Market Commentary July 2016
Posted on Friday, July 15, 2016
By Kevin O'Keefe, CIMA®, AIF® | Chief Investment Officer
The Roller Coaster Returns
Calendar year 2016 opened with a stock market selloff over worries that slowing economic growth in China would become a contagion and lead to a global recession. But those concerns faded, and stock prices rebounded, with the U.S. stock market climbing to near all-time highs. In late June, global equity markets sold off sharply in the wake of the United Kingdom's shocking vote to leave the European Union. Currency markets experienced their most volatile day in modern history, leaving the British Pound and the Euro down significantly against the U.S. dollar. In the closing days of the quarter, market direction suddenly reversed and moved to the upside, ending a tumultuous first half of the year. Stock markets in Europe and Asia haven't fared as well as U.S. stocks so far in 2016. The Stoxx Europe 600 was down almost 10% in the first half of 2016, while Japan's Nikkei Stock Average fell 18%. Volatility is not expected to abate any time soon. Ongoing concerns about the economy here and abroad, uncertainty about interest rates, and the November elections are causing daily worry and high transaction volumes.
Mutual Fund Recap
Stock funds struggled in June, with all categories except for large-cap value posting negative returns. As typically happens in the wake of negatively perceived geopolitical events, investors overreacted to the news from the UK. In the days following the June 23rd referendum, the average U.S. large-blend mutual fund fell by roughly 4%, while foreign large-blend funds fell almost 7%. But the ensuing rally lifted all stock funds by quarter end, with most categories finishing with net gains for the quarter. Bond mutual funds have had an excellent year so far. Long-term bonds have performed especially well. Real estate funds added to strong first-quarter returns, and are well ahead of diversified equity funds year-to-date. International funds have lagged for some time. One can't help but wonder how long will the dominance of U.S. stocks persist?
Let's Talk About Europe
Looking back over the past 45 years, there has not
been much difference in terms of overall performance
between European and U.S. stock market returns. However, as
the table shows, some decades have had clear winners. Although the
annualized returns for the entire periods are fairly similar, there
have been long stretches in which one has dominated the other. Over
the past five years, the
has outperformed its European counterpart by about 8.5% per year.
It is understandable that investors would be asking why it would
ever make sense to invest overseas given the superior performance
of U.S. stocks in recent years, plus the heightened economic
uncertainty outside the U.S. However, what often happens when one
developed market dramatically outperforms another developed
market for several years is that stock valuations
diverge. The stocks that comprise the "winning" stock market
become more expensive relative to their fundamentals, while the
stocks in the "losing" market become more and more of a
bargain, as this table illustrates:
European stocks are much cheaper than U.S. stocks based on key financial metrics. This is not to say that European stocks won't become even bigger bargains relative to U.S. stocks, but generally speaking, buying financially sound securities when they are relatively unpopular, while resisting the temptation to "go all in" on the most popular stocks, will improve your likelihood of success over time. Simply stated, the goals of investing are to manage portfolio volatility while achieving above-average long-term returns. That is far easier said than done; it is very rarely comfortable to invest in bargain-priced assets. There are reasons why certain investments and markets become bargains - for prices to drop to really attractive levels there needs to be bad news. And Europe has plenty of bad news these days. Their problems will not be solved any time soon: political uncertainty, demographics, economic stagnation, etc. And the stock market reflects the rampant doom-and-gloom. But surprises happen. When expectations are overwhelmingly negative, it does not take much good news to surprise on the upside. Yes, Europe has problems aplenty, but the tide will turn in Europe. It's a question of when, not if. The odds are good that investors who are patient with their European stock holdings will reap the rewards.
What Will Propel the Stock Market Higher?
