It seems every year at this time, Europe manages to spook the markets. A European recession, a threatened default by a Eurozone member (Greece) or (this time) an exit from the EU by a member nation, Britain (i.e. “Brexit”) have all come across the headlines. Markets deplore uncertainty and this most recent drama has ratcheted up global economic apprehension and reduced global GDP expectations. While there is plenty of uncertainty in the system, it is only fair to note that many fears were overstated by a sensational media and those wishing to scare British voters into the “remain” camp. We will expound on our viewpoint below.
The economy continues to slowly improve, albeit with fits and starts. The current estimate for second quarter GDP from the Federal Reserve Bank of Atlanta is 2.6%. After a muted first quarter result of 1.1%, we are encouraged by the expected acceleration. However, we continue to see mixed economic indicators in the most recent data.
The quarter started off on a strong note with retail sales jumping 1.3%, a full 1.0% better than estimates. Recessionary fears appeared to be misguided with the consumer showing strength. However, by mid-quarter, spending tapered off and based on early indications for June, sales may have slowed even further.
In addition to moderating retail sales, the U.S. economy added a dismal 38,000 jobs in May (much fewer than anticipated). Average hourly earnings increased at a slower 0.2% in May. However, monthly data can be erratic as evidenced by the most recent July 8 report which showed 287,000 new jobs. This is a perfect example of our “fits and starts” description.
Two bright spots in the quarter came from the ISM manufacturing report for June. The Purchasing Managers Index came in at 53.2, the best reading since February of 2015. The report’s new orders index was especially strong as well, up 1.3 points in June to 57.0. While all of this is encouraging, manufacturing is a much smaller piece of the economy than it used to be. Additionally, “Brexit” issues will likely inhibit the export order numbers for a period of time. So while we were encouraged with the June report, we are in a “wait and see mode” for the back-half of the year to verify the trend.
Construction and housing have been up and down this quarter. New home sales in April surged to a 619,000 annualized rate for a 16.6% monthly gain that was last exceeded in January 1992. The rate itself is the highest since January 2008 and dwarfs all readings during the recovery. Year-over-year, total sales of new homes in April were up 24% which is very impressive. However, construction spending proved weak in May. Spending on single-family homes fell in May for a third straight decline with the year-on-year still positive at a 6.0% rate. So again, we have a mixed bag of economic data.
Concerning “Brexit” and its implications, we remain unconcerned for the long-term situation. In the short term there will be uncertainty and therefore volatility. For U.S. companies we think the Brexit vote is not all that material since 70% of U.S. companies’ revenues are domestic. We are not seeing any significant stress in the domestic credit markets, though bond yields continue to fall (more below). We think it is helpful to frame the issue in terms of share of world GDP in 2015: England 3.9%, Germany 4.6%, France 3.3%, U.S. 24.4%. As Jim Paulsen from Wells Capital says, “It’s not like the U.K. is going to remove itself from the world economy and not trade with anyone. Once the emotion of this event fades, investors may get back to the fundamentals, which at least in the U.S. are looking better.” We tend to agree. While we would not be surprised if economic growth in the U.K. and Europe was destabilized due to this new development, we do not believe it will have a lasting impact.
For the second quarter of 2016, the S&P 500 posted a positive 2.5% return. As we discussed earlier, on June 24th Britain voted to leave the EU which closed the quarter on a volatile note. U.S. equity markets fell over 5.0% in the subsequent days but quickly recouped most of the losses before the quarter closed. It is still too early to know exactly how “Brexit” will impact global economic growth, but for now investors have become more cautious. In fact, International equity markets were off nearly 3.0% during the quarter, and the Pound (Britain’s currency) has fallen 14% since the vote to a low not seen since 1985.
Eight of the ten economic sectors in the S&P 500 posted positive results for the second quarter. Technology (down 2.8%) and Consumer Discretionary (down 0.9%) were the two worst performing sectors for the quarter. These are also two of the more economically sensitive sectors. Similar to Q1, investors again flocked to sectors perceived as “safer,” including higher dividend yielding areas of the market. Telecommunications (up 7.1%), Utilities (up 6.8%), & Real Estate Investment Trusts or REITs (up 6.6%), were three of the best performing sectors during the quarter. REITs will split off from the Financials sector in September to form the eleventh economic sector. Uncertainty and the drop in long-term bond yields have undoubtedly attracted investors to these sectors. However, as seen in the chart to the left, some of these “safe-haven” dividend sectors are beginning to look expensive versus historical levels. This chart shows that as the 10-year Treasury yield (blue line) has fallen, investors have become more willing to pay up for Utility stocks (as shown by the Price to Earnings line in yellow).
