Most categories of financial investments turned in flat results for the April-June period. Global stocks were solidly in the black until the quarter’s last two trading days, when unsettling news from Greece, China and Puerto Rico resulted in a sharp, synchronized sell-off that left most markets near the unchanged mark. Elsewhere, real-estate securities declined, while commodity-related investments gained. In an unfamiliar development, bond yields were broadly higher – the 10-year U.S. Treasury Note finished the period at 2.34%, up from 1.93% at the end of March – resulting in modest losses for most fixed-income investments.
Within the U.S. stock market, relatively strong returns came from stocks in the Capital Goods, Business Services, Financial Services and Health Care sectors. Weaker results came from stocks in the Basic Materials, Consumer Cyclical, Energy and Utilities groups. Small-company stocks slightly lagged their large-company counterparts, while there was no clear pattern among returns provided by growth- versus value-oriented investments.
Benchmark Performance – Equities
|Second Quarter 2015||Last Twelve Months|
|S&P 500 Index||+0.4%||+7.1%|
|Large-Cap. Core Mutual Fund Avg. (Morningstar)||+0.02%||+5.3%|
|Small-Cap Stocks (Russell 2000)||+0.4%||+6.5%|
|Non-U.S. Stocks (Developed – MSCI EAFE)||+0.8%||-3.8%|
|Non-U.S. Stocks (Emerging – MSCI EM)||+0.8%||-4.8%|
Benchmark Performance – Fixed Income
|Second Quarter 2015||Last Twelve Months|
|Barclays Intermediate Gov’t/Credit Index (taxable)||-0.6%||+1.5%|
|Intermediate Municipal Mutual Fund Avg. (Morningstar)||-0.9%||+2.2%|
Prior to the quarter-end jolt of volatility, U.S. financial markets experienced an unusually calm spring. The S&P 500 Index spent the entire period within an extremely narrow range of less than 75 points (approximately 3% of its March 31st value), and until the June 29th sell-off, the quarter saw no single-day gain or loss exceeding 1.5%. According to Bespoke Investment Research, the first half of 2015 was one of the least volatile on record, with the S&P 500 Index never venturing more than 3.5% (plus or minus) from its 2014 year-end level. Overseas, things were a bit more exciting, particularly in China, where stock-market benchmarks soared to twelve-month gains of 100% or more through early June before falling sharply – more than 25% from the peak – toward the end of the period.
Economic news during the quarter was mixed, but improved noticeably as the period progressed. For the second year running, the U.S. economy contracted slightly during the winter quarter, impacted by severe weather, slashed energy-sector spending, and exporters hamstrung by a strong dollar and strikes at West Coast ports. While statistics emanating from the industrial side of the economy have yet to pick up much, recent reports from the much larger consumer sector have been firm: monthly employment gains around 250,000 pushed the unemployment rate below its 20-year average; real estate prices continued to rise; and surveys of consumer confidence neared post-recession highs. Economists perplexed by persistently weak consumer spending during the winter – despite a boost to disposable income from dramatically lower gasoline prices – were gratified by a sizeable upturn in May.
Outside the U.S., data continued to suggest another year of below-average global growth, with improving but slow growth in developed economies offset by deteriorating conditions in faster-growing emerging markets. As the European Central Bank’s (ECB’s) quantitative easing (bond-buying) program proceeded, forecasters upgraded growth projections; Eurozone consumer prices and inflation expectations both edged up, signaling a receding threat of deflation. The Japanese economy (also under the influence of central-bank bond-buying) notched its best growth in a year during the winter quarter, though consumer prices continued to fall. In China, a spate of weak statistics from the real-estate and industrial sectors prompted the People’s Bank (PBOC) to ease monetary policy aggressively during the period, fueling the country’s stock-market bubble. Though reports late in the period hinted at improvement in some underlying economic trends, many observers doubted growth was on pace with Beijing’s ‘new normal’ target of around 7%.
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 explain the +0.4% S&P 500 total return?
|Second Quarter (April – June) 2015|
|+ Change in Earnings||+4.3%|
|+ Change in Valuation||-4.2%|
|= Total Return||+0.4%|
Our read: The large gain in next-four-quarters earnings resulted from dropping a particularly bad 1Q15 and adding a highly optimistic figure for 2016’s first quarter. Until reported earnings turn up, we would take the implied improvement (decline) in valuation with a grain of salt.
Improving economic trends and the (related) increasing probability that the U.S. Federal Reserve will soon begin to raise short-term interest rates pushed bond yields higher in most markets during the quarter. In their first meaningful rise since mid-2013, U.S. benchmarks rates climbed by more than four tenths of a percentage point. As deflation fears waned, Europe, too, saw dramatic change, with 10-year German government bond yields more than doubling from an early-year low below 0.40% and finishing the period around a still extremely low 0.80%.
Hit by a reeling energy sector and an appreciating currency, U.S. corporate profits for the first quarter (reported during April/May) came in about 5% below year-ago levels. Wall Street analysts continued to reduce their estimates for the remainder of 2015, though the pace of cuts diminished during the quarter; they remain characteristically optimistic regarding 2016, predicting a gain of nearly 15%.
