Investor Discussions - Q2|2016 Commentary
Wealth & Pension Services Group
William Kring, CFP, AIF - Chief Investment Officer
Matt B. Bailey, CFA, CMT - Senior Portfolio Manager
- Global growth remains intact but faces headwinds
- Stocks are attractive; however, caution is warranted as most indexes have not made new highs in 1-2 years
- Interest rates continue to fall and run the risk of remaining depressed over the coming years
- Commodities remain bifurcated although opportunities are arising
Since our last update, a lot has happened but not much has changed. Volatility remains elevated, a number of economic, corporate and political issues endure, and investors remain confused and skeptical of the future.
The legendary economist John Maynard Keynes was once quoted as saying, “The market can stay irrational longer than you can stay solvent.” This timeless quote has felt relevant over the last few quarters. During the second quarter, global stocks were generally flat, interest rates fell further, commodities rallied, and economic growth muddled along.
Looking forward, investors must remain patient and cautious during this tumultuous time; however, investment opportunities exist and should be viewed through a long-term lens.
The U.S. economy stayed true to its current trend and grew at an annualized rate of 1.1% during Q1 (GDP figures are released with a one quarter lag in order to gather all the data). In line with recent years, economists overestimated the perceived strength of the economy and were forced to cut their forecasts. This has become commonplace across the globe as estimates have continuously been revised down (see Chart 1).
What’s causing the revisions and or lack of growth? Many reasons have been given but one factor seems to remain consistent: weak household spending (Chart 2). As illustrated on the chart, households within developed markets (U.S., Europe, Japan, etc.) have cut their spending and paid down debt since the Financial Crisis in 2008/09. This deleveraging limits the economy’s upside growth potential as consumers make up roughly 2/3’s of the U.S. economy. It also perplexes economists who have expected increased spending as energy prices have fallen and wages have ticked up. On a side note, corporations have also kept their borrowing below the previous peak levels and are once again starting to reduce their debt.
“Generally speaking, the U.S. economy is healthy and the risk of a recession in the next 12-months is low.”
Generally speaking, the U.S. economy is healthy and the risk of a recession in the next 12-months is low. Unemployment is at 4.9%, interest rates are at historical lows, and wages appear to be trending higher. In addition, the housing market remains strong and is well below the frothy levels seen a decade ago. Finally, the Federal Reserve remains committed to maintaining a monetary policy that is supportive of growth as near-term rate increases seem unlikely. All of this points toward the status quo of continued slow growth into the future.
Looking abroad, the global economy continues to be split between slow growth in the developed areas (e.g. Europe, Japan, etc.) and slowing growth in emerging countries (e.g. Brazil, China, etc.). Developed regions are in a similar situation to that of the U.S. as consumers and corporations have remained cautious and reduced their balance sheets over the last few years. This has led central banks in many of these areas to utilize extreme measures such as negative interest rates in an attempt to stimulate growth. Unfortunately, negative rates have only exacerbated the problem by creating anxiety that things aren’t getting better; this negative feedback loop has caused consumers to save more and corporations to spend less. In addition, the recent Brexit vote within the U.K. has led many economists to lower their growth estimates within the U.K. and Euro area. Nevertheless, the majority of these economies are intact and shouldn’t enter recession in the near term; furthermore, they all have the staunch support of their central banks.
The emerging markets (EM) may be one bright spot in the global economy. Over the last few years, EM economies have struggled with persistently low commodity prices, reduced foreign demand from developed markets, and weakening currencies. Even so, these headwinds may be abating as oil prices have risen, the U.S. dollar may be poised to weaken, and interest rates are likely to remain lower for longer. Additionally, many central banks within the emerging markets have room to cut rates in order to stimulate growth. Overall, the outlook for EM countries isn’t great but it may be getting better.
U.S. stocks didn’t accomplish a lot during the quarter but certainly covered a lot of ground. The S&P 500 index (large caps) came within a percent of its all-time highs and finished up 2.46%. The Russell 2000 index (small caps) slightly trailed its large cap counterpart finishing up 1.96%.
