Market Insight - July 2016

Markets were book ended in the first half of 2016 by January’s precipitous collapse, driven by concerns over China, Fed policy and oil prices, and the Brexit surprise in late June, which sent markets down over 900 points in 2 days. In between we had one of the fastest gains in the market (from February through the end of March.) Then, following the Brexit drop, rattled investors who sold into the panic were whipsawed, as markets rallied aggressively in the final days of June. Global investors sought safety in US Government bonds; prices jumped and 10 year Treasury yields plunged to 1.45%, a four year low. Currency markets were shaken, as the British pound plunged to a multi-decade low in relationship to the dollar and yen.

Asset Class Performance (YTD)

As one would expect, developed markets abroad were hit hardest midyear with the MSCI EAFE index (EFA) losing 2.3%. Emerging markets fared somewhat better, gaining 7.5%. Large company US stocks ended mid-year up 2.7%, measured by the S&P 500, while smaller company stocks in the S&P Small Cap 600 gained 6.2%. Real estate investment trusts were a standout; Cohen & Steers Realty shares (CSRSX) added 8.66%.

The bond and fixed income portion of our clients’ portfolios has proven its resiliency in 2016

The bond and fixed income portion of our clients’ portfolios has proven its resiliency in 2016, benefiting from the easing of yields and a flight to safety, and providing an important balance to stock volatility. The benchmark 7-10 year treasury ETF (IEF) is up 7.69% YTD, while the high yield sector, measured by the Pimco High Yield Fund, added 5.68%. The tax-free bond market was weighed down by continuing concerns over the slow motion default of the Commonwealth of Puerto Rico; still, high quality tax free bonds, measured by the Vanguard Intermediate-Term Investment Grade Bond Fund, were up 3.77% for the year, while high yield tax-free bonds rose 5.76%.

Markets don’t deal well with surprises in the short term; uncertainty grows, and invariably leads to emotional sell-offs.  Predictions of impending doom and collapse multiply exponentially. However, recent events which rattled markets, as shown in the chart below, tended to have rather short recovery times.

We’ll avoid the temptation to fill several paragraphs with the possible implication of Brexit. As stimulating as it is to mull over possible outcomes, these have been addressed ad infinitum by the media over the last week. Suffice to say that they range from a global meltdown, financial collapse of the Euro, and break-up of the EU on one hand, to a resurgence of national independence and economic strength for the UK and any other members who want to go it alone on the other. Some even forecast the eventual dismantling of the UK, as Scotland, which voted overwhelmingly to stay, tries to find a way back in. In both Europe and the UK, there is certainly a resurgence of nationalism, in some instances nativism, and a reassessment of how the benefits of globalism have been distributed over the last two decades.

Brexit fallout will surely be a factor in further policy decisions.

We believe that the direction and pace of the Federal Reserve, the results of companies earnings over the past quarter, and what is projected for the remainder of the year, are what will be most relevant to our clients’ portfolios. Earnings projections have been lowered dramatically, and a decline of -5.2% for companies in the S&P 500 is now the consensus. This would be the first time earnings have posted five consecutive quarters of year-over-year declines since third quarter 2009. This is what the market is discounting. That we are in an earnings recession seems in little doubt; however, if global developments don’t blindside US multinational results, markets may find these number a low bar, and look toward the second half of 2016 for a meaningful recovery.  The Federal Reserve has been increasingly focused on global events in its drive towards employment and stable inflation; it has pointed to international factors several times over the past year as it has deferred raising rates. Brexit fallout will surely be a factor in further policy decisions.

Investor sentiment in the near term remains poor, with the AAII survey showing only 28.9% of the respondents looking for positive returns in the next six months. This tends to be a contrarian indicator, and stock markets often climb an improbable “wall of worry “in cases like this. However, we are cautious of near term risks, and with the broad US market selling at 16.5 times earnings there is not a lot of room on the downside for disappointment.

Steven Weber
The Bedminster Group

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