A Closer Look
What a difference a month makes. In June, when the U.K. voted to leave the European Union (a decision popularly known as "Brexit"), equity markets fell sharply around the world. July, however, saw stocks surge - both domestically and abroad. This was especially true in the U.S., where the S&P 500 posted a series of record-high closes before ending the month up more than 3½%. U.S. bonds also gained, as fixed income investors continued to weigh concerns about investment principal against the need for income in an ultra-low yield environment.
Mixed signals on the economy: These days, it's easy to feel a bit dazed about the state of the U.S. economy. Different data points seem to tell conflicting stories. For instance, the June employment report showed that U.S. employers added jobs at a rapid pace. Total nonfarm payrolls increased by 287,000 in June (significantly higher than expected), and average hourly earnings rose 2.6% from a year earlier. At the same time, though, the first estimate of second-quarter gross domestic product came in at only 1.2%, much lower than forecast. Putting it all together, it seems that the U.S. economy continues to grow, but only at a modest pace.
Plus, mixed signals on interest rates: The U.S. Federal Reserve chose to keep interest rates unchanged at its July meeting. While doing so, however, the Fed indicated that "near-term risks have diminished," perhaps suggesting that the economy could withstand additional rate hikes. Whether the Fed would consider raising rates before the November presidential election is anyone's guess, though some have speculated that the timing makes a near-term move less likely. Fed chairwoman Janet Yellen has insisted that any rate hike will be "data-dependent" - that is, not influenced by political considerations.
July was a record breaker for U.S. stocks. The large-cap-oriented S&P 500 Index surged to an all-time high during the month, while small-caps posted even more impressive gains. What's most remarkable is that this upward move came in spite of a number of significant geopolitical concerns, including the ongoing effects of Brexit, and the recent unsuccessful coup attempt in Turkey.
Let's take a look at large-caps first. The S&P 500 rallied 3.69% for the month, and is now up 7.66% year to date. Why the move higher? It's hard to say for sure, but it could be that investors who had been sitting on the sidelines, holding out for a better entry point, have given up the wait, and are now powering in at higher levels. Another possibility is that, as interest rates continue to decrease, income-minded investors are accepting greater risk to meet their spending and planning goals.
Higher-risk assets, of course, include small-cap securities - and these were standout performers in July. The small-cap-oriented Russell 2000 Index soared 5.97% for the month, the biggest monthly advance of any major index we track. Year to date, the Russell 2000 is firmly in positive territory, now up 8.32%.
Turning to the sectors that make up the U.S. equity markets (based on the S&P 500 sector indexes), information technology (IT) was the best performer in July, followed by materials and health care. The IT sector may have been buoyed by strong earnings reports from Apple, Microsoft, and a number of other major tech companies. The month's weakest performers were energy, consumer staples, and utilities. On a year-to-date basis, telecom and utilities have been the strongest sectors (both up more than 20%), while financials, consumer discretionary, and health care stocks have lagged. All sectors, however, are in positive territory for the year so far.
According to the Russell 3000 Growth and Value Indexes, growth stocks were far and away the leaders in July - another sign that investors have been willing to take on greater risk. But year to date, the opposite has been true, with value stocks leading growth by more than three percentage points.
July's optimism wasn't limited to U.S. stocks. International equities also surged, shaking off concerns about Brexit and the situation in Turkey, as well as terrorist attacks in France and Germany. Developed and emerging markets performed roughly in line.
The MSCI EAFE Index, a widely followed measure of developed-market performance, leapt 5.07% in July. All regions of the index were higher, with the U.K. posting the smallest gain. This may be due to ongoing concerns over the significance of Brexit for the British economy. Year to date, the MSCI EAFE Index is now barely in positive territory, up 0.42%.
Emerging markets continued to show strength in July, with the MSCI Emerging Markets Index finishing the month 5.03% higher. The index was boosted by a rally in Latin America, as well as strength in Asia, perhaps influenced by a growing sense among investors that the Chinese economy may be stabilizing. On a year-to-date basis, emerging markets are on a tear, now up 11.77%. The biggest contributor year to date has been Latin America, which has rallied more than 30% on gains in the price of oil, political events, and other factors.
With equity markets advancing around the world, stock investors seem to have concluded that life after Brexit will be just fine. But what about bond investors? Are they telegraphing the same message?
Maybe not. In July, investors continued to be net buyers of long-term U.S. Treasuries, pressuring interest rates to new lows. This suggests that - in spite of the move toward riskier assets in stocks - many bond investors remain concerned, and are willing to accept very little income for the perceived safety that U.S. Treasuries provide. The Barclays U.S. Aggregate Index rose 0.63% in July, and is now up 5.98% for the year so far.
Taking a closer look at U.S. Treasuries, we find that the yield on the benchmark 10-year note fell three basis points in July, to 1.46%. (A basis point is one-hundredth of a percent.) In fact, twice during the month, the 10-year yield dropped to 1.37%, a historic low. What's more, the yield curve flattened in July, as rates were pressured lower at the long end.
Among the sectors that make up the U.S. fixed income market, high-yield bonds (also known as junk bonds) were the month's best performers, followed by long-term U.S. Treasuries and corporates. The weakest performer was short-term Treasuries. On a year-to-date basis, the story's a similar one: Long-term Treasuries and high-yield bonds have been the strongest, while T-bills and short-term Treasuries have lagged.
The Bottom Line
The environment for fixed income investors remains challenging. Yields are meager, motivating income-hungry investors to consider taking on more risk by buying lower-quality bonds, or even look to equities for income or appreciation. This may, in fact, have contributed to the recent surge in stocks, at home and abroad.
Bond investors feeling confused about these issues may not be alone. Buying U.S. Treasuries may entail taking on interest-rate risk - the possibility that the value of the investment will decline if yields rise. Buying high-yield bonds or dividend-paying stocks may subject investors to unpleasant surprises if the companies or credit issuers struggle.
So what should a bond investor do? Of course, there's no easy answer. In general, the best prescription, we believe, is to pursue a path of moderation, investing in a well-diversified portfolio aligned with one's goals, time horizon, and risk tolerance. Investors concerned about the fixed income portion of their portfolios may want to consider overweighting shorter-term securities (either government or often higher-yielding corporates), which are somewhat less vulnerable to interest-rate risk. Those who choose to reach for yield by adding greater credit risk should do so judiciously, perhaps only as a small component of a fully balanced bond portfolio.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.