Be Wary of the Consensus

The first half of 2016 proved yet again investors can expect the unexpected. After the worst start to a year ever in January, just about everyone concluded 2016 would be the year for a long-anticipated market correction. We were seven years into a bullmarket, the Federal Reserve needed to tap the breaks on the “easy money,” and the global leadership stage in this exceptional period of history was looking rather sparse. Fast forward to the 2016 mid-way point and the S&P 500 has gained a respectable 4%. The MSCI all-world index is up 1%. Emerging markets are still down for the year, but there have been pockets of strength including Brazil’s 46% increase despite the Zika threat.

Interest rates, which the Federal Reserve was looking to raise almost certainly once and possibly twice in 2016, are at the lows for the year. Investors now think a rate cut is more likely than a hike in 2016 based on the forward curve. Consequently, the Barclays Aggregate Bond Index has climbed 9% year-to-date, and Ten and Thirty-Year U.S. Treasuries are up 6% and 12%, respectively. These low rates are fueling mergers and acquisitions activity. After all, the cheap debt makes the hurdle for earnings accretion incredibly low, while the search for growth and the boardroom incentives to get bigger remain.

Surprise, Surprise

Few investors or media types expected a British majority to vote to leave the European Union (EU) given the well-publicized threat of economic depression and being placed at the “back of the queue.” Despite the polls showing a close race, markets rallied leading up to the vote. Even gamblers got on board. Two days before the vote, wagers on “remain” indicated an 80% chance in favor of the status quo.

Surprised by the vote to “leave,” global markets shed $3 trillion of value in two trading days including a 5% drop for the S&P 500, 6% decline for the British FTSE index, and 7% fall for the MSCI All-World index. The British sterling fell 11%. Investors fled perceived risks for safety. In fact, on day two of the Brexit rout, equity funds experienced the 7th largest day ever for redemptions. Then, markets rallied. In three days they effectively recovered their losses and in some cases, including the British FTSE, registered gains during the Brexit rout and rebound. Buying prior to the vote and selling amidst the frenzy proved ill-timed. These are tough lessons all investors have heard, but worth repeating; risks are managed via maintaining an asset allocation consistent with an investor’s risk tolerance before the storm begins, not during it. And, be wary of a crowd confident in a sure thing.

Cold Water on a Cold Economy?

Central bankers around the globe have done their best to incent investment. In the process, the world’s debt mountain has climbed from $40 trillion to $225 trillion in two decades. At $30 trillion, China’s building boom represented a big share of the effort and was a major reason for the commodity boom and bust we have discussed before. Despite central bankers’ determination, economic growth at home and abroad has remained tepid and is now showing signs of slowing. One of the most comprehensive economic measures, total business sales, is down 5% since its August 2014 peak.

Whether an ultimate British exit from the EU, coupled with the increasingly harsh policy tone toward global trade in general, is the cold water that chills an already cool global economy is unclear. Far from certain given the post-vote political posturing and ultimate terms, most believe a Brexit would negatively impact global growth by less than 0.5%. That math makes sense to us given the small size of Britain’s GDP relative to the world. Of course, it assumes the cloud of Brexit has not impaired global consumers’ willingness to spend their wages or managers’ confidence to invest. While these essential cogs in the economic wheel have regularly proven their resilience, ISIS attacks, lots of political rhetoric but few substantive policy advances, and rapidly changing business models throughout the economy are certain to test this fortitude.

Stocks and Bonds are Both Up: So Much for the Inverse Correlation

Historically, stocks go up when the economy is expected to strengthen. Conversely, bonds weaken in anticipation that a faster growing economy leads to higher interest rates. Thus far in 2016, stocks and bonds have rallied together counter to the historical correlation. A very modest economic recovery and interest rates persisting near historical lows have caused stock investors to incorporate a much lower discount rate into their valuation analysis. Put another way, the current 2.1% yield for the S&P 500 looks relatively attractive if the alternative is a 1.5% annual yield on the Ten-Year and 2.3% for a Thirty-Year Treasury. These unusual investment circumstances have helped elevate stocks to above average valuations by most measures. And it is why the market remains so fixated on the outlook for interest rates.

