Investment Commentaries: Third Quarter 2016
Editor's Note: This publication is part of our quarterly commentary series. If you would like to be notified when we publish new commentaries or other articles click here to subscribe.
|Index Returns||3rd Quarter||Year to Date||Trailing 12 Months|
|S&P 500 US Large Cap Index||3.78%||7.74%||15.30%|
|MSCI All Country World Stock Index||5.10%||7.27%||12.45%|
|Barclays Capital Aggregate Bond Index||0.38%||5.71%||5.17%|
|US Core Consumer Price Index - (Inflation)||0.39%||1.04%||2.06%|
Market levels increased broadly during the 3rd quarter of 2016, with Non-US stocks leading the way after a tumultuous first half of the year. Heading into the 4th quarter we move closer to another election-day in the US, and with it the certainty of a new President. While there is certainty in a change, uncertainty remains regarding who the next President will be, as well as the makeup and resulting mood of the Congress they will be working with. We expect uncertainty resulting from elections and other on-going domestic and global issues to result in periods of heightened market volatility during the quarter. Given the current fundamental backdrop, we will continue to approach significant short-term changes in market levels opportunistically.
Measured by Real Gross Domestic Product, the US economy grew during the 2nd quarter of 2016 at rate of 4.3%  relative to the 1st quarter, and 1.3% relative to the 2nd quarter of 2015. Since then, indicators of economic productivity have primarily confirmed continuing growth. For example, data from August indicate strong growth in disposable income at the household level (2.4% annualized) along with growth in consumer spending and residential fixed investment (4.3% and 5.7%, respectively). Amidst the growth in consumer spending, rates of inflation remain reasonable by almost any measure (CPI: 2.3%, PCE:1.7%); an encouraging signal that continued spending growth will not be undermined by rising prices. The Unemployment Rate is currently at a level of 5%, accompanied by a continuation of the trends of declining initial jobless claims and increasing wages and salaries (-6.8% vs previous and 3.9% growth over last year, respectively).
While indicators demonstrate healthy growth for the most part, a few areas of concern have been building across both consumer and business segments. On the consumer side, light vehicle sales and consumer sentiment declined sharply in August (-3.8% and -2.3%, respectively), although both are notoriously volatile over shorter time periods. In the housing market, declines in building permits and new home prices have been offset to an extent by below-average housing inventory (months of inventory for both new and existing home were at 4.6 months in August), and mortgage rates remain low by historical standards, with the 30-year at 3.4%. In the business segment, total business sales are trending at low to no growth for the year, durable goods orders were down sharply in August (-4.7%), and corporate profits are still declining on a year-over-year basis but recovering on a quarter-by-quarter basis (-1.7% and 5.6%, respectively).
Globally, strengthening measures of economic growth and productivity indicate a positive outlook going forward. China’s GDP growth, which has been declining from over 20% to below 7% since 2011, has returned to above 7% so far in 2016. Strength in the Chinese economy is also extending to other Asian countries and Australia. We would expect growth in these economies to continue gaining momentum as long as China’s economy continues to benefit from the devaluation of its currency relative to the US Dollar. An additional tailwind is the low commodities prices, which translate into lower input costs and lower prices of manufactured goods. Both of these factors drive higher demand for Chinese goods relative to the rest of the world. This in turn bolsters economies of China’s major trading partners.
Europe continues to demonstrate signs of economic stabilization coming out of their sovereign credit crisis and more-recently the UK’s referendum-vote to exit the European Union. While growth in Eurozone economies continues at a crawl, the little growth they have delivered is more than markets expected, which has contributed to the outperformance of international stocks during the 3rd quarter.
Bond returns, both for the quarter and year-to-date lag stocks in aggregate but are in-line with historical averages. Corporate bonds (both investment-grade and high-yield) and long-dated Treasuries contributed most to overall returns for the asset class, as markets continue to adjust to the likelihood of rising short term rates, and heightened concern over credit risk receded as corporate profits showed improvement.
Anecdotally, we have observed a significant increase in concern amongst the ranks of professional commentators over the continued strength of bonds despite already-low yields/high-prices and the high likelihood of rising rates over the coming years. We are no more or less concerned than we have been already, but increasing attention could accelerate the investing public’s adjustment to the reality that continually chasing yields to levels below the rate of inflation will result in negative real returns and loss of purchasing power.
While much of the recent return in equity markets can be attributed to positive economic developments, investors should also be aware of the extent to which low interest rates and bond yields have pushed capital into dividend-paying stocks and other alternative sources of income. As an example, the Price to Earnings Ratio (PE) for the S&P 500 index is currently 19.6, but the PE for a subset of dividend paying stocks is significantly higher at 22.7. The difference would not be as concerning without also considering that the consensus analyst-forecast of next-twelve-month earnings growth for the S&P 500 is 6% compared to -5% for the dividend-paying subset.
These observations lead us to two conclusions:
- Investors have become more focused on dividends and interest alone than the underlying payer’s ability to continue generating sufficient cash flow; and
- Being selective in which dividend-paying stocks to hold should provide more consistent income with less interest rate sensitivity than blindly buying a basket of dividend-yielding stocks.
We employ a few methods of analysis to protect portfolios from the impacts of yield-at-any-cost behavior. We primarily focus on understanding the level, growth, and predictability of underlying companies’ Cash Flow, which should be the source of dividend payments for shareholders. Additionally, we review companies’ Shareholder Yield, rather than just the Dividend Yield. Shareholder yield combines not only dividends, but also the effects of net share repurchases/issuances. If a company’s dividend yield is higher than its shareholder yield, then shareholders can assume that some portion of their dividend was funded by the dilution of their ownership in the company through the issuance of additional shares to the market.
The majority of our clients’ portfolios are diversified across multiple asset classes according to their risk-tolerance and long-term objectives. Trading activity in those portfolios reflected the views we described above over the quarter as we routinely rotated out of selected Utilities, Telecom, and Real Estate Investment Trust holdings that began exhibiting deteriorating fundamentals or increased share issuance to fund dividend-maintenance, and into more attractive ones.
We also continued systematically rebalancing portfolios to maintain target allocations across asset classes and sub-categories. Rebalancing activity during the quarter resulted in partial sales in areas of the portfolio with strong short-term performance such as precious metals and emerging market stocks, and purchases in areas of the portfolio that had fallen below target allocations, such as international bonds and preferred stocks.
We look forward to discussing these and other recent changes within your portfolio, as well as portfolio positioning in general further when we next speak with you. We do not take lightly the trust you place in us as your advisors and look forward to meeting with you soon.
Matt A. Morley, CVA
Chief Investment Officer
- Changes in economic indicators are presented as annualized rates vs the same point last year, unless otherwise noted.