Robert C. Doll, CFA
Chief Equity Strategist,
Senior Portfolio Manager
Nuveen Asset Management, LLC

Weekly Investment Commentary

Tug of War Continues Between Fundamentals and Geopolitics


August 18, 2014
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Key Points

  • Important progress in the global recovery, U.S. labor market and corporate earnings has been masked by geopolitical tensions.
  • The conflict involving Russia could have a significant impact on the eurozone and global growth.
  • Market volatility is likely to increase in the short term, causing headwinds for risk assets.


U.S. equities finished higher last week with the S&P 500 increasing 1.3%.1 A relatively steady tone continued in spite of the weakness in global economic data. Fed dynamics were viewed as somewhat supportive. The geopolitical backdrop seemed more favorable for global risk appetite, however, renewed volatility surrounding the crisis in Ukraine reversed an early rally on Friday, fueling a bond rally. Health care and technology were among the best performers. Energy was the only sector to finish negative, as oil fell for a fourth straight week.1

 

Favorable Environment Offset by Areas of Caution

The overall environment is largely represented by strengthening global economic growth, improving corporate earnings and profits, as well as relatively reasonable equity valuations. Federal Reserve (Fed) officials have recently become concerned about pockets of illiquidity in the repurchase agreement (repo) market. Repos are equivalent to the plumbing of the global financial system, and holders of government securities use repos as a source of overnight borrowing. Liquidity questions are a headwind for the Fed, and possible turbulence could result once the fed funds rate moves beyond 0%.

The turmoil involving Russia and escalating sanctions are weighing on the eurozone economy, placing global growth at risk. Eurozone business confidence has declined, which to us indicates early signs of a slowdown. Japan reported extremely weak GDP data, signaling a slide back into recession.2 Other countries in recession include Italy, Portugal, Russia and Ukraine. Countries at risk are France, Brazil, much of Latin America and potentially Germany.

 

Weekly Top Themes

  1. Industrial production increased in July, exceeding expectations. Production increased 0.4% and manufacturing output expanded 1.0% for the month.3
  2. Initial unemployment claims increased. Weekly claims rose by 21,000, which was a disappointment compared to expectations.4
  3. Wage growth typically accelerates in the second half of a business cycle. U.S. wage growth appears to have developed momentum, indicating tighter monetary policy should be on the way.
  4. The large budget deficit reductions in recent years are starting to slow. This is occurring as the Fed is exiting its asset purchase program.
  5. The equity market continues to emphasize stock selection as not all stocks are rising together. Technology holds the leadership position.
 

Risk Assets Prepare for a Bumpy Ride

Equities have cooled off after a strong spring rally. The strengthening labor market has reintroduced an element of monetary policy uncertainty, despite the Fed’s plans to keep rates lower for longer. While interest rate hikes are not imminent, debate about the timing of the first move will probably intensify as the labor market expands. As a result, risk tolerance has waned somewhat, and high levels of leverage virtually assure increased volatility. So far, this has manifested itself in outflows in the high yield corporate market, pushing spreads wider. The U.S. dollar is under upward pressure due not only to heightened geopolitical risks and investor inflows resulting from perceived safe haven potential, but also from U.S. economic and interest rate expectations breaking out relative to the rest of the world.

U.S. equities were primarily driven by valuation expansion throughout 2012 and 2013. Now, profits are showing signs of renewed vigor, however, we expect additional stock market volatility over the next few months as the appetite for risk assets diminishes. Concerns have escalated that the eurozone could move back into recession because of uncertainty around the standoff with Russia and the potential for increased sanctions. Euro area equities led on the downside and the euro has weakened, although fortunately global contagion has not yet been meaningful.

 

1 Source: Morningstar Direct, as of 8/15/14.
2 Source: Bloomberg.
3 Source: Federal Reserve.
4 Source: U.S. Department of Labor.

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.