 

 

As for rates, we recognize in a world where $12 trillion of sovereign debt trades at negative yields, the current 1.5% return on the Ten-Year Treasury could represent more of a ceiling than a floor. For some time, we have accepted a “lower for longer” view. It was why when rates increased and spreads widened earlier this year, we sought to add higher yielding investments where appropriate. The view also influenced our decision to aggressively purchase dividend paying stocks in 2011 and 2012. Yet, we have stopped short of joining the “lower forever” camp. The risks of principal loss upon an over commitment to a “lower forever” view is too great. Instead, we are content to maintain some cash for most clients to reduce portfolio volatility and have available when the reward for the level of risks is greater.

Low Rates and Investor Fear Continue to Push Defensive Sector Valuations Higher

Today’s low-rate environment presents a real dilemma for retirees, many of whom, by all historical measures, had accumulated more than enough wealth from which to fund a comfortable lifestyle in retirement. Add concerns for the economic outlook to the equation and it is easy to understand the solution for many has been to load up on higher-yielding utilities, consumer staples, and telecom stocks. Surging as rates fell to 2016 lows during the Brexit, these sectors are now up 27%, 16%, and 14%, respectively, the past twelve months. REITs are also benefiting; up 11% in 2016 and increasing four fold since the Great Recession. In contrast, less defensive financials, healthcare, technology and transportation stocks are down from 4% to 8% the past year. This trend toward safety versus growth has also made things difficult for many active managers. All nine mutual fund categories tracked by Morningstar are trailing the S&P by 4% or more for the past year.

Investors’ attraction to dividend-paying and defensive stocks is understandable. We still recognize a company with a sustainable and growing dividend deserves a premium. But the valuation divide is starting to look stretched. Obviously, if we are in a “lower forever” interest rate world these bond-like stocks, whose valuations are 20–30% above their five-year averages, should continue to perform. We are increasingly sensitive, however, to the connection between rates and price for these sectors, and are looking closely at segments of the market abandoned during investors’ desperate search for yield and safety.

 

Earnings Comparisons Eventually Get Easier

Second quarter earnings for the S&P 500 are forecast to decline 5% versus the previous year. This represents five consecutive quarters of declining earnings. If current third quarter forecasts for slight revenue and earnings growth holds, the streak would end there. And as we approach the second half of 2016 and look to 2017, the comparisons for earnings get easier. The easier comparisons are partly a result of lapping the currency headwinds presented by a strong dollar in the second half of 2015. Also, while energy earnings are not expected to improve the next few quarters, the magnitude of the growth drag has diminished.

 

Wall Street often focuses on the relative versus the absolute. A return to earnings growth for the first time in five quarters could help the S&P 500 index, which currently trades at 18X 2016 adjusted and 20X GAAP EPS. Increased valuations for the higher yielding segments of the index and record levels of corporate stock repurchases, however, have undoubtedly helped support the broader market in the face of earnings stagnation. Therefore, while we expect certain pockets to benefit, our expectations remain measured for a meaningful broad-market response to the potential return of growth.

No One is Expecting a Duel

The musical “Hamilton” is the hottest show to arrive on Broadway in decades, setting records for ticket sales and winning eleven Tony awards. A delegate to the first constitutional convention and the first U.S. Secretary of the Treasury, Alexander Hamilton, died in a duel with former Vice President Aaron Burr. Political rivals, Hamilton had infuriated Burr when he wrote that he was “the most unfit and dangerous man of the community.” Burr’s response was to challenge Hamilton to a duel.

As crazy as the insults may get in this year’s Presidential election, no one expects the candidates to face off, take ten paces, and then fire. Everyone is expecting both sides (or more appropriately all three given the momentum-gaining Johnson/Weld Libertarian ticket) to pull no punches. The resulting rhetoric will be plentiful. On the foreign policy front, recent ISIS attacks in Orlando, Istanbul, Bangladesh, and Baghdad will keep the threat of terrorism front and center. There is much for markets to worry about heading into the convention season and fall campaign. But, as history reminds us, our nation has overcome significant political and economic challenges at every step since our founding fathers declared their own exit in 1776. It may no longer be consensus, but we expect our nation to weather this storm too.

Tags: Quarterly Commentary