Investor Discussions - Q2|2015 Commentary
Wealth & Pension Services Group
Matt B. Bailey, CFA - Portfolio Manager
The second quarter ended in the same fashion as it began, with lots of volatility. Stocks posted minimal gains, bonds struggled, and commodity prices turned positive for a change. The S&P 500 gave up most of its small gains as the half ended, to finish up year to date at just over 1.0%. International stocks, which are the clear leader so far this year, also gave back a good bit to finish the quarter basically flat.
Overall, the global economy showed signs of improvement as most central banks remained accommodative. Generally speaking, the global recovery appears to be intact and headed in the right direction, albeit at a very slow pace compared to previous expansions.
Final Q1 GDP came in lower than expected at an annualized real rate of -0.2%, as seen on chart 1. The slowdown has been attributed to transitory factors including: harsh winter weather, the west coast port strikes, and the recent strength of the US dollar. Looking ahead, most economists expect growth to improve in the coming months due to pent- up demand both here and abroad.
One area of enduring strength has been the labor market. Unemployment claims continued to fall during the quarter (chart 2). The unemployment and underemployment rates remain near cycle lows at 5.3% and 10.5%, respectively. In addition, wage inflation appears to be picking up but remains uncertain. Positive wage inflation is usually a good indicator that labor conditions are tightening. More specifically, it hints that workers are successfully demanding higher wages.
The broad measure of inflation, as indicated by the Consumer Price Index (CPI) on chart 3, remained near zero on a year-over-year basis. Core inflation (less food and energy) also remained low and came in at an annualized rate of 1.7%. This figure has consistently remained just below the Federal Reserve’s 2.0% target and suggests that they will likely remain accommodative in the near term. It also suggests that fear of deflation has passed and was likely a short-term byproduct of falling energy prices.
Looking ahead, the domestic economy continues to improve but remains fragile. We see many positives including: housing, consumer spending, manufacturing, and low commodity prices. The weakness seen in the first quarter will likely prove to be transitory and short-term in nature. Even so, rising rates, U.S. dollar strength, and political instability abroad may produce unwanted headwinds. Overall, we remain optimistic that the U.S. economic recovery will remain intact.
The economic picture abroad continues to improve in both Europe and Japan. Earlier this year, the European Central Bank (ECB) initiated a quantitative easing program in hopes of stimulating growth. According to many economic surveys, the plan seems to be working. General business conditions, employment levels, and input prices all suggest the eurozone is healing. Additionally, the euro has weakened significantly over the last 12 months which has likely had a positive effect on the economy (chart 4). Not only has it boosted manufacturing (a weak currency helps exporters by making their goods cheaper to foreign consumers), but it has also helped keep inflation low for local consumers.
The only glaring problem for the eurozone is its lingering issues with Greece. Chart 5 illustrates how Greek 10-year government bond rates have risen over the last year while most other euroland rates have remained low. This indicates that the market is pricing in additional risk of default into Greek bonds. The chart also shows how much of an outlier Greece is relative to its neighbor countries. The Greek government continues to negotiate with creditors as it seeks additional bailout funds. Currently, the two sides remain at a stalemate but appear to be closing in on a deal. Once resolved, eurozone leaders can focus on economic growth and implementing productive policy measures.
Japan continues to enjoy the impacts of quantitative easing. The Bank of Japan’s (BOJ) aggressive monetary policy bets appear to be paying off. Business conditions are improving and fears of deflation have moderated for now. Even so, last year’s sales tax increase still appears to be negatively reverberating through the economy. Many business leaders continue to cite the tax increase as the seminal reason for their diminished outlook. In addition, decreased demand from China has had a negative effect on exports. Overall, the good is outweighing the bad and their economy seems to be gaining positive momentum.
Contrary to the developed world, the emerging markets and frontier markets continue to struggle. After years of strong growth, these economies have been plagued by poor capital allocations and weak foreign demand. Additionally, many of their governments depend on commodity exports to balance their budgets. This has only added to their woes as commodity prices have fallen over the last few years. Looking ahead, the outlook remains bifurcated for the group. Many countries such as Brazil and China will likely face recession; while others in areas such as Eastern Europe may escape unscathed.
During the second quarter, U.S. stocks ended up marginally after experiencing a late inning a sell off. The bellwether S&P 500 index (large caps) and Russell 2000 index (small caps) finished up 0.28% and 0.42%, respectively. Small cap stocks continued to benefit from the strength of the U.S. dollar and remain ahead of large caps for the quarter and year-to-date.
