A Decent Second Quarter, Despite Disruption From Our Friends Across The Pond
Following the first quarter and its worst-ever start to a year for the US markets, the second quarter was relatively calm despite a two-day panic from the Brexit (Britain voting to leave the EU). The S&P 500 saw a solid 2.5% second quarter gain and finished just shy of up 4% for the year. The upward trend has continued into July with the S&P recently setting an all-time high.
These gains were registered despite a 5.3% two-day sell-off due to the Brexit and investor’s subsequent panic. While we don’t want to give short shrift to the Brexit and its implications, we do believe (now and during the “crisis”) that it has limited impact on the US economy, and thus the markets for the time being. The sell-off proved once again that crisis events generally create opportunities for the calm investor. For some context, the S&P fell 5.3% during the two-day sell off and took only 8 days to re-coup the entire loss. It now sits 2% above levels seen before the Brexit and 8% above the lows. The key takeaway: sharp market corrections due to one-off events very often are overreactions based on fear.
While Calmer Markets Are Welcome, We Aren’t Becoming Complacent
At the risk of sounding like a broken record, we think it’s worth repeating our belief the US economy remains healthy. It’s not a perfect picture, but it is one that signals to us that we’re at least a year away from a recession. Our confidence stems from the fact the US consumer continues to benefit from solid job growth, higher wages, appreciating home values and lower gasoline prices. Additionally, consumer balance sheets are in the best shape seen in over a decade due to de-leveraging coupled with low rates reducing interest expense for debt service.
The biggest challenge for US markets stems from valuation. Valuations have become elevated as the market continues to creep higher despite a stall in US corporate profits (no growth since 2013). There are reasons to be optimistic on this front, however. First, a strong US dollar and weak oil prices have been key drags on US corporate profits over the past few years. The dollar has begun to stabilize and oil has rebounded to the $45-$50/barrel range from the $20s. Both of these factors should provide a tailwind over the coming quarters. Second, while valuations look somewhat elevated on traditional price to earnings metrics, they are downright attractive versus bonds and their historically low yields. This juxtaposition may create some volatility in the near-term, but we’ll continue to closely monitor the things that matter most for your portfolio — the US economy coupled with corporate profits.
Why Are US Interest Rates So Low If The US Economy Is On Solid Footing?
You may be asking: if the US economy is in such good shape, why are yields so low? It’s a great question and one we wrestle with every day, particularly with the 10-year treasury yield recently hitting an all-time low of 1.32%. We think some of this stems from slower than normal economic growth and high debt levels (in the US and abroad), but another key factor is global monetary policy is extremely dovish. This global central bank policy has depressed yields to historic lows. In fact, over $10 trillion in global debt yields less than zero! That is an astonishing number. Our belief is that German and Japanese investors (where rates are negative) see a 1.5% US treasury as an attractive investment, particularly given the strength in the US economy. So while we monitor yields very closely for allocation decisions, we believe the low yields don’t hold the same historical insight into the US economy due to global central bank policy.
Summing It All Up – Despite The Run Up, We Still See Value (And Risks)
A question we’re always asked: ‘Should I wait to put our money to work?” We’re not market timers. While risks remain, we reiterate our view from last quarter – cash is a very expensive asset class, even with low inflation, but particularly if inflation rears its head to the upside. And we happen to think one of the big risks to the market right now lies with the mispricing of inflation expectations. Our belief stems from the fact central bankers remain very dovish, while the labor market is tightening (rising wages) and oil is stabilizing at higher levels.
What do we do to protect against this? We continue to maintain diversified portfolios that lean a little toward equities that can benefit from inflation and have attractive yields (over 60% of the S&P 500 currently yields more than the 10-year treasury). Additionally, with current rates, we believe equities offer a better relative value than bonds. We also continue to favor asset classes with built-in inflation hedges (e.g., TIPS, REITs, MLPs, and floating rate preferreds).
That’s how we see the world today. Please reach out with any concerns or questions. We’re here to help.
Regards,
The Investment Committee
Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.
*All percentages were pulled as of July 13th, 2016 at close of market.