As I write this, the Dow Jones Industrial Average is near 18,000, a level that has been both familiar and somewhat treacherous. The Dow has closed above 18,000 seven times in 2016, but the longest it stayed above 18,000 was for one three-day stretch. It has yet to surpass its record closing high, set in May of 2015. What will it take to move stock prices to new highs? Low interest rates have done their job; that hand has been played. Maybe there needs to be some sort of positive surprise, like better than expected economic news or corporate results. We need to see economic strength and earnings growth, even if that leads to a change in interest rate policy. For S&P 500 companies, earnings have fallen for four consecutive quarters, and they are expected to decline again. The question is, how much of a decline: Five percent? Six percent? Surprises in either direction could result in sharp market moves. Some consider the high levels of caution among investors (a contrarian indicator ) as one of the biggest reasons to expect stocks to move higher.
Patience is a Virtue
Fred Rogers' empathic anthem was intended for children, but it might also provide solace for investors during dry spells. The S&P 500 is about where it was fourteen months ago. There have been gains followed by gut-wrenching market sell-offs during that time, but no overall progress. Fourteen months of reading statements and reports, the investment news, following the business reports, to what end?
Aren't Investments Supposed to go Up, Up, Up?
Actually, no. Sideways markets are quite common. The six consecutive years of "up, up, up" that investors enjoyed from 2009 through 2015 is the exception, not the rule. One could say we are overdue for a multi-year sideways market. Unfortunately, the stock market is not designed or intended to help investors' portfolios go up, up, up. Because the stock market moves so unpredictably, investors have to adapt to the vicissitudes of the market or get crushed, because the stock market will not adapt to investors. The market does not know about or care about our investment goals. It often behaves as if it is trying to thwart us, testing our confidence and resolve. To succeed as an investor, we need to practice patience. 2016 is my 36th year in the investment services industry. My concept of "long term" - as in "you need to have a long-term time horizon in order to invest successfully" - is longer than it has ever been. I am sorry, but five years is not long-term. If you are saving for a goal that must be funded in five years, do not invest in stocks to reach your goal. I consider ten years to be border line long-term. For my granddaughters' 529 college savings plans, I opt for the Target-Date option which gradually reduces the stock portfolio of the investment portfolio starting about ten years before the money is needed. It's entirely possible that when my granddaughters' tuition bills come due, stocks will be in a bear market. That risk has to be managed well in advance rather than left to chance. For the individual who is planning for their financial future, the sequence of returns matters a lot. Expecting an average return of 8% per year from stocks may be useful for long-term planning purposes, but because returns for any given year might range from -50% to +50%, when the goal becomes short-term, it is foolhardy to rely on the stock market to come through for you. You have to manage sequence-of-returns risk. For those of us whose primary investment goal is retirement income, our time horizon (i.e., the time when we need the money to be available) is actually quite long. Even if we know when we're going to retire, we don't know how long we will live (and therefore how long the retirement income will need to continue). With growing life expectancies, it is more important than ever to manage retirement savings with the expectation that it will need to provide income for many years. Again, sequence-of-returns risk has to be managed. What other strategies can help us effectively deal with frustratingly long periods of no investment returns, which inevitably happen in the course of our long-term investment plan?
Two Ways to Handle Dry Spells
One way is to become opportunistic. Keep in mind that the more the stock market declines, the greater the likely future returns will be up from that lower price level. Therefore, it is a good idea to hold some cash available so that you can buy more shares when they "go on sale." If you deploy cash when the stock market stumbles, it shortens the amount of time it takes to get back to where you were before the market dropped. Another way to deal with zero-return (or worse) investment periods is to practice patience. Patience is a virtue - as a person and as an investor - and the benefits are often quite significant. Periods of financial famine have historically been followed by periods of financial abundance. The stock market may have delivered average returns of 10% over the past ninety years, but the variability of those returns was extreme. Not coincidentally, the strongest bull markets followed the most painful stretches. Think of these periods of low-to-no return as the price investors have to be willing to pay in order to achieve longterm goals. If investing were easy and predictable, the returns would be low. It is precisely because investing is difficult emotionally and because it requires such an unwavering commitment to the long-term that it can offer the prospect of financial reward. Investing isn't easy. It is said that if you aren't already humble, the stock market will help you become so. Your financial planner can't tame the financial markets to adapt to your specific needs, but they can be your companion, your mentor, your guide - so that you don't have to walk the journey alone.
