Global Markets: Cautiously Good
This quarter and 1st half have been full of ups and downs, and everything in between. Commodities and emerging markets quietly led the way in performance, after several years near or at the bottom, while REITS stayed on top for the 3rd year. But the big talk has been Brexit which sent the markets into a brief tailspin, quickly followed by a run up in equity prices leading to new highs. Energy prices rising continue to benefit all producers, but remain low enough to benefit consumers. While world interest rates, remaining historically low to negative, make money cheaper than ever before. Despite a great degree of uncertainty in the Eurozone, overall this appears to be shaping up as decent year for overall returns.
U.S. Economy: Good
U.S. Economic data continue to be healthy, and while sentiment remains cautious, it is improving. The economy is expanding, albeit slowly, with unemployment creeping ever downward, a firming housing market, and credit usage increasing. Yet, the consumer is still maintaining an above average savings rate. Wages are showing signs of finally moving up, with recent announcements from Starbucks, JP Morgan and others of establishing their own internal minimum wage 20-50% above the Federal rate. Corporations also continue to spend and hire but still maintain remarkably high levels of cash, frequently now being deployed in share buybacks and M&A activity. The weakness we saw earlier in the year in manufacturing and productivity shows signs of reversing, with a backlog of orders forecasting stronger numbers through the end of the year. Earnings so far have been just average which is to say not bad, while valuations for the equity market are still healthy. Look for signs of inflation, which would be welcome at a reasonable rate as long as it accompanies growth in wages. This stimulus might help the Fed to get off the bench and really work on normalizing rates.
Inflation continues to be well below historical averages, and below the Fed target of 2%, although there are signs that it might creep up. While energy and food are excluded from the Core PCE figure, the effect of energy prices on the pricing of all other things can be felt in the price of those goods and services. While energy will likely continue to be volatile, the general consensus is that it will continue to creep up over time. However, absent an unforeseen spike, and with continued low interest rates, low cost manufacturing, and other factors, inflation appears to continue to be much lower than average. Year over year core PCE in May measured 1.62.
Interest Rates: Neutral
Yellen has explicitly indicated that she will be very slow in normalizing rates. With Brexit pressure softening Europe, and providing additional uncertainty, it appears that this stance will not change soon. However, recent wage and unemployment data might move Yellen to inch forward once or twice by the end of the year. The market is pricing in about half of the increase in rates the Fed has alluded to. This suppression of normal rates is seen as a lack of confidence on the part of the Fed, and a headwind to improving margins in the financial sector. Delaying the increase in rates also removes any sense of urgency among consumers and corporations to borrow and spend, which could stimulate growth. Finally, historically low rates makes the banking sector very difficult to manage towards expected profit margins, which might be popular among the “occupy Wall Street” type, but is not good for shareholders of U.S. Equities.
U.S. Stock Market: Cautiously Good
This quarter has continued the 2016 theme of a hair raising wild ride. Quarter end looked fine for U.S Equities, REITS, and bonds. But we all know that sleep was lost, and confidence was challenged with huge mid quarter selloffs as a result of the surprise Brexit vote. The drumbeat of financial health cannot be ignored however, and despite some serious road bumps, we see earnings, unemployment, real estate, manufacturing, and wages all improving. It’s reasonable to expect that the markets will improve as well. Energy also plays a role, rebounding year to date, while Telecom and Utilities have been very strong sectors with returns year to date over 20% each.
Historically election years have not been great for U.S. markets, but with the field of candidates narrowed, and the possible outcomes more defined, the market can reasonably price in what impacts are likely. As always, removing these variables allows the market to become less cautious.
Once again this quarter has shown us that sticking to disciplined allocations is the key to investment success. Our commitment has been tested very seriously twice so far in 2016, and will certainly be tested again. It’s time to make sure that your portfolio risk level is correct, and that you continue to average into these swinging markets. We hold to our earlier prediction of mid-single digit returns for the broad U.S. market for the year.
U.S. Bonds: Cautious
Bonds rallied with the Brexit mayhem, although it is not clear whether this was due to a general flight to safety, or because the market was signaling no confidence in the Fed’s raising of rates in the near term. In either case the 10 year ended the quarter at 1.49%2, vs an historical average of 6.21%. It may be that the pace of raising rates is being stretched out over an even longer time than predicted by the Fed, or that the future increases will come in rapid fire succession once the environment seems safe to do so. In any case, maintaining quality, and correct risk exposure, and not reaching farther and farther afield for yield is the key to protecting your fixed income portfolio.