July started on a strong note. The US stock market pushed to new highs in the early days of the month, and then pulled back slightly as world events weighed on investors’ minds in the following weeks. US markets saw a nice recovery coming into the final week of the month, but renewed tensions with Russia squelched any momentum and US stocks finished the month in negative territory.
The conflict in Ukraine continues to concern investors. While that situation seemed to quiet down during the spring, fighting intensified in July. The crisis grabbed headlines again, when a passenger jet was shot down by separatists in eastern Ukraine. Commercial flights were rerouted to avoid entering Ukrainian airspace and both sides scrambled to blame each other for the tragedy. The ensuing finger-pointing between Ukraine, Russia, and western nations only added to the confusion and unsettled European markets. By the end of the month, Russian troops were massed along the Ukrainian border and western nations approved another round of economic sanctions to pressure Russia into aiding the stalled diplomatic process.
Meanwhile in the Middle East, the simmering conflict between Israel and Palestine came to a boil in Gaza, and the conflict in Syria spread deep into Iraq. In Gaza, fighting escalated quickly and, for a time, halted western flights to Israel’s major airport at Tel Aviv. While the fear in Israel is that this could be a prolonged war, the fear in Iraq is that their government could be overthrown by the end of the summer. Militants swept in from Syria and seemed to brush aside the Iraqi military. Government officials are now requesting western military assistance, but the US and the EU are reluctant to reenter the fray.
The markets’ responses to these conflicts reflect general concern for the global economy, rather than specific fears. None of these regions is an economic center. In each case, specific sectors (e.g. energy) responded, but the broader economic impact should remain limited as long as western nations avoid direct involvement.
The more fundamental risk to world markets came out of Portugal. Banco Espirito Santo (BES), Portugal’s largest lender, saw its shares suspended from trading for a short time due to concerns that it was insolvent. Those concerns proved justified and the Portuguese central bank was forced to bail out the bank to prevent a default. As of the end of the month, the courts were still determining whether this action was a “bankruptcy action” that would trigger the insurance provisions on some of BES’s more complex products.
The concern with BES is that it is indicative of the types of risks that still lurk in the European financial system. Technically, the rescue of Portugal’s financial system concluded this spring, when aid from the EU and the International Monetary Fund ended. Investors are right to be concerned by the fact that an event of this magnitude could occur so soon afterwards.
After investors seemed largely optimistic through the frigid winter and lackluster spring, they finally started to move toward lower-risk investments or cash. August and September will determine whether these moves are just small movements to adjust for the increased risks or larger shifts in investing strategy.
In July, investors were clearly looking to control the risk in their portfolios. Across the major asset classes, those with higher risk usually suffered more than those with lower risk. US equities dominated last year but are continuing to fall behind in 2014. This is not surprising and a strong reminder of the need for broad-based diversification.
Both US and foreign stocks declined during July and those returns were led by small cap stocks, which represent some of the highest risk companies traded on the market. During periods of economic expansion, they use low interest rates to finance their rapids growth, and they are also more agile than larger companies. These characteristics make them very attractive to investors looking to benefit from an optimistic stock market, but investors must remember that their reliance on borrowing makes them more susceptible to economic downturns.
Foreign stocks also saw declines. In light of the renewed concern for the European banking system, it is not surprising the stocks declined in developed nations. Until investors can have confidence that the banking system can facilitate lending safely, it will be difficult for foreign stocks to find their footing. Emerging markets did comparably well, and were one of the only positive performing equity markets in July. This may come as a surprise in a month when investors sought to limit their risk exposure, and it indicates that investors still see significant potential in those markets. After last year’s dismal performance, many investors chose to stay clear of the emerging markets and did not benefit from their strong performance.
Relative to stocks, US bonds held better value during July. Treasuries and TIPs held up especially well in a difficult month. On the other hand, high-yield bonds saw a slight decline as investors preferred lower risk bonds. Relative to the US, foreign bonds suffered more, due to the concerns about European bank health. Emerging market bonds avoided this pull-back and, like emerging market stocks, experienced small increases in values.
Although traditional assets (i.e. stocks and bonds) were quite weak, alternatives were surprisingly disappointing. When investors are frightened, commodities and precious metals usually get a boost. This month, it seems that investors were not acting out of fear, but merely trying to adjust the risk in their portfolios. As a result, they elected to move their money to low-risk bonds or cash, rather than turn to more pessimistic safe havens. For the first time this year, hybrids were lackluster. Investors clearly preferred the relative safety of bonds and were less concerned about foregoing the growth potential of the stock markets. As a result, hybrids saw modest declines in values during July. However, hybrids remain the best-performing asset class for the year.
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