A Solid Quarter for Bonds
By William Mock
US Treasury and municipal bond investors fared well in the second quarter of 2016, with the bond markets being supported by rhetoric from the Federal Reserve taking a dovish turn and a flight to quality both preceding and after the Brexit vote in the United Kingdom (a referendum to leave the European Union). The Barclays Capital US Aggregate Bond Index returned 2.21%. The US Treasury yield curve continued to flatten with the 2-10 year spread falling from 1.05% to 0.89% over the quarter. The 30 year US Treasury ended the quarter at 2.29%, the 10 year at 1.47%, the 5 year at 1.00% and the 2 year at 0.58%. The Barclays Municipal Bond index returned 2.61% for the period. The municipal markets followed the US Treasury markets with a flattening term structure over the period, with the Bloomberg Muni AAA Benchmark 30 year yield falling from 2.66% to 2.18%, the 10 year from 1.76% to 1.36%, the 5 year from 1.14% to 0.92% and the 2 year from 0.74% to 0.62%.
Outlook from the Fed
Though it appears the Federal Reserve would like to raise the Fed Funds rate , the less than dynamic growth of the economy has put them on hold. They have indicated that rate increases would be data dependent, while simultaneously expressing concern about economic growth as exhibited by recent payroll data and the lack of inflation. In fact, the median economic projections of the Federal Reserve Board members and Federal Reserve Bank presidents show that their 2016 GDP projections have fallen from 2.2% to 2.0% and the median PCE inflation projections are only 1.4% in 2016, 1.9% in 2017, and 2.0% in 2018. Until the data clearly demonstrates stronger growth and inflation, an increase to the Fed Funds rate is unlikely.
There continues to be strong demand for municipal bonds, driven both by the search for income with falling US Treasury rates and a technical supply issue that is the result of a higher than normal percentage of recent issuance being refunding bonds (bonds being issued to refinance old debt as opposed to new debt issuance). We anticipate a continued flattening of the yield curve but given the historically low rates recommend that investors avoid undue credit or maturity extension risk.
Puerto Rico Update
In a rare showing of bipartisan compromise, the U.S. Congress passed, and President Obama signed into law a bill that will help Puerto Rico restructure its debt . The legislation did not prevent Puerto Rico's default on July 1, 2016, the first state-level borrower since the 1930s to default on general obligation debt, but it should help pave the way for an orderly resolution. The new law does not provide any funding to Puerto Rico, but it provides for the creation of a federally appointed control board to oversee the commonwealth's budget and debt management. It places a stay on shareholder lawsuits, preventing potential court orders to make debt payments instead of maintaining essential services such as schools, law enforcement, and health care to the islands residents. Puerto Rico's governor issued executive orders on June 30th which declare a moratorium on debt payments and block transfer of funds to government entities which have issued debt guaranteed by the Commonwealth. We are actively monitoring the situation in Puerto Rico, though even with this new framework in place the resolution process is most likely measured in years. Trading has continued to be sporadic and will likely remain that way until settlement terms are determined. We recommend that bondholders wait until settlement terms are negotiated rather than selling at this time.
Green Bond Market Continues to Grow
The growth of the green bond sector is accelerating, with global second quarter issuance of more than $18 billion of labelled "green bonds." The Climate Bonds Initiative reports that there are now a total of $118 billion in green bonds outstanding. The green bond market's growth will most likely continue to accelerate as rating agencies such as Moody's and data providers such as MSCI, S&P, and Bloomberg continue to expand their coverage. The standards for definition and validation of green bonds continue to evolve, driven in large part by the Green Bond Principles.