As the U.S. markets continue to reach new highs and valuations become stretched, it’s becoming more and more difficult to find bargains. In fact, many fundamental metrics are now trading at their highest levels since the late 90’s. This suggests that the markets are becomming expensive or are at least fairly valued. Nonetheless, corporate earnings (ex-energy) continue to come in strong. Low interest rates and falling energy prices have helped domestic firms keep margins high and balance sheets healthy. Sectors such as health care and technology have been leaders during the current bull market. While others such as energy and materials have struggled on the back of consistently low commodity prices.
On the technical side, waning momentum and overly-bullish investor sentiment may indicate more downside risk than upside potential. Additionally, the equity markets have historically performed poorly during the summer months. Thus the old Wall Street adage, “Sell in May and go away.” Even so, the U.S. bull market remains intact and has continued to dissapoint stock market bears over the last 6 years.
In line with the U.S. markets, international developed stocks performed well until the last week of Q2. The broad market MSCI EAFE index finished up a meager 0.62%. This equity index encompasses most international developed stock markets such as: Europe, Japan, and the U.K. Its recent strength indicates that many investors have a positive outlook on the future of these regions. Improving economic conditions, attractive valuations, and favorable monetary policy should help keep investors content.
Emerging Market (EM) and Frontier Market (FM) equities, as represented by the MSCI EM index and MSCI FM Index, finished the quarter up 0.69% and down 1.51%, respectively. As noted above, these markets are experiencing a difficult period of economic progress. On a positive note, their fundamental valuations are relatively more attractive than developed market equities. Also, much of the bad news may already be priced into their stocks. This indicates that positive news such as increased commodity prices or stronger economic demand from abroad could send them reeling higher.
The bond market has recently garnered lots of attention and the second quarter was no different. The U.S. 10-year Treasury index (10-yr) continued its rollercoaster ride and finished the quarter up over 40 basis points at 2.34%. The uneasiness of the 10-yr once again caused the Barclays US Aggregate Bond Index to lag riskier areas of the market. By the end of the quarter, the Barclays US Aggregate Bond Index finished down 1.68%. Its riskier counterparts, the Barclays Corporate High Yield Bond Index and Barclays Global Aggregate ex-USD Bond Index, finished flat and down 0.83%, respectively.
The rising 10-yr yield and weak bond returns can both be attributed to one thing - the discussion of when the Federal Reserve will begin raising rates. Most analysts now think that the first rate hike will come in September and the current economic data supports that view.
What does this mean for the economy and bond markets? Typically, the Federal Reserve raises rates when it believes the economy is strong enough to sustain such a move. It’s worth noting that the Fed has a dual mandate: keep prices stable and employment at its maximum level (i.e. low inflation and low unemployment). As of now, unemployment is low but has room to improve and inflation is still below the Fed’s target of 2.0%. Nonetheless, interest rates have been near zero for over 6 years and the Fed doesn’t want to let the economy overheat. All in all, both the U.S. economy and bond markets should be ready to withstand a slight rate increase, especially because rates will still be at historically low levels. In addition, global demand for bonds from both individuals and large institutions remains strong and may increase as yields move higher.
Commodities finished in positive territory for the first time in a few quarters. This outperformance came as the U.S. dollar gave back some of its gains going back to early last summer. The Bloomberg Commodity Index finished the quarter up 4.66%, while the U.S. dollar index was down 3.37%. This reversal isn’t a complete surprise, especially considering the run the U.S. dollar has made since last summer.
Looking ahead, commodities still face significant headwinds. These include: the potential for further U.S. dollar strength, waning global demand, and oversupplied markets. All these factors point to future weakness in the space. Nevertheless, even the worst performing asset classes have periods of strength from time to time. Also, the potential for rising inflation may bode well for asset the class (investors typically buy commodities as a hedge against inflation).
As we enter the second half of 2015, two things remain certain: the markets are becoming more volatile and Federal Reserve policy continues to dictate the market’s direction. As of now, the Fed’s policy remains accommodative, but this may start to change in the coming months.
Looking forward, U.S. stocks appear to be fully valued and are starting to get expensive. International stocks appear cheaper but come with many risks. Bonds remain less attractive than stocks but are approaching an area where they may find support. Finally, commodities continue to face headwinds but may find demand if we start seeing inflationary data.
When we combine all this together, we see increased levels of risk within the capital markets. Although our longer-term view remains positive, we see the potential for increased volatility in the near term. We plan to manage around this risk by remaining diversified and reducing exposure to risky assets as needed.
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®
Source: Bloomberg.com, Morningstar, Markit, Leuthold Group, St. Louis Federal Reserve, Chicago Federal Reserve