As we’ve previously noted, over the last few years, global stocks (with the exception of the S&P 500) have generally moved lower (see Chart 3) and no major global stock index has made new highs in the last 12-24 months - including the S&P 500. In addition, corporate earnings within the U.S. have been contracting and margins compressing. None of these characteristics are positive for stocks; however, all is not lost. Rising commodity prices, low inflation, and falling interest rates each have the potential to help buoy the markets. Looking ahead, earnings are expected to move higher in the coming quarters and might be the kickstart stocks need to move higher once again.
Overall, we remain long-term stock market bulls but maintain a cautious stance. Our investment process requires us to weigh potential outcomes and currently the good outweighs the bad for stocks. Going forward, we like dividend-focused companies and see value related sectors (i.e. energy) outperforming.
The international developed markets as represented by the MSCI EAFE index struggled during the quarter and finished down -1.46%. The outcome of the Brexit vote and uncertainty around the long-term implications of negative interest rates sent investors fleeing. Even so, many countries within the MSCI EAFE index appear attractive from a valuation standpoint and for that reason we have not given up on them. We currently maintain a modest allocation.
Emerging Market (EM) as represented by the MSCI EM index finished the quarter up a modest 0.66%. Even so, it appears that the emerging markets may finally be attracting long-term investor capital as low interest rates and a weaker U.S. dollar have benefited the index. Beyond these factors, attractive valuations and years of relative underperformance have investors wondering if the tide has finally turned. We think it has and plan to allocate capital accordingly in the coming months.
During the quarter, global interest rates continued their downward trajectory as central banks pushed rates lower and investors sought safety and income. The U.S. 10-year Treasury index (10-yr) finished at 1.49% and nearly made all-time lows during the quarter. The Barclays US Aggregate Bond Index ended up 2.21% while the riskier Barclays Corporate High Yield Bond Index finished 5.52% higher.
“Strong demand for U.S. bonds has the potential to continue driving yields lower”
As noted last quarter, strong demand for U.S. bonds has the potential to continue driving yields lower. According to J.P. Morgan, as of June 16th, nearly $8.6tr (yes trillion) of global bonds traded with negative interest rates (see Chart 4). This number has recently ballooned as central banks remain steadfast in their desire to use monetary policy in an attempt to stimulate growth. As international bond yields sink further, U.S. bonds become more attractive due to our yields being higher on a relative basis.
For now, this trend shows no sign of ending and points towards lower interest rates for the foreseeable future. This has led us to increase our high-quality bond allocation in order to receive more income. We remain skeptical of high yield due to its volatile nature and deteriorating corporate profits. However, we are actively considering EM debt as a way to increase income and benefit from the weakening U.S. dollar.
Commodities rallied during the quarter as the Bloomberg Commodity Index finished up 13.36%. Oil likely put in its bottom earlier this year and is poised to continue rising due to supply constraints linked to reduced output from the U.S. and unplanned disruptions abroad. Gold also performed well as investors sought safe haven assets to hedge against portfolio volatility; this comes after multiple down years by the metal. Looking ahead, commodities are likely to remain volatile but the worst may be over.
Having crossed the halfway point, we must now focus on the year-end and possible scenarios that will impact the markets, including: the U.S. Presidential election, Federal Reserve meetings, and numerous data releases. All of this is likely to create a volatile environment and will force investors to remain patient and committed to their long-term plan.
For now, we continue to take a guarded view on risk assets but recognize that opportunities exist. We have a favorable view of income-focused investments such as high-quality bonds and dividend-focused stocks. Within commodities, we think energy and precious metals have likely put in a bottom and may outperform. Finally, we remain focused on reducing volatility and protecting our clients from large drawdowns through active risk management and diversification.
As always, please feel free to contact us with any questions you may have.
William Kring, CFP®, AIF®
Chief Investment Officer
Matt B. Bailey, CFA®, CMT®
Senior Portfolio Manager
Source: Bloomberg.com, Morningstar, MSCI, Investing.com, Yahoo! Finance, Goldman Sachs, DoubleLine Capital, J.P. Morgan.