Stay The Course
- This market has been beset by one event after another, with various cross-currents muting recent performance. However, the uneven and often frustrating global economy continues to slowly evolve and grow, and should eventually lead to progress for patient investors.
- Our outlooks for the second half of 2015 remains constructive, as we believe that the multiple positive fundamental factors continue to outweigh the immediate issues facing markets.
- While we are disappointed in recent flat performance, we remain properly positioned in the better performing asset classes such as foreign and domestic stocks, and specialty bonds.
- We remain dedicated to proven investment methods and principles. Critical to long-term success is the ability to ride out short-term corrections and volatility when fundamentals remain favorable.
Overseas stocks led U.S. stocks and all other asset classes in the first half of 2015. As the graph below shows, foreign stocks were the clear winners, followed by domestic growth stocks and specialty bonds. Traditional bonds, domestic value stocks, and commodities trailed during the period and were all down slightly.
While covering only a short time frame, the performance shows the relative attractiveness of foreign stocks, as well as that of stocks in general relative to traditional (“interest rate sensitive”) bonds and commodities. Also, the dispersion of returns is reflective of the variance of regional global economics and market fundamentals, and a good reminder of why portfolio diversification is so important.
The important themes that we believe will influence the second half of 2015 are Greece and China in the near-term, and interest rates, global economic growth, and valuations in the longer-term.
While Greece is a very small part of the global economy (0.26% of global GDP) and less than 1% of the MSCI All World Equity Index, the Greek economic troubles remain front of mind for most investors. The unknown impact of a Greek default on their debt and/or exit from the European Union (“the EU”) remains troublesome. Because of the efforts to date by the European Central Bank (“the ECB”) to provide liquidity to the banking system, and the relatively small amount of exposure European banks now have to Greece (see chart), we believe this issue is largely contained and does not pose a significant long-term threat to economic growth and healthy markets. For these reasons we believe any further market weakness related to Greece will be short-term volatility that will create potential opportunities in foreign stocks.
China has also caused some uneasiness recently because of losses stemming from excessive speculation in its domestic stock market. Much of the issue has to do with individual Chinese investors trading stocks with borrowed money (“on margin”). Regardless of the efforts of the Chinese government to stem the decline, highly-leveraged investing on a mass scale seldom ends well. While we have no direct investment allocation to China, we do expect some indirect impact to domestic and foreign company stocks that are either doing business with China or are otherwise exposed to commodity prices that are adversely affected by the Chinese market situation. To be fair, China has done a good job of transitioning to a service-based economy while maintaining a reasonable amount of economic growth. They have significant and adequate resources which are being actively used to remedy problems that pop up along this new path of sustainable growth.
Global growth remains tepid, and recent data shows that an interest rate hike by the Fed in September is not a sure thing. While growth next year still remains on track, 2015 global growth forecasts for North America have been reduced recently for reasons ranging from the impact of the strong U.S. dollar on exports to the harsh winter weather. The Fed continues to use GDP growth and inflation as its primary monetary policy objectives, and both continue to register below their desired levels.
As of this writing, the Federal Reserve (“The Fed”) continues to be committed to raising interest rates by 0.25% at their September 17th meeting. However, recent events and a lack of strong growth and/or inflation domestically have markets questioning this timing.
Short-term bond instruments (30 day Fed Funds futures prices, specifically) now reflect only a chance of a September rate hike. This data is currently at odds with what the Fed is saying about the likelihood of a September rate hike. While a very real possibility, the Fed’s actions are “data dependent” and that data over the coming months will be the determining factor for an interest rate hike.
Regardless of the timing, the good news is that the Fed is paying attention to new data to formulate its policy to ensure that the pace of rate increases is appropriate.
Why we think gains in a diversified global portfolio remain likely in the second half of 2015:
Central banks are on our side. While we are overdue for a market correction, and the combination of near-term issues in Europe and Asia together could be the catalysts, global central banks are likely to act. A slowdown in economic activity in any region may actually lead to more monetary stimulus from other vigilant central banks in Europe and China. And in the case of no Fed rate hike in September, global stock markets would likely rally.
- Stocks are attractive relative to bonds (see chart). When compared on an earnings yield basis, which is to divide earnings by price, the S&P500’s earnings yield of 6.3% compares favorably with the domestic bond market’s 2.3% yield. This 4% yield advantage is attractive on its own, and also when compared to the 1.3% historical average differential. One of the reasons for this current large differential is the expectation that interest rates on bonds will rise and close the gap. However, as we have stated, any rising of interest rates on bonds is likely to be gradual, and should still only partially impact the total yield advantage.
- Eurozone stocks are even more appealing than domestic stocks. European stocks remain less expensive than U.S. stocks (see chart). This is partially due to delayed monetary stimulus last year (see our previous market letters), and partially due to Greece and other Eurozone countries with fiscal problems. However, behind these headlines is new economic growth that is starting to accelerate and should attract capital to these markets.
- The risk of recession remains low. While not at the Fed’s optimal growth rate, the economy is estimated to grow at roughly a 2.0% to 2.5% rate in the second half of 2015. The “Big Four” Indicators shown (see chart) measure different aspects of the economy, and are considered important in economic cycle analysis. Currently three of the four indicators continue to show strength, and one, Industrial Production, shows modest weakness. The recent decline in Industrial Production is largely due to a decline in the pace of activity in oil and gas well drilling associated with the recent fall in oil prices.
- Investor Sentiment is bearish. Market tops and bear markets typically start when investors are euphoric. The current mindset among investors seems to be vacillating between cautious optimism (associated with the early stages of a bull market) and periodic bouts of panic (associated with the later stages of a bear market and subsequent recovery). The current high level of fear in the market (see graphic) suggests that we are not at a market top, nor at the beginning of a bear market.
In summary, the last year has been challenging with various cross-currents muting recent performance. However, the uneven and often frustrating global economy continues to slowly evolve and grow, and we see many reasons why patient investors should remain optimistic.
– Peter Lowden, CFA