Most categories of financial investments recorded a second-straight period of gains during the July-September quarter. Large-company U.S. stock benchmarks advanced more than 3%; small-caps did considerably better. Overseas equity investments outperformed, too, with especially strong results coming from the emerging-market category. Real-estate investments gained, with timber-related issues bouncing back strongly from declines in the spring. Commodity prices were only modestly lower: oil and gold both dipped less than 1%. Bond yields edged higher: the 10-year U.S. Treasury note finished at 1.60%, up from 1.49% at the end of June, resulting in muted but positive returns for most fixed-income investments.
Among U.S. stocks, better results came from companies in the Basic Materials, Consumer Cyclicals, Financial Services, and Technology sectors. Weaker groups included Capital Goods, Consumer Staples, Energy, Health Care and Utilities. Growth-oriented names outperformed the value category, reversing the trend of the prior two quarters.
Benchmark Performance – Equities
|Third Quarter 2016||Last Twelve Months|
|S&P 500 Index||+3.9%||+15.4%|
|Large-Cap Core Mutual Fund Avg. (Morningstar)||+3.8%||+12.0%|
|Small-Cap Stocks (Russell 2000)||+9.1%||+15.5%|
|Non-U.S. Stocks – Developed (MSCI EAFE)||+6.4%||+6.5%|
|Non-U.S. Stocks – Emerging (MSCI EM)||+8.8%||+16.2%|
Benchmark Performance – Fixed Income
|Third Quarter 2016||Last Twelve Months|
|Intermediate Gov’t/Credit Index (taxable; Barclays)||+0.1%||+3.3%|
|Intermediate Municipal Mutual Fund Avg. (Morningstar)||-0.2%||+4.8%|
Following the late-June market turmoil triggered by the surprise ‘Brexit’ vote, the July-September period saw a return of the extremely low volatility that has prevailed for much of 2016. After quickly recouping the 6-percentage-point loss triggered by the U.K. referendum, U.S. stocks (as measured by the S&P 500 Index) had climbed to new all-time highs by mid-July, and spent the rest of the quarter trading in a very narrow range. Meanwhile, bond yields (as measured by the benchmark 10-year U.S. Treasury note) briefly plumbed new lows below 1.40% in early July before recovering somewhat and spending the remainder of the period between 1.50% and 1.70%.
Readings on the health of the U.S. economy released during the quarter were a mixed bag, showing the lingering effects of another early-year slow-down – particularly in the industrial sector – as well as indications of second-half pick-up. Second-quarter gross domestic product (GDP) came in well below expectations at +1.4%, though the key personal-consumption component was a robust +4.3%. Purchasing-managers indices declined through the period, and both wage growth and retail sales were mostly disappointing. Meanwhile, the economy added a monthly average of more than 230,000 jobs, the housing market remained healthy, and consumer confidence hit a nine-year high. Inflation remained low and stable. On balance, the data seemed to show an economy continuing to expand at a modest rate with few signs of meaningful imbalances (either overheating or weakness).
Overseas economic news was highlighted by indications that neither the U.K. nor continental European economies had yet experienced much downside from the Brexit referendum: both business and consumer sentiment seemed largely unfazed and a number of other coincident and forward-looking indicators suggested doomsayers’ predictions may have been overdone. Elsewhere, the Japanese economy continued its chronic underperformance, with the industrial sector weighed down by a stubbornly strong currency. Data released from China during the period seemed to confirm that the world’s second-largest economy had stabilized (at least temporarily): official second-quarter GDP came in at +6.7%; purchasing-managers’ indices were stable or modestly rising; and retail sales and industrial production showed solid gains in the +10% and +6% ranges, respectively. Among other emerging markets, the Nigerian economy – hamstrung by low energy prices and soaring inflation – entered its first recession in two decades. The Mexican economy also exhibited weakness, while Brazil, Russia and South Africa all showed signs of relative strength (albeit against low expectations).
Global central bank policies remained highly accommodative during the period. The U.S. Federal Reserve continued to refrain from raising its short-term interest rate target (though it strongly signaled that, on current economic trends, it intends to hike rates before yearend). The Bank of England was joined by the central banks of Australia, New Zealand, Indonesia, Russia and Turkey in easing monetary conditions. The European Central Bank and Bank of Japan made no major changes to their quantitative easing (bond-buying) programs, which resulted in more than ten trillion dollars of government debt being priced to produce negative yields during the period.
Quarterly earnings (generally covering the April-June period) reported by the companies that comprise the S&P 500 Index declined once again, but came in less than 2% below the year-ago figure. With year-over-year commodity-price and foreign-currency comparisons continuing to improve, Wall Street analysts expect third-quarter profits to show the first gain since late 2014. They project a strong second-half to push the full-year 2016 figure up nearly 10%, with the gains continuing to accelerate in 2017.
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 +3.9% S&P 500 total return?
|Third Quarter (July – September) 2016|
|+ Change in Earnings||+1.9%|
|+ Change in Valuation||+1.5%|
|= Total Return||+3.9%|
Our read: Price gains once again exceeded the improvement in year-ahead earnings, so valuation remained elevated. We expect accelerating profit growth over the next several quarters to help address this predicament.
The near-term outlook for the U.S. financial markets is surely dominated by the looming November election; below we take a stab at handicapping the contest from investors’ (admittedly narrow) perspective. Beyond the next few weeks, two other developments likely to be scrutinized as 2016 winds down are evolving global monetary policy and a potential increase in government spending (‘fiscal stimulus’) across a number of regions.
