Investment Commentaries: Second Quarter 2016
|Index Returns||2nd Quarter||Year to Date||Trailing 12 Months|
|S&P 500 US Large Cap Index||2.45%||3.82%||3.97%|
|MSCI All Country World Stock Index||1.63%||2.06%||-2.93%|
|Barclays Capital Aggregate Bond Index||2.21%||5.30%||6.17%|
|US Core Consumer Price Index - (Inflation)||0.39%||1.04%||2.06%|
After a relatively calm few months, markets were shocked near the end of the 2nd quarter by the U.K.’s vote to exit the European Union on June 23rd. Investors reacted quickly by broadly selling equities and other relatively volatile securities. Domestic and international stocks declined by 5-10% within four days of the vote. Yet, over the next three days, stocks rallied 5-6%. No major equity market segment recovered fully from the shock, but stocks in aggregate did provide positive total returns (dividends and price appreciation) for the quarter.
Even though the market downturn was relatively shallow and short-lived, we continued to scour company and market data to find opportunities. As prices declined, we carefully re-deployed some of the cash we raised through late 2015 and the first half of 2016 into fundamentally-sound income-focused securities that had been hit particularly hard by the market downturn. We will continue to seek opportunities and maintain readiness to act on those opportunities when the fundamental health of the underlying investment meets our standards. That said, we expect markets to remain more volatile going forward, and we are becoming wary of the market’s ability to continue bouncing back so quickly given the macro-economic and fundamental backdrop; a view which we explain more fully below in the context of both equity and fixed income markets.
The time between the Brexit vote and quarter-end exemplifies broad market behavior for the last 13 months specifically, but also for the last three years in general: A financial or political shock induces investors to sell equities indiscriminately, causing markets to decline quickly and sharply. The sharp decline and the seemingly inevitable reminder from central banks around the world that they will supply endless liquidity to stabilize markets then prompts investors to adjust portfolios toward stocks as markets re-approach the pre-shock levels.
This “buy-the-dip” mentality is particularly interesting given the fact that, as of quarter-end, the S&P 500 index has not surpassed the high of 2,129 that it reached over a year ago on May 21, 2015 (see chart to the left). The fact that we and other market participants have become so acutely aware of this repeating pattern (shock-induced decline followed by a return to, but not over, previous levels) could be why this dip halted at -5.5% for US stocks, as compared to previous declines in August of 2015 and February of 2016 which both resulted in declines of greater than 10% from the May, 2015 high. The general awareness of this behavior and the diminishing returns of anticipating it are also reasons to be skeptical that it will continue.
Without improvement in global economic conditions and business fundamentals, we believe the benefit of buying quicker and shallower market declines will become increasingly short-lived, and the possibility that a true bear market is misidentified as a quick dip will be higher. If fundamental improvement does materialize (for example, strong corporate revenue and earnings growth along-side growth in consumer spending and continued health in the labor and housing markets), our view on valuations relative to prices would change significantly for the better. The possibility of either a recession on the one hand, or a period of strong economic growth and improvement in fundamentals on the other hand seem foggy at best.
Market history (see chart above) and our experience show us that rather than attempt to time the market, we should primarily be constructing and maintaining diversified portfolios of healthy and under/fairly-valued securities. Additionally, we focus on remaining invested to the extent possible, while rebalancing portfolios to capture the long-term benefits of volatility and low correlation between major asset classes. That is what we have been and will continue doing.
Compared to equities, bonds remained relatively calm through the quarter and increased in price despite already low-yields/high-prices. Longer-dated US Treasury bond yields are still at historically-low levels, while comparable-maturity yields on government bonds of Germany and Japan are currently negative (see chart below and to the left). While negative yields are not without precedent, the geographic breadth of both short and long-dated bonds exhibiting negative yields is a new phenomenon.
As the chart above and to the right illustrates, nearly-all European and Japanese government bonds with less than two years to maturity exhibit negative yields. To put this into perspective, buying Germany’s most-recently issued 2-year bond would equate to paying $101.31 today, and in return receiving no interest while waiting to receive $100 at the end of two years – essentially, paying the government of Germany $1.31 today to hold $100 for two years.
We are also watching non-government bonds closely, because they are generally priced and traded at spreads above corresponding treasury bond yields. With treasury yields so low, even if corporate and other non-government bonds are priced at historically-normal spreads, absolute yields have become low compared to historical averages, and relative to both credit and interest-rate risk.
Sustained low rates have been good for corporate borrowers and stock-holders of those companies that have been issuing debt to buy back outstanding shares. Remarkably, companies within the S&P 500 have been paying out more than 100% of quarterly Earnings in the form of Dividends and Share Buybacks for six consecutive quarters (see chart below). On the other hand, low rates have been disadvantageous for more-conservative investors such as retirees, and institutional investors including pension plans and insurance companies.
As rates on highly-rated bonds have declined to historically-low levels, many investors who require higher levels of income from their portfolios have faced tough decisions: First, as treasury yields reached historically low levels, those investors had to decide whether to adjust return requirements down or take on more risk via longer-dated and/or lower-quality bonds. Then, as rates on longer-dated and lower-quality bonds declined to historically-low levels (2) adjust return requirements down or take on more risk via dividend-paying equities or illiquid investments (i.e. non-traded real estate investment trusts, physical real estate, personal loans, etc...). This trend of taking on riskier investments for marginally higher income will continue as long as rates remain uncharacteristically low.
Looking forward, we think there are a few anticipated events that could influence markets significantly in the second half of 2016:
- A rate hike by the US Federal Reserve: At the most recent FOMC meeting, Fed chair Janet Yellen indicated that she does not expect the committee to vote to raise short-term rates this year, even though both the unemployment rate and inflation are in the middle of the Fed’s communicated targets for those benchmarks, which are indicators tied to the Central Bank’s primary mandates of maximum employment and price stability. The decision appears to be driven primarily by concerns over the US financial markets and the global financial system, which are not technically under the purview of the Bank, but could be argued to have an indirect yet significant impact on the labor market and price stability within the US.
- The US presidential election: On average in election years, markets have increased beginning in early fall and into the year-end. A major determinant of how much markets increase is whether the winner of the election belongs to the incumbent or non-incumbent party. A study by Ned Davis Research Group1 found that, on average, stocks increase by 10.1% in the second half of the year when incumbents win, and 1.4% if they do not.
- Continued fall-out from Brexit: Now that the UK is setting a precedent by leaving the EU, other countries may follow. This would add significant uncertainty at both political and economic levels that would have unavoidable repercussions of unpredictable magnitude. Markets will continue to use the UK exit as a test case to understand the impact of exit, but it must not be forgotten that the UK did not belong to the currency union, and it is one of the strongest EU countries with many options to minimize the economic pain of leaving the EU. Other countries that may consider leaving, such as Italy or Portugal, are more significantly tied to the other countries that use the Euro-currency and are significantly weaker than the UK with less ability to control the impact of leaving the union.
As we did over the 2nd quarter, we will continue to update you via commentary publications throughout the 3rd quarter as situations evolve. We appreciate the trust you place in us as advisors, and look forward to speaking with you soon.
Matt A. Morley, CVA
Chief Investment Officer