 

Last Week's Commentary

Correction Talk Heats Up, with Volatility Rising in Both Directions


August 11, 2014
 
 

Key Points

  • Volatility is rising, and fears of a sharp and sustained market setback are growing.
  • We do not expect this type of setback, but a modest near-term correction could be possible.
  • We would advise investors to ride out any volatility and consider adding to equity positions.


U.S. equity markets bounced around last week before finishing the week higher, with a rally on Friday carrying the S&P 500 Index to a weekly gain of 0.4%.1 Following a sharp downturn the prior week, volatility in both directions continued to rise compared to recent months.

 

Positives and Negatives Cause Markets to Fluctuate

Geopolitical tensions continued to unnerve investors, and while there is skepticism about how much these issues will affect the economy and markets, headline risks have been enough to cause both upward and downward volatility to climb. Additionally, negative news included downbeat merger and acquisition headlines given the collapse of some expected deals and rising concerns over potential tax reforms that could hurt overseas corporate earnings. These factors were balanced by some positives, which included improving labor market data, ongoing solid corporate earnings results and some easing of lending standards.

 

Weekly Top Themes

  1. Labor market data continue to be strong, which should help capital market sentiment. Unemployment claims fell by 14,000 last week, bringing the four-week moving average to its lowest reading since February 2006.2
  2. The lending environment is improving. The Federal Reserve released its third-quarter senior loans officer survey, which showed easing standards and rising demand for loans.3
  3. The private sector and investment spending are increasingly driving growth. Real U.S. gross domestic product growth has averaged just over 2% over the past three-and-a-half years, but during that same time, private sector GDP has grown by 3%, driven by capital expenditures and investment.4 We expect these factors will continue to be critical drivers of U.S. growth.
  4. Companies are continuing to put cash to work. We have witnessed a multi-year trend of dividend increases, share buy-backs, debt reduction and M&A activity. We are now also starting to see more capital spending and hiring.
  5. Tax reform of overseas earnings remains unlikely. Despite more noise from Washington regarding corporate inversions (the practice of companies incorporating overseas), we believe the odds are against any legislation that would affect this practice.
  6. Risks to eurozone growth remain high. Although the U.S. economy appears to be accelerating, eurozone growth remains troubled. Italy has slipped back into recession, manufacturing trends are weakening, and additional sanctions against Russia could negatively affect the region’s growth prospects.
  7. Additional quantitative easing in Europe would be a positive for risk assets. European Central Bank President Mario Draghi sounded quite dovish at his press conference last week, and we believe the odds of a large-scale QE program for Europe are increasing.
 

A Sharp and Sustained Market Downturn Seems Unlikely

Equity markets have followed an abnormally long upward path without a material setback, causing some to believe we are at the forefront of such an event. Corrections are a normal part of bull markets, and we may be due (or overdue) for one, but we do not believe this bull market is at an end. Bull markets typically end when central banks are trying to put the brakes on growth and are combatting inflation. Today, we are quite far away from such an environment. Global monetary policy is still accommodative and while some central banks may start tightening campaigns next year, it would likely be in response to improving growth rather than to rising inflation.

With global economic growth conditions strengthening, corporate earnings and profits improving, and equity valuations still reasonable on their own and attractive versus government bonds, we do not believe that the macro environment is consistent with a major correction. Yet, a mild, shorter-term correction could occur at any time, possibly driven by some combination of overbought conditions, a growth scare or a sudden backup in bond yields. Should a correction occur, we would advise long-term investors to ride out near-term volatility and use weakness to increase equity positions.

 

1 Source: Morningstar Direct, as of 8/8/14.
2 Source: U.S. Department of Labor.
3 Source: Federal Reserve.
4 Source: Bureau of Economic Analysis and Cornerstone Macro.

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.



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A Word on Risk
The views and opinions expressed are for informational and educational purposes only as of the date of writing and may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-investment-grade bonds involve heightened credit risk, liquidity risk, and potential for default. Foreign investing involves additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. Past performance is no guarantee of future results. Certain information contained herein is based upon third-party sources, which we believe to be reliable, but is not guaranteed for accuracy or completeness.

Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc.

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