. Similarly, growth-oriented sectors, including Internet and biotech stocks, have rebounded from their spring selloff. Cyclical, or economically sensitive, stocks traded in a narrow range during the week as investors avoided categories perceived to be more vulnerable to the Federal Reserve’s first interest-rate hike, now expected in June 2015.
Outside of the U.S., Japanese equities posted a loss for the week amid weak consumer spending and factory production data. European stocks, which had rallied impressively in the wake of European Central Bank (ECB) President Mario Draghi’s “dovish” Jackson Hole speech on August 22, reversed course late in the week on Ukraine worries.
European sovereign debt markets continued to rally, with German and other government bond yields reaching new record lows. (Yields and prices move in opposite directions.) Weak economic data and anticipation of more aggressive ECB action to avert deflation helped push yields downward.
Yields on longer-term Treasuries declined, in sympathy with European debt. Most “spread” products (higher-yielding, non-Treasury fixed-income securities) also generated positive results. Investor demand for yield boosted returns for investment-grade and high-yield corporate bonds, commercial mortgage-backed securities, and emerging-markets debt.
The Bureau of Economic Analysis raised its estimate of second-quarter GDP growth, from 4.0% to 4.2%, driven largely by stronger business investment and capital expenditures. Higher consumer spending, however, failed to materialize in the second quarter and in July.
With eurozone inflation weaker in August, the prospect of ECB intervention has grown more likely. While pressure mounts on Mario Draghi to act sooner rather than later, we do not anticipate a dramatic policy announcement in September. By year’s end, however, we would not be surprised to see some form of quantitative easing, most likely via ECB purchases of asset-backed securities.
The absence of increased consumer spending in the revised second-quarter GDP estimate and at the beginning of the third quarter is surprising. It remains to be seen whether continued healthy jobs growth and rising consumer optimism will translate into stronger consumer demand. For now, our forecasts remain unchanged.
Assuming no broadening of the Ukraine conflict, we believe the S&P 500 still has room to rise. That said, further gains may be limited given how far the index has already advanced. Moreover, contrarian indicators of market sentiment warrant caution. Hedge funds, for example, have raised their net exposures to equities from low to neutral levels. Although not yet in the danger zone of enthusiasm that often presages a market downturn, this elevated sentiment makes us more wary of a correction.
In our view, an eventual correction of up to 10% is to be expected but might not occur until after the S&P 500 reaches higher intermediate target levels. One likely trigger for a correction would be the formal end of Fed tapering in October, usually the most volatile month of the year. We would consider such a correction a buying opportunity.
Foreign equity markets may have even more upside potential than the U.S. European equities, for example, appear poised to continue their rally, assuming that Russian sanctions do not overwhelm positive factors such as the potential for ECB quantitative easing, a depreciating euro, lower corporate borrowing costs, and a possible move toward economic reforms in France. In Japan, the Nikkei index has stalled but could resume its advance on the back of additional monetary stimulus from the Bank of Japan and a continuation of positive earnings revisions.
In fixed-income markets, the dominant theme remains the ongoing decline in government bond yields in the U.S. and in Europe. The differential in yields between German bonds and U.S. Treasuries has reached levels not seen in 30 or more years. The magnitude of this trend may be overdone, particularly since there is no guarantee the ECB will implement new stimulus in September. What is increasingly apparent is that the 10-year Treasury yield is unlikely to breach 3% by year-end, even with continued U.S. economic improvement. Additionally, the dollar should strengthen further against the euro, as the U.S. is likely to experience rising interest rates much sooner than Europe. A stronger dollar would help boost Europe’s economy modestly while having little negative impact on U.S. growth.
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.