Market volatility: The volatility investors witnessed in the global financial markets at the beginning of the year has certainly lessened in intensity recently, but various issues and events persist that will likely continue to cause flare-ups in market volatility for the remainder of the year. Whether it is the Brexit vote, FOMC meetings, or the political rhetoric that is about to heat up with the national nominating conventions for the Presidential election, there are plenty of factors that have the potential to keep market volatility elevated in the near-term. That said, recent market corrections have quickly found their footing, something we will touch on more in a bit.
The most recent notable example was the Brexit vote that took place on June 23rd. Although this event was well telegraphed and widely discussed, the decision to leave the EU surprised markets and caused a sharp plunge in the following days. One of the reasons markets bounced back so quickly was likely the realization that there will be little immediate impact (the effect on the British pound notwithstanding). Britain first has to elect a new Prime Minister, then enact Article 50 of the Lisbon Treaty (Q4) to start the clock on the withdrawal process. So negotiations surrounding their exit from the EU won’t even begin to take form until 2017, and could last up to 2 years.
Economic growth: As for the US economy, it continues to muddle along in slow growth fashion, marked by noisy economic data that frequently vacillates between accelerating and decelerating growth – frustrating for investors. Case in point, last month’s jobs report came in much better than expected with 287,000 jobs created that month. But the prior month was far worse than consensus expectations (only 11k). Averaging the two months together produces similar jobs figures to what we have seen in prior months, which aren’t exactly strong enough to get investors excited.
Fixed income: One would have thought that last month’s strong jobs report would have caused Treasury bonds to sell off, as investors priced in stronger growth. But despite 10-year bond yields at all-time record lows, there was no sell off. To wit, the US Treasury bond ETF (TLT) was actually up on the day of the report. Our non-consensus recommendation to buy TLT at the start of the year has been a huge but positive surprise, as the gains have reached+20% year-to-date.
There is a debate currently as to why bond yields in the US are so low. The bond purists believe it is a reflection of slowing growth, just like the action in yields witnessed in most economic slowdowns.
The other camp believes that in this world of QE, and with negative interest rates in many parts of the globe, that global investors are simply desperate for yield and that even record low yields in the US still compare favorably to most other developed countries.
We think there are merits to both sides of the argument. Certainly slowing economic growth around the world has pushed bond yields lower as the bond market prices in this backdrop. But the current experiment by global central banks to push interest rates into negative territory is one we have never seen before and don’t know how it will end. This phenomenon has to be exacerbating the demand for safe bonds with positive yields, of which US Treasuries are the poster child. It has also pushed up prices on other “yield” assets such as utility stocks, REITs, and consumer staples.
Stocks: As for equities, they too have benefitted from this QE environment whereby the flood of liquidity provided by central banks has flowed into ‘yield stocks’. The table below shows how various defensive-oriented yield sectors have performed relative to more traditionally growth-oriented sectors. Historically, strong bull markets have been led by growth sectors. When defensive sectors lead the market, it often means investors are skittish and there is heightened uncertainty among investors. This seems to be the best characterization for the market in which we currently find ourselves.
Additionally, stock prices and forecasts for corporate profit growth have been diverging for much of the year. Normally stock prices generally follow the direction of earnings growth. But as of Q2, earnings estimates for the S&P 500 have declined -9.0% since the start of the year. Over that same time frame, the S&P 500 Index itself is up +2.7%. Divergences like this tend to rectify themselves in time. As such, one could expect either earnings estimates to start to see positive revisions or stock prices struggle. But with a P/E ratio of more than 18x 2016 EPS, valuations already look rich.
Summary: Coming into 2016 we were already starting to become more cautious about the markets and moving towards a more conservative asset allocation in client accounts. At times so far this year those moves have looked warranted, while at other times they have looked I bit too cautious. Our big picture thinking was that this economic expansion was approaching the second longest on record, and growth was beginning to show signs of slowing. Central bankers were also becoming more desperate in their attempts to manufacture economic growth, but at what cost?
With stretched valuations in the stock market, and continued potential for heightened volatility, we think our current stance remains warranted. There will be a better time to allocate portfolios back towards more growth for those who can exercise patience – which admittedly can be a rare commodity in investing. In this QE world of excess central bank liquidity, it often seems that markets can continue to levitate despite deteriorating fundamentals beneath the surface. It’s difficult to predict how long this can last, but we are reminded of the musical chairs analogy and prefer to stay close to an available seat versus being left scrambling if the music stops.
Jordan L. Kahn, CFA
Chief Investment Officer