The Energy sector was actually the best performing sector during Q2 (up 11.6%), thanks to the continued rally in oil prices after last year’s rout. Oil posted a 28% gain during the quarter, helped by production declines in the U.S., supply disruptions in Canada & Nigeria and steady demand.
As of the date of this letter bond yields globally are setting new lows. The 10-year U.S. Treasury note began the quarter at 1.77% and rallied to close at 1.47% on June 30th. Yields have fallen further to start the third quarter and touched a generational low of 1.36% on July 6th. It appears the U.S. is “importing” the absurdly low interest rate scenario in Europe and Asia, where yields on sovereign debt are negative in many cases out to 10 years and longer. As bond investors, this is good news for bond prices, but it does not build confidence in a robust economic recovery. Reinvestment opportunities are shrinking along with the yield curve as it appears international capital is flowing into the relative safety and high yields of our domestic bond market. Even at these anemic rates we still offer the highest yields in the global high grade universe. Consider the relative value of a German 10-year Bund at -0.15% vs. a U.S. 10-year Note at 1.4%.
There are signs of some credit stress in the European banking system, due to the dramatic drop in the Pound versus the Euro after the Brexit. Those European banks that have loans backed by real estate collateral in the U.K. will likely have to reevaluate the safety of those loans and adequacy of the collateral. Bank stock prices in Europe are nearing their 2009 lows as a result of this coupled with the negative interest rates on their balance sheets. The chart to the left shows the relationship between EU bank stocks (in blue) and the U.S. 10-year Treasury yield (in red). We are monitoring this situation closely. With global markets in this condition it becomes difficult to see intermediate and long rates rising dramatically, however we believe that some pull back from these levels is warranted.
At the start of the year, the Federal Reserve was forecast to raise the Federal Funds rates multiple times this year. That forecast has now been abandoned. Notwithstanding the Brexit effects on monetary policy globally, the domestic economy appears to be slowing. The Federal Reserve minutes have shown that the labor market may be cooling, and this alone had put the rate increases on hold even before the EU referendum. The below charts show the probability of a rate hike(s) to start the year, and how those probabilities have changed in light of incoming data. The first chart below shows that in January, it was almost a given (79% chance) that we would have a rate hike by July.
Now that we are here, there is a zero chance of a rate hike and the market is only pricing in a 22% probability that we’ll have a rate hike by July of 2017.
With the Fed out of the way for now, the result of this has been what we would term a “reach for yield”. In the investment grade universe the longer duration and lower quality the better. For the quarter, the AAA sector of the bond market returned 1.67%, versus the Baa sector returning 4.30%. The 1-3 year sector was up 0.68% versus the 10+ year sector returned 6.55%. We are maintaining our strategy of positioning portfolios with an intermediate duration and pristine credit quality. Step-up agency securities are still favored but the 2% starting coupons are getting more difficult to find. We do not expect yields to stay this depressed for a long period of time and as a result we are participating in the market but at a subdued pace. If the second quarter GDP estimates prove accurate, the Federal Reserve could come back into the equation and provide better opportunities to invest toward the back half of the year.
The tax-free municipal market continues to show strength. The S&P Municipal Index returned 2.67% in the second quarter. The Brexit market move did benefit municipal prices, as the curve was “bumped” (i.e. yields were lowered) by nearly 20 basis points in a single day after the voting results in the U.K were finalized. We view the municipal market for taxable investors as the only game in town in this environment, as we can still achieve nearly 100% of the taxable Treasury equivalent yields and build AA rated portfolios.
The only part about the second half of 2016 we’re willing to bet on is high volatility. Undoubtedly, the presidential election will be one driver as various policies are debated. The pros and cons of globalization have come to light recently and this issue seems to be at the heart of many of the recent headlines. There are implications for many sectors in the market should it become clear that globalization is reversing and “Brexit” may have been the beginning of those war drums.
The valuations of the various indexes domestically are high relative to history, but not when compared on a relative basis to interest rates. According to FactSet Research, the S&P 500 12-month forward P/E Ratio is 16.4x, which is just above long term averages. A closer examination reveals some portions of the market trading at substantial premiums while others are at attractive discounts. We are still finding good quality companies to buy at valuations we see as attractive, but generally stocks are expensive. Corporate earnings likely need to recover before stocks can move demonstrably higher. More clarity from the Fed and a better political environment would help, but both seem unlikely in the near term. We continue to stay disciplined and diversified as we watch to see if global growth can improve.