Surprise END to
We continue to live in unprecedented times. Consider that 40% of the world’s sovereign debt is at negative interest rates and central bank balance sheets worldwide hold a combined $10 trillion of fixed income assets. The latest shock occurred at the end of the quarter when Britain voted to leave the European Union. Clearly financial markets were surprised by the outcome as stocks fell, bond prices rose, and the dollar and yen strengthened once the results were tallied.
The world bond markets are telling investors that growth is lackluster and will likely take a step lower after Brexit. Ten-year sovereign yields plummeted across the globe as investors ran to traditional safe-haven securities. Brexit will reduce confidence and likely restrain spending by businesses. Forecasting firm IHS Global Insight predicts that the UK’s economic growth rates will fall sharply for the next several years, hitting just 0.2% in 2017.
Unmistakably there is a backlash under way against free trade and globalization because the downside of globalization (lost jobs) are often more tangible than the upsides (lower prices, stronger markets, and higher economic growth). This trend is a significant risk to the world’s long-term growth potential and will be monitored closely. Hopefully a full retreat can be avoided and the benefits of globalization shared more widely.
A good part of the volatility at the end of the quarter was simply because stocks had already made a remarkable recovery from the February lows and was susceptible to a pullback. The S&P 500 has been in a trading range since late 2014 which coincides with the ending of quantitative easing by the Federal Reserve with a high near 2100 and a low near 1850. While the market reaction to Brexit was dramatic, at this time we don’t think it heralds a financial crisis like we saw with the Lehman bankruptcy in 2008. However, we will be on high alert in case this event has more meaningful repercussions. The market has had trouble breaking above its highs because earnings remain lackluster. Globally, the profits of MSCI World companies are down 4% from their peak in 2014, and back to where they were five years ago. However, stocks find support at the bottom of the trading range around 1850 because the dividend yield becomes quite attractive in a world of negative interest rates.
In some aspects the quarter was similar to the recent past –US stocks meaningfully outperforming international stocks, defensive stocks did well, and interest rates probed new lows. Below the surface, however, there were signs of change. Most importantly, market breadth broaden out which is a positive sign and a big improvement from last year. Value stocks lagged growth stocks badly last year but value is outperforming growth so far in 2016. Likewise small- and mid-capitalization stocks are doing better. From a bottom-up perspective more stocks are looking attractive as many have been through nasty bear markets resulting in companies with reasonable valuations and strong balance sheets. We used some of the cash in the portfolio late in the quarter to buy stocks as prices fell and hope to do more in the second half of the year.
Jim Tillar, CFA, Steve Wenstrup
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