Despite turbulence following the United Kingdom’s late-June ‘Brexit’ vote, nearly all investment categories posted gains during the April-June quarter. Large-company U.S. stock benchmarks advanced around 2%; small-cap stocks did slightly better, on average. Many overseas equity investments gained modestly, though those with a U.K. and/or European focus declined; emerging- and frontier-markets were relative bright spots for a second-straight quarter. Real-estate investments were up, on average, though timber-related issues declined modestly. Commodity prices were sharply higher. Bond yields fell: the 10-year U.S. Treasury note finished at 1.49%, down from 1.79% at the end of March; credit spreads improved, led by energy/commodity-sector issuers, resulting in solid returns for most fixed-income investments.
Among U.S. stocks, better results came from companies in the Basic Materials Communication Services, Energy, Health Care and Utilities sectors. Weaker groups included Consumer Cyclicals, Financial Services and Technology. Value-oriented names outperformed the growth category for a second-straight quarter.
Benchmark Performance – Equities
|Second Quarter 2016||Last Twelve Months|
|S&P 500 Index||+2.5%||+4.0%|
|Large-Cap Core Mutual Fund Avg. (Morningstar)||+2.1%||-0.4%|
|Small-Cap Stocks (Russell 2000)||+3.8%||-6.7%|
|Non-U.S. Stocks – Developed (MSCI EAFE)||-1.5%||-10.2%|
|Non-U.S. Stocks – Emerging (MSCI EM)||+1.0%||-12.0%|
Benchmark Performance – Fixed Income
|Second Quarter 2016||Last Twelve Months|
|Intermediate Gov’t/Credit Index (taxable; Barclays)||+1.8%||+4.3%|
|Intermediate Municipal Mutual Fund Avg. (Morningstar)||+2.2%||+6.4%|
Prior to the shocking Brexit result, financial markets enjoyed a calm spring. Domestic large-company indices traded in a narrow range of minus one percent to plus three percent compared to March-end levels; U.S. bond yields, too, were well behaved, varying by no more than around 20 basis points (0.20 percentage points) in either direction. Meanwhile, the VIX ‘fear’ (volatility) index hovered near its lowest levels of the year.
The calm was thoroughly – albeit briefly – sundered by the June 23rd Brexit vote. Although opinion polls had for months indicated a ‘leave’ result was possible, investors were apparently convinced (or hopeful) ‘remain’ would carry the day. In the two trading days after the vote, global market values declined by some $3 trillion, bond yields plummeted, the pound declined more than 10% against the dollar and yen (and only slightly less against an also-reeling euro) to its lowest level in three decades, and rating agencies cut the U.K.’s sovereign credit rating. U.K. stock market losses were heaviest among domestic-oriented names; however, severe declines on major continental markets suggested investors viewed Brexit as likely to be equally – or perhaps even more – painful across the Channel. Remarkably, in the final three trading sessions of the period, many stock markets recouped nearly all of their losses (though domestic U.K. and continental European benchmarks remained around 5% lower). Bond yields, however, remained very near their immediate post-vote lows.
Brexit aside, economic news during the period was mostly benign. In the U.S., despite yet another winter-quarter slow-down, most data released during the spring pointed to a resumption of the steady, if underwhelming, pace of growth that has been the norm since the 2008-2009 recession. Although the May non-farm payrolls report showed a surprising drop in job creation, other labor-market data (initial jobless claims, job openings, wage increases) failed to confirm a meaningful down-shift. Meanwhile, retail sales, consumer confidence, and housing-market indicators suggested firming growth. Overseas, growth picked up slightly in Europe, while Japan continued to disappoint. The much-feared Chinese ‘hard landing’ failed to materialize; if anything, growth seemed to have picked up somewhat following last year’s dip. Aided by rebounding commodity prices and a recently-weaker U.S. currency, data from other emerging markets, too, was, on balance, ‘less bad’ than feared.
Global central bankers, having spent much of the previous six months moving on seemingly divergent paths, came into greater harmony during the period. While the European and Japanese central banks refrained from embarking on major new stimulus programs, the U.S. Federal Reserve retreated from its late-2015 prediction of fairly aggressive rate hikes. With the Fed back on the sidelines, U.S. bond yield eased and the dollar weakened.
As noted, commodity prices were a notable bright spot during the period. The broad-based Goldman Sachs Commodity Index gained 16%; oil surged by more than 25% and gold rose 8%. While supply reductions – particularly among North American oil drillers – surely played a role, the price increases also constituted a hopeful sign with regard to the outlook for global economic growth.
Profits reported by large U.S. companies during the quarter (generally covering the first three months of the year) came in 7% below the year-ago figure. Wall Street analysts expect commodity-price and currency headwinds to continue to subside over the remainder of the year, resulting in year-over-year gains in the remaining quarterly reporting periods.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to give us the 2.5% S&P 500 total return?
|Second Quarter (April-June) 2016|
|+ Change in Earnings||+2.6%|
|+ Change in Valuation||-0.7%|
|= Total Return||+2.5%|
Our read: With stock prices essentially tracking the improvement in year-ahead earnings expectations, valuation remained above the long-term average; we expect continuing profit gains over the remainder of the year to help address this concern.
