Altium 2016 Second Quarter Update
On behalf of the Altium Investment Committee;
The baseball season is approaching its mid-season break and “Yogi (Berra)-isms” keep coming up. One of them seems particularly appropriate given recent developments in world events. As Yogi wisely surmised, “Making predictions is hard, especially when it comes to the future”. Just ask the UK bookmakers who were offering 9:1 betting odds on the “Leave” vote the day before the British electorate surprised everyone by voting to exit the European Union. We trust that you survived the “Brexit” surprise and hope that you are enjoying summer and staying well.
In fact, international developments including “Brexit” dominated the investment scene over the course of the last quarter. In our March update we said that we would be watching the 3 C’s – China (pretty quiet since then; no abrupt and disruptive currency devaluation like the one experienced in Q1), Commodities (prices have continued to rise in response to supply rebalancing; oil most notably, with gold re-entering the picture as a “safe haven”) and Central Banks (here is where we think the issues lie). We went on to say that maintaining a positive outlook would depend on the ability of the central banks to find the right tools to support asset prices and keep the economic expansion on track, pointing out that navigating an appropriate course in a low growth, near-zero interest environment would be an on-going test of will and skill and one likely to produce considerable volatility. Recent developments in the UK and Japan are testimony to the problems that central banks can encounter in attempting to carry out their mandate in today’s abnormal circumstances. This reminds us that an over-reliance on easy money as practically-speaking the only option policy makers have today does indeed produce volatility, sometimes of an extreme nature.
Less sensational than “Brexit”, but certainly a negative surprise during the quarter was the apparent failure of “Abe-nomics” and Bank of Japan (BOJ) policy that manifested itself in that country. Rather than inspiring weakness in the yen which was designed to lead to an acceleration in GDP growth and inflation, central bank policy which called for massive quantitative easing (including supporting the Tokyo stock market) had the reverse effect as the yen showed surprising and significant strength, thus dampening the outlook for growth and the desired pickup in inflation. Faced with unexpected and significant yen strength, the BOJ chose not to “double down” with further easing (causing further strength in the yen) midway through the quarter. Reflecting these developments, Japanese equities declined sharply during the period and have been the worst performing asset class in 2016. What the Japanese central bank chooses to do from here is really a hard choice. Judging how effective further monetary ease might be, is extremely difficult given the fact that Japanese interest rates are already in negative territory.
Meanwhile back in the U.S., the Federal Reserve’s attempt to normalize monetary policy by raising rates has been hampered by its growing concern over the downside risks coming from abroad. The uncertainty over growth prospects in the UK and Europe following the “Brexit” vote seems likely to delay any rate increase on the part of the Fed for some time to come. The fact that rates are already near zero leaves the Fed with little room to respond and explains the central bank’s preoccupation with global downside risks. Growth of the U.S. economy continues to bump along, alternating between pickup and slowdown, but not showing any meaningful signs of slipping back into recession. Real GDP did fall back to a 1.1% growth rate in Q1, but is forecast to continue a 1.5 – 2.5% growth trajectory for the balance of the year. Inflation measured by the PCE indicator is also rising at a slow pace, but has not yet reached the Fed’s target of 2%. Below is a 10-year chart of U.S. Monthly GDP growth (blue) and Inflation (orange).
Of perhaps greater concern to policy makers in the U.S. is the vexingly slow rate of growth in the productivity of labor. How is it that GDP is only growing at a rate approaching 2% when millions of new jobs have been created? We are at “full employment” as measured by an unemployment rate of under 5% (although the growth in nonfarm payrolls has slowed from last year’s pace) and yet wage growth has not been able to reach 2%, which would still be a subpar pace by historical standards. About all we can say on the positive side is that we don’t seem to be looking at an overheating situation that would call for significant monetary tightening which could lead to a recession.
So what about our investment strategy in a post “Brexit” world? In many respects it is difficult to get very excited about the outlook for either stocks or bonds at present given the uncertainty surrounding global growth prospects on the stock side and the “flight to quality” run-up in prices on the bond side. The performance of U.S. stocks as measured by the S&P 500 has been disappointing, but nonetheless is better than that of European and Japanese stocks, which have suffered significantly from the currency and political turmoil described above. Emerging market stocks, last year’s lead underperformer, have generally been the best performer this year, despite giving back some of their Q1 outperformance in the global “Brexit” meltdown. Other than a possible rebalancing of the sub-asset classes in the equity portion of our clients’ portfolios to get them in line with their targeted weightings, we are not changing our equity allocation at this time.
Investment grade fixed income securities have been the star performer this year and outperformed stocks again in Q2 driven by a “flight to quality” and a decline in interest rates that few people saw coming. While we didn’t see the rate decline coming either, we have regularly re-affirmed our commitment to maintaining our clients’ bond allocations as an important element of diversification even in the face of the prospect of rising rates (See chart below). Looking for a continuation of bond outperformance is a tough call at present, but we are again encouraging our clients to stick with their fixed income allocation targets even if the Fed decides to raise interest rates later this year. When we consider the likelihood of the kind of spike in longer term interest rates in the U.S. that could do significant damage to our clients’ bond portfolios we are reminded of our belief that our bonds are relatively attractive to foreigners. To us the 1.40% current yield on the U.S. Treasury 10year bond is so low that it may no longer appear to be an attractive investment; but to a European or Japanese buyer looking at the prospect of buying 10year domestic bonds with no yield at all (in fact at a negative yield), the opportunity in U.S. Treasuries is significant even with the attendant currency depreciation risk (Refer to Appendix B for global yield chart). As long as this inter-country interest rate differential persists and the opportunity for global arbitrage exists, we don’t worry too much about a spike in interest rates that would significantly impair the value of our clients’ bonds.
Looking ahead to the rest of the year, we have no shortage of things to watch out for. Additionally, we have the overlay of a presidential race in the U.S., the outcome of which is by no means clear. It is a particularly tricky time in the world as political uncertainty has re-asserted itself alongside of the economic issues that persist in many countries. The unpredictability of populist and nationalistic politics that is on the rise has definitely complicated the outlook. Central banks have got their work cut out for them. They are the only policy making game in town and financial market participants continue to rely heavily on them to steer the right course. We’ll do the best we can to help you keep track of these developments by staying in touch regularly. Hopefully we will see you in the office soon. Have a wonderful summer.
All the best for now,
Altium Investment Committee
A) 12mth major index market returns; US Equity (Russell 3000); Domestic Bond (LQD); International Equity (EFA)
B) 10- year Global Bond Yields
C) Monthly Asset Class Returns
Asset Categories represented by: Large Cap (Russell 1000 TR USD), Small Cap (Russell 2000 TR USD), International (MSCI EAFE GR USD), Emerging Markets Equities (MSCI EM GR USD), Corporate Bonds (Barclays US Agg Bond TR USD), High Yield (BofAML US HY Master II TR USD), Long Term Treasury (Barclays Long Term US Treasury Yld USD), Emerging Market Bond Index (JPM EMBI Global Diversified TR USD), 60/40 (37 % Russell 1000 TR USD, 5% Russell 2000 TR USD, 12% MSCI EAFE GR USD, 6% MSCI EM GR USD, 30% Barclays US Agg Bond TR USD, 4% BofAML US HY Master II TR USD, 4% JPM EMBI Global Diversified TR USD, 2% FTSE NAREIT All Equity REITs TR USD). Performance as of 7/1/2016. Past Performance does not guarantee future results. Indices are not directly investable. Source: Morningstar
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