Equities were mixed over the past month, with the Nasdaq leading the field with a 2.08 percent return, followed by the S&P 500’s gain of 1.33 percent. The Dow Jones Industrial Average fell 0.82 percent, while the Russell 2000 Index dipped 2.34 percent. These moves were insignificant compared to the volatility in the commodities market, where oil fell to its 2015 lows and threatened to break lower. Further pain was felt when China devalued the yuan and paved the way for even more devaluation over time.
China’s decision to weaken the currency is an admission that the yuan was overvalued versus the U.S. dollar. Relative to other currencies, the yuan has been rising since July because it is closely pegged to the U.S. dollar. The greenback has been in a bull market since July of last year, and the yuan piggybacked on that move. While the U.S. remains in an expansionary cycle, China has entered a contractionary one. This currency appreciation dealt a triple blow to China. Its exports became more expensive as the dollar rose against export competitors such as Europe, Japan and other emerging markets. Emerging markets were the main growth engine for exports, but many of those economies are resource dependent. The U.S. dollar rally accompanied a bear market in commodities, severely impacting economies such as Brazil. Finally, a slowdown in reserve growth led to a contractionary monetary policy in China.
Commodities sold off on the news of the devaluation, and the next shoe to drop may include other Asian currencies, most importantly the Japanese yen. West Texas Intermediate Crude oil fell to a new 52-week low, joining commodities such as copper and iron ore at multiyear lows. The euro rebounded on news of a new deal “in principle” for Greece. Details still need to be added, and the Greek parliament must approve the agreement.
While there was turmoil in the commodity and currency markets, domestic markets benefited by being a safe haven for investors. The 10-year Treasury yield edged down from 2.5 percent a month ago to 2.2 percent. If a move toward the U.S. dollar continues, the Federal Reserve will have room to hike short-term rates without worrying about a significant increase in long-term rates. In fact, a rate hike by the Federal Reserve in the current environment could exacerbate some of the weakness seen overseas and in commodities, pushing long-term yields lower even as short-term rates rise.
As for the U.S. economy, it remains on sound footing. Second-quarter GDP growth came in at 2.3 percent. The Atlanta Federal Reserve GDP Now model increased its GDP estimate throughout the quarter as stronger data was released. The trend points to a possible upward revision when the second estimate is released in late August. Unit labor costs increased 0.5 percent in the second quarter, down from a revised 2.3 percent in the first quarter, but up from forecasts of a 0.1 percent decline. The Federal Reserve is most concerned about labor costs, and the rise, while small, pushes the Fed closer to a rate hike. Along with rising labor costs, jobless claims hit a four-decade low in July, payrolls are steady and income growth is solid.
Amazon (AMZN), Google (GOOG) and Netflix (NFLX) were among the companies rewarded with double-digit gains following strong earnings reports, while Tesla (TLSA) and Keurig Green Mountain (GMCR) were hit with double-digit losses. The Dow Jones Industrial Average was a victim of these earnings-related stock losses. Caterpillar (CAT), Disney (DIS), Procter & Gamble (PG), Exxon (XOM), Chevron (CVX), United Technologies (UTX) and International Business Machines (IBM), as well as underperformance by Apple (AAPL) and DuPont (DD), weighed on the index. Disney also sparked concerns across the entire media industry as investors worried about how competition from Netflix, Amazon and other streaming services would impact its future growth outlook.
With nearly 450 companies in the S&P 500 having delivered second-quarter earnings, FactSet Research reports earnings have fallen 1.0 percent from a year ago, with nearly all of the decline due to the energy sector. Fifty-one percent of firms beat sales estimates, while 73 percent beat earnings estimates. The energy sector reported a 56.4 percent decline in earnings thus far, while industrials, which may be suffering partially from lower spending by energy companies, reported a decline of 4.8 percent. In contrast, the healthcare sector remains the market leader in terms of performance and earnings, reporting growth of 15.4 percent, more than double analyst estimates. Consumer discretionary, telecom and financials were the next three strongest sectors for earnings.
Strong earnings, solid economic growth and instability overseas are positive for U.S. asset markets. The main risk to equities over the coming month will be from commodities or currency markets. Many shale oil producers will face bankruptcy concerns if oil prices dip into the $30 range, due to large borrowings used to finance capital investments. A currency crisis in emerging markets is possible for similar reasons; many companies borrowed in U.S. dollars, expecting the currency to fall, but if the greenback surges to a new high, defaults could rise. The U.S. economy is insulated from emerging market currency troubles, but the financial markets are global. If investors start selling overseas, there is likely to be some spillover into the United States and other developed markets.