No Solace in Small Caps
Recent US economic data—including the ISM non-manufacturing survey and the July non-farm payroll report—have provided more evidence that the economy in the second half of the year should show an improvement over what we saw in the first half. As such, there’s a growing perception that the economy is strong enough for the Federal Reserve (the Fed) to begin removing the ultra-accommodating conditions that have defined US monetary policy since 2008, and many market watchers expect the Fed to start raising interest rates this fall.
Market Realist – Signs that the US economy is improving: improving labor market, robust services growth.
The graph above shows the monthly changes in the non-farm payrolls, submitted by the US Bureau of Labor Statistics every month in its labor report. The economy has been producing more than 200,000 non-farm jobs consistently over the last year and a half.
The US economy added ~215,000 jobs in July, compared to ~260,000 in April and ~231,000 jobs in June. Although the number is dipping, it is still above the 200,000 mark, which is usually seen during economic booms. However, wage growth remains anemic.
The service sector
Also, the service sector has been performing very well. The ISM (Institute for Supply Management) noted that its service sector index rose to 60.3, which is the highest reading since August 2005. This signals confidence in the service sector, which makes up roughly two-thirds of the country’s economic activities.
The strength in the labor market and the service sector could nudge the Fed to hike rates. As the rates normalize, small caps (IWM) are likely to give you subdued returns going forward. Meanwhile, the convergence in monetary policy could ensure that the dollar (UUP) would remain strong.
Although the Fed is likely to hike interest rates soon, European (EZU) and Japanese stocks (EWJ) are likely to be supported by monetary accommodation in their relative economies. Funds tend to flow where interest rates are higher—in this case, the US—making the dollar stronger. A stronger dollar could continue to erode large-cap (OEF) earnings.
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