The third quarter of 2014 saw US equities take a small drop toward the end of July only to recover and hit record highs in Mid-September and then slide back to close lower than we ended up last quarter. The S&P 500 index reflects an 8.3% increase for the year so far. The Dow Jones Industrial Average did not do as well and is up only 4.6% year to date. Small company stocks as represented by the Russell 2000 are actually down 4.4% for the year. International equities as represented by the MSCI World Ex U.S. Index are down 0.7%. Fixed Income as represented by Barclays Aggregate Bond Index exceeded expectations and is up 4.1% year to date.
Despite some of the geopolitical concerns, U.S. Equities have managed to hit a record high level during the past quarter while supported by continued accommodative monetary policies. Most sectors of the U.S. economy continue to show some incremental improvements. Housing and employment however remain weak and have yet to fully recover to their pre-recession levels. Although the unemployment number reflects an improvement, it is important to note that workforce participation has decreased, thereby skewing the meaning of that number.
Despite the spike earlier this year, inflation numbers slowed this summer and reflect at below 2% on a year over year basis. Consumer confidence has returned to pre-recession levels and consumption activity has been positive. The consumer debt service ratio is at its lowest level in three decades under a backdrop of improving credit conditions which are conducive to continued economic expansion. In the corporate sector, fundamentals are strong with healthy balance sheets and profitability. Business capital expenditures are also showing improvements.
Overseas, we are looking at a very mixed picture. Growth in Europe has decelerated and is pointing toward stagnation as it is hampered by structural and geopolitical headwinds. The European Central Bank showed willingness to take additional steps to provide stimulus, particularly in light of the economic impact resulting from the Russian/Ukraine conflict and the sanctions imposed on Russia. The global outlook for the rest of the world is one of slow growth under a low inflation environment. The overall global trend however still remains upwards, albeit mildly.
On balance the economic and monetary environment remains supportive for stocks. The potential for an interest rate increase in 2015 is already being felt in the financial markets through a strengthening Dollar, higher real yields, declining commodity prices and increased volatility in the bond markets. A small increase in rates although not desirable for stocks, particularly for certain segments of the stock market would hopefully be offset by corresponding growth and other positives in the economy so as to not be too disruptive to the current bullish trend. There is certainly an increased level of risk at this juncture and with the volatility in equities actually lower, one might be concerned about a certain amount of complacency. One of the positives about a slower but sustained economic expansion amid a lower inflationary setting is that stock prices can continue to increase at a more measured pace for an extended period of time and that’s not so bad.
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