While the early market reaction suggests many investors have chalked up Brexit as a non-event, we fear that may be a naïve – or at least unhealthily complacent – conclusion. No one has any idea how Brexit will play out – a process that will unfold over as long as two years. The current U.K. government has indicated it will leave negotiations to its successor, whose leadership is unidentified and which won’t be in place until autumn. Even the leaders of the ‘Leave’ movement – which rode to victory on a muddled (some would say highly cynical) message combining anti-immigrant, anti-establishment, pro-sovereignty, and pro-welfare-state/pocket-book themes – seem to have no clue what their priorities will be. How the E.U. will approach negotiations is unclear, too. Some constituents will want to punish Britain and deter other would-be leavers; others will seek to ensure the most productive (least damaging) future economic and political relationship. How these divergent agendas eventually find resolution will determine the future strength or weakness of what has been the world’s most important continent for much of the past half-millennium.
Unless negotiations yield a new U.K./E.U. relationship remarkably similar to the old one (a possibility, to be sure), Brexit will have meaningful, negative implications for both the U.K. and E.U. economies. Most economists predict a recession in the U.K., with direct repercussions on the Continent given the large trade links between the two (a one-percent drop in the U.K. economy would likely translate into 1/3 to 1/2 as much damage in the much large E.U.). This likely downward impulse to global growth seems sure to keep global central banks, including the Fed, in accommodation mode beyond what otherwise would have been the case. In fact, Bank of England governor Mark Carney has indicated that Brexit is likely to require monetary-policy easing in coming months, while market indicators suggest investors have essentially abandoned the notion of Fed rate hikes this year. ‘Lower for longer’ (yields) is the unambiguous post-Brexit message.
Perhaps the most concerning aspect of Brexit is as another indication of populist, anti-globalization sentiment even in rich and relatively economically-healthy nations. If Brexit comes to be seen as the beginning of a tide – auguring gains by European nationalist/populist parties, additional departures from the E.U. and/or the common-currency bloc, and perhaps a growing likelihood that the U.S., too, veers away from long-established internationalist, free-trade policies in favor of a more inward-looking stance – financial markets could riot, anticipating both heightened political uncertainty and slower economic growth. That market participants seem – in these very early days – to be counting on a relatively undisruptive outcome to the momentous and complicated process that lies ahead makes us somewhat uneasy.
While handicapping future European economic growth and political development, as well as the likelihood that an even larger swath of the world is preparing to turn its back on globalization, investors will also remain focused on divining future trends in underlying investment fundamentals: corporate profits and the interest rates/bond yields used to derive their present value.
Last year’s 11% year-over-year decline in earnings for the companies that comprise the S&P 500 Index was an unusually poor result against a non-recessionary economic backdrop. Given the 1Q16 decline, even solid growth over the remainder of the year would leave aggregate profits well below their 2014 level. Given this trend, it is perhaps no surprise that U.S. stocks have gone essentially nowhere over the past 18 months. Looking ahead, the improvement in commodity prices, if sustained, will boost activity – from a dismally depressed base – in the energy and basic-materials sectors. The U.S. dollar has been roughly flat over the past year, following its major appreciation during 2014. As a result, relatively benign currency effects will help the results posted by industrial/export-oriented firms and multinationals with substantial overseas sales and earnings. On the other side of the ledger, a Brexit-braked global economy and very low inflation will everywhere hamper top-line growth, while rising labor costs (a result of low productivity growth) in the U.S. seem set to squeeze profit margins. All in, though some improvement seems likely in coming quarters, the degree of earnings acceleration currently penciled in by Wall Street analysts may prove optimistic.
As for interest rates, despite six-plus years of recovery following the 2008-2009 financial crisis/recession, bond yields across the developed world are at all-time lows, providing an important prop to asset values. Many investors (Oarsman clients among them) seem drawn to the notion that this interest rate environment is ‘artificial;’ i.e., that it has been engineered by activist central banks and that bond yields ‘should be’ meaningfully higher. While unconventional monetary policies have played an important role in lowering market yields, there is scant economic or financial-market evidence that rates/yields are ‘too low.’ Across the globe, economic growth is below potential, unemployment/underemployment is elevated, corporations are hoarding mountains of cash for want of attractive investment opportunities, and inflation is very low. And though real-estate and equity-market prices have risen substantially from the depressed levels of 2009, there are few signs of bubble-like exuberance.
Whatever their causes, low yields look to be a fact of investing life longer than we (or almost anyone) had anticipated – the more so in the wake of Brexit. As a strategic response, investment portfolios targeting a given level of return and/or income may need to rely more on dividend-paying stocks and higher-yielding non-core investment categories (e.g., real-estate securities, non-investment-grade debt), with an attendant increase in the variability of shorter-term results (i.e., greater volatility). At the same time, heightened economic and political uncertainty – and potentially adverse market reactions – may call for a tactical increase in portfolio holdings of cash and near-cash equivalents (e.g., very-short-term bond funds). Such reserves provide some protection against market dips and – importantly – serve as ‘dry powder’ to fund opportunistic investments in temporarily cheap assets.
We hope you are enjoying the summer; please let us know if you have questions about our management of your investments.
Alan Purintun, CFA Robert W. Phelps, CFA
Principal & Portfolio Manager Principal & Portfolio Manager