Q2 2015 Market Perspective
Can you believe that the 4th of July is already here? The markets had been pretty quiet since we last wrote to you back in April. Up until a couple of weeks ago that is, when the Greek financial crisis jumped back into the headlines and European stock and bond prices fell sharply (dragging U.S. bond prices with them). So what’s going on out there? It’s time for us to share our latest thoughts on the financial markets with you.
WHILE EUROPE WORRIES ABOUT A 'GREXIT', THE U.S. IS SHOWING SIGNS OF A RETURN TO NORMALCY
The employment numbers continue to represent the most hopeful sign of a full recovery in the U.S. as the monthly number of new jobs created remains steady at 250,000-300,000. Wage growth, however, has stubbornly and somewhat inexplicably lagged the good performance of the jobs numbers. But the May number showed a welcome pickup - wages increased at an annual rate of 2.3%, the highest rate in 2 years. This is a good sign, but not the 3-4% growth that the Fed would like to see (in order to push the inflation rate up to its 2% target rate). Nonetheless the U.S. labor situation is starting to make sense again.
The May retail sales number also caught our attention, increasing a robust 1.2%. The drop in oil prices was supposed to spur a surge in consumer spending, but retail sales had remained flat until the May report. If consumers continue to respond, the U.S. economy, which was reported to have shrunk at an annual rate of 0.7% in the first quarter, could have grown at a much faster rate in the most recent quarter. However, even if the 1st quarter GDP gets revised up to zero and the 2nd quarter grows at 3%, we still only get to 1.5% growth in the first half. Nice uptick and another indication of a return to normalcy, but nothing to get too excited about.
As these better numbers fall into place, the Fed has us all on notice that it will start to raise interest rates in the near future. But the timing of the first increase remains “data dependent” and thus, elusive. Up until April, the bond market was pricing in little or no increase in interest rates. But then all of a sudden the 10 year U.S. Treasury yield shot up to 2.50% from 1.85%, leaving bond investors somewhat shaken. Painful and perhaps overdone, the direction of bond yields makes sense in light of recent developments in the economy.
So what about the unusual volatility in bond yields across the globe? Was this volatility caused by the current Fed policy or the pace of recovery in Europe and Japan? Or was it the result of what noted bond expert Bill Gross, founder and former CIO of Pimco Asset Management now with Janus Capital, has labeled a “malinvestment” in financial assets or the “short (sale) of a life time.” Bill Gross was referring to investing in German bunds yielding an interest rate of less than ¼ of 1% (shown by the blue line in the chart below) which he believed was due to the excessive global monetary policy that set short term interest rates at 0%. The volatility began when German bond yields scraped zero, then abruptly turned and raced back to 1%, pulling global yields dramatically higher. This action causes us to reflect on the abnormality of today’s low interest rate environment and what other volatility-inducing “malinvestments” might be lurking out there.
U.S. STOCKS 'HANG IN THERE' WHILE EUROPEAN & EMERGING MARKET STOCKS DECLINE; JAPAN & CHINA SHINE
While bond prices around the world have suffered recently, stocks in the U.S. remain close to their all-time highs. Stocks in Europe however have given back a significant portion of their 1st quarter gains in response to the unresolved situation in Greece and mixed signals about the pace of economic recovery in the Eurozone. Stocks have continued to advance in Japan as investors remain firm in their support of “Abenomics” as well as in China where demand continues to outpace supply. However, stocks in the rest of Asia and in other emerging markets have suffered from the rise in interest rates and the continuing slump in commodity prices (other than oil which has recovered a bit since its 1st quarter lows).
INVESTMENT STRATEGY UPDATE
When it comes to your investments, you have heard us say this before. “Let’s review the portfolio to make sure that your asset allocation is in line with your risk tolerance and if so, then let’s leave it alone.” Steady as she goes - remembering to resist the temptation to double up on that part of the portfolio that did the best last quarter or even last year (because there is no guarantee that that sector is going to continue to outperform).
“But what about my bonds? I thought they weren’t supposed to keep me up at night.” While the recent bout of volatility in bonds is unsettling for sure, we remain committed to this asset class for the long term. To reiterate, the role of bonds in a portfolio is primarily as a volatility-reducing and balancing element, capable of hanging in there, when the stock allocations in the portfolio are under pressure. We do not generally look to bonds to carry the performance burden of a portfolio; we look to them more to counterbalance the higher risk normally associated with the equity asset classes.
Gregory Slater, CFA, CFP®
Chief Investment Officer
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