The November election, in our view, has the potential to be among the most impactful in some time with respect to the financial markets. Though many market participants (including a fair share of Oarsman Capital clients) would not welcome a Clinton win, we nonetheless believe they would find the contours of her administration familiar, and their meaning for financial investments – whether positive or negative – relatively straight-forward to assess. After all, Mrs. Clinton has been a leading political figure for the better part of three decades, and her policy positions lie well within the Democratic mainstream. Donald Trump, on the other hand, is a political novice, many of whose policy notions do not conform to traditional Republican (or conservative) norms, and whose demeanor and management style stand in stark contrast to the Washington establishment. A Trump victory would be viewed by most observers as a sharp turn in American politics and could inaugurate a period of potentially dramatic uncertainty – a condition rarely conducive to positive short-run investment results.
We believe early October’s high market prices and low volatility discount conventional wisdom – supported by polling data – that Mrs. Clinton has a relatively high probability of winning the election, but that her margin of victory will be insufficient to give her an undisputed policy mandate or yield Democratic control of both houses of congress. But after the failure of both pollsters and the elite punditry to accurately predict the outcome of June’s Brexit referendum (ditto the more recent Colombian peace referendum), we are more than a little apprehensive about the current calm. As October progresses, we will be closely eyeing the polls and electronic betting markets for signs that the race is evolving to the detriment of client portfolios.
While the election might produce some unsettling short-term market turbulence, the medium-term outlook may hinge on perceptions of evolving global central bank policies. A year ago, we wrote to you about a looming divergence of central bank policies: the Fed had primed investors to expect multiple 2016 rate increases, while central bankers elsewhere (Japan, Europe, China) seemed intent to ease monetary conditions. Investors didn’t care for this prospect, presumably fearful an aggressive Fed would tip a fragile global economy into recession. The January-February global market sell-off, combined with (yet!) another first-half slow-down in the U.S. economy, prompted the Fed to beat a hasty retreat; rates have remained on-hold since last December. Today, it’s déjà vu all over again: at its latest meeting, the Fed put investors on notice that, barring an unexpected swoon in the economic data, short-term interest rates will likely be raised soon. Meanwhile, the other major banks, though arguably running short of new ideas, are by no means ready to begin withdrawing support from their respective economies. An important difference this time around, however, is that the Fed has indicated a much more gradual pace of rate increases, with the overnight rate (currently 0.25%-0.50%) projected to remain below 2% through 2018. Market behavior since the September Fed meeting suggests investors are – at least so far – substantially more comfortable with this year’s iteration.
Former PIMCO co-CEO Mohamed El-Erian recently published a book on central banks called ‘The Only Game in Town’ – a nod to the preponderant role played by monetary policy – at the expense of fiscal policy – in supporting the global economy in the aftermath of the 2008-2009 financial crisis/recession. We suspect the game may be about to change. Evident in recent months has been growing disillusionment with ‘unconventional’ monetary policy, epitomized by negative interest rates in Japan and Europe that seem to have done little to ignite growth. This disillusionment has increasingly been paired with a willingness to entertain expansionary fiscal policy as a tool for boosting growth: Governments from Canada to Japan, the U.K. and even Germany have begun to spend more and/or tax less. The early-September G20 summit in China yielded a commitment among the world’s major economies to “use all policy tools – monetary, fiscal and structural” to achieve growth. And the rhetoric on both sides of the U.S. presidential campaign likewise calls for higher government spending on the military and infrastructure projects, in addition to tax cuts. If this trend continues, it could mark a meaningful turn in the struggle to escape the sluggish growth that has plagued the post-financial-crisis global economy. We will be watching these developments, and the markets’ reaction, with keen interest.
As we have discussed in past letters, the collapse in commodity prices and surge in the U.S. dollar since mid-2014 have weighed heavily on the aggregate profits generated by large publicly traded U.S. companies; in fact, the most recent trailing-12-month figure was more than 10% below the 2014 peak. Battling this headwind – and despite finishing September just one-percent off an all-time high – the S&P 500 Index stands a meager 3% above a level first reached during the fourth quarter of 2014. Unless earnings growth can be reestablished, we suspect the market will remain tethered. As noted, commodity and currency comparisons are presently turning positive, providing a profit tailwind for the next several quarters. Persistently sluggish global economic growth and low inflation have made top-line gains hard to come by for much of the recovery. We will be watching closely to see if the nascent shift to fiscal expansion discussed above can begin to alter this dynamic in coming months and quarters.
In closing, we are pleased to note that the July-September period marked the first time in almost three years that all categories of non-U.S. equities (i.e., developed, emerging and frontier markets) outperformed the S&P 500. As geographically-diversified investors know all too well, the recent results stand in contrast to a dismal showing by overseas stocks from 2011 through 2015. While we won’t go on record that a new trend has been established, we will observe that, in addition to potentially benefitting in coming months from more supportive monetary policies, non-U.S. equities are now meaningfully cheaper, on average, than domestic stocks. According to data compiled by German investment firm Star Capital, European, Japanese, and Emerging-Market equities all trade at substantial discounts to U.S. stocks in terms of price-to-cyclically-adjusted earnings (i.e., P/E ratio using earnings averaged over 10 years), price-to-book, and dividend yield. We have long held that exposure to non-U.S. stocks is likely to benefit long-term portfolio performance; the valuation advantage currently enjoyed by overseas equities only increases our confidence in that call as it relates to the period ahead.
We encourage you to call or email us if you have comments or questions regarding our management of your investment portfolio.
Alan Purintun, CFA Robert W. Phelps, CFA
Principal & Portfolio Manager Principal & Portfolio Manager