As we write this letter, investors are mesmerized by rapidly unfolding dramas emanating from Greece, China and Puerto Rico; definitive analysis is likely to be overtaken by events before it reaches you. We feel safe repeating about Greece what we have said before: even the messiest of outcomes seems unlikely to be calamitous. Nearly all Greek debt is now held by European governments and central banks (rather than commercial banks), so default poses scant threat to the financial system. Moreover, the ECB now has the authority (and political will) to fight ‘contagion’ by buying unlimited quantities of the sovereign debt of any nation (e.g., Spain, Portugal, Italy) that might come under attack by speculators. Whatever the precise outcome, however, it seems to us that the Greek crisis will have seriously undermined the entire Euro project. In its aftermath, Europe will be more in need than ever of politically fraught reforms to prevent future crises from causing further unraveling.
The Puerto Rican situation has been simmering in the background for many months, though the Governor’s late-June announcement that the island’s debts are unpayable was a bit of a bombshell. In all likelihood the worst case for most bond-holders is an eventual ‘haircut’ of 30-40% of face value; many will fare much better. (Most uninsured Puerto Rican bonds are already trading at substantial discounts, so much of the damage has, in effect, already been done.) And since most Puerto Rican debt is held by hedge funds and wealthy individuals, rather than banks, the potential for financial-market dislocation should be small. Finally, ‘contagion’ of other muni-market participants is likely to be limited (no other large issuer’s finances are nearly as parlous as Puerto Rico’s, where per capita debt is roughly three times that of the most heavily burdened states). However, legal precedents likely to be set as the Puerto Rican situation unfolds could cause investors to re-rate the likelihood of similar events elsewhere, which could push some muni yields higher.
With respect to the Chinese stock market, the PBOC seems to be taking a page from Alan Greenspan’s successful monetary-policy playbook following the 1987 Wall Street crash – which, to the surprise of contemporaneous commentators, did not lead to recession. We suspect Beijing will leave few holds barred to prevent a full-scale melt-down; healthy equity markets are too important to the authorities’ plans for modernizing the Chinese financial sector and reducing the economy’s reliance on debt financing. However, we must acknowledge that China is the world’s second-largest and probably most-opaque economy: at more than 50-times the size of Greece (as the Wall Street Journal’s Jon Hilsenrath has observed), a two-percentage-point drop in China’s growth rate would be equivalent to the Greek economy ceasing to exist. As such, we will be watching developments carefully.
The near-term distractions discussed above obscure what we believe is a fairly straight-forward and not especially alarming picture for investors: the U.S. economy is on solid footing; global central bank policies remain supportive of improving growth, receding risks of deflation, and rising asset prices; and though some valuations are higher than we might like, there are few signs of financial-market imbalances that might augur a major downturn. Nevertheless, uncertainties remain – the most important being the shape of the Federal Reserve’s long-anticipated ‘normalization’ of monetary conditions and the future trajectory of earnings growth.
Barring a Greece- (or perhaps China-) triggered financial-market dislocation, the recent performance of the U.S. economy puts the Fed squarely on course to begin raising interest rates late this year or early next. However, even if the timing is no longer much of a mystery, the pace of rate hikes and the level to which yields eventually rise both remain quite uncertain. If growth remains subpar (as it has for the entire recovery) and inflation quiescent (the Fed’s preferred gauge has undershot the unofficial 2% target for the past 37 consecutive months), the Fed seems likely to raise rates gradually and stop with the overnight ‘Fed Funds’ rate considerably below the recent-historical norm of 4% or more. We believe this scenario, which might leave the 10-year Treasury yield well below 4%, is what market participants, on average, currently anticipate. If inflation and/or growth were to surprise to the upside, causing the Fed to raise rates more quickly and/or to a higher level, both bond and stock markets would likely experience increased turbulence.
We have pointed in past letters to a worrisome deceleration in earnings growth, from year-over-year gains of 10% or more as recently as mid-2014 to the most recent quarter’s decline of around 5%. The slow-down has been largely due to the roughly 10% appreciation in the trade-weighted value of the dollar (which depresses both export sales and the dollar-value of profits earned abroad) and the collapse of energy-sector earnings due to the 50% decline in the price of crude oil over the past year. While a repeat of the oil-price collapse seems unlikely, further appreciation of the dollar, brought about by unanticipated shifts in Federal Reserve policy or a worse-than-expected outcome of the Greece crisis, is quite plausible. Barring further dollar strength, a resumption of earnings growth could hinge importantly on the path of unit-labor costs. These costs are the product of wages, which seem set to rise as slack disappears from the jobs market, and productivity growth, which has been weak of late. If productivity growth doesn’t pick up, rising wages – though a boon to U.S. households – would erode profit margins and hold back earnings growth.
The current valuation of U.S. stocks, which we would characterize as moderately above average, suggests investors expect interest rates to rise gradually and modestly and earnings growth to reaccelerate. We think these are reasonable expectations, but by no means sure bets. Though disappointment on either front would not necessarily result in a major decline in prices, we feel it is prudent to maintain a degree of caution with regard to stock-market exposure, and, at the margin, look to add to bond holdings if yields become more attractive in coming months.
We hope you are enjoying the summer; please let us know if you have questions regarding our management of your investments.
Alan Purintun, CFA Robert W. Phelps, CFA
Principal & Portfolio Manager Principal & Portfolio Manager
759 North Milwaukee St. Suite 605
Milwaukee, WI 53202
Madison Area Office
634 Water St. Suite A
Prairie du Sac, WI 53578
13160 West Burleigh Rd.
Brookfield, WI 53005
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