Second Quarter 2016 Investment Update
Second quarter will long be remembered for Brexit, Britain’s referendum vote on June 23rd that shockingly decided the UK’s departure from the European Union (EU) after more than four decades of membership. But, in actuality, the vast majority of 2Q16 had nothing to do with Brexit. Rather it was a fairly range-bound quarter that chopped higher as first quarter earnings came in slightly better than expectations, oil moved through $50/bbl and the Fed left rates unchanged at their mid-June meeting.
Just before the Brexit polls closed on June 23rd, the S&P 500 surged toward prior all-time highs in anticipation of a vote in favor of Great Britain remaining in the EU. When the shocking results showed that voters had decided in favor of an exit, the S&P 500 plunged 6.1% in the following two trading sessions, bottoming on June 27th. European stocks suffered low double digit losses on fears of economic repercussions. However, after two days of intense selling, the emotional response to the surprise vote results were behind us and stocks began to rally. Analysis showed that our domestic economy should be fairly insulated from the slowing that’s expected in Britain’s economy. By June 30th, the S&P 500 had recovered into positive territory for the quarter, returning 2.5% and bringing year-to-date returns to 3.8%. The Russell 2000 Small Cap index had a strong second quarter, up 3.8% however a weak first quarter capped YTD returns at 2.2%. International stocks, Developed Markets in particular, have struggled this year. The MSCI EAFE was off -1.5% for the quarter and down -4.0% for the first half, with much of the weakness being related to Brexit concerns. Emerging Market stocks have done much better, rising 0.7% in 2Q and returning 6.6% for the first half of 2016.
Bonds were, once again, the beneficiaries of a flight to safe-haven investments during the quarter. Additionally, the Fed’s dovish tone due to a combination of a very soft May jobs report and overseas concerns (Brexit) was interpreted by the markets as reinforcing the assumption that there was virtually no chance of a rate hike before September if at all in 2016. The Barclays Aggregate bond index returned a healthy 2.2% for the quarter and 5.3% for the first six months. The yield on the 10-year Treasury ended the quarter at 1.49%, down from 2.27% at the outset of the year. Current startlingly low yields are at levels that we’ve not seen in the past five decades and are aided by the extremely low interest rate environment globally. It’s estimated that $8-10 Trillion of sovereign bonds, a percentage trending toward 40% of all sovereign debt, now yield less than zero. Thus, in comparison, U.S. treasuries offer a highly competitive yield. We believe that, were U.S. yields to begin to move higher, the flow of international funds into U.S. bonds would temper that increase. Based on our moderate pace of economic growth and the dynamics of the global interest rate environment, it’s difficult to envision 10-year T-bill rates rising much beyond 2% over the next year.
The just-released, advance estimate for second quarter GDP came in at a disappointing 1.2%. Expectations were for a significant bounce from our economy’s 0.8% growth rate in the first quarter, with the consensus at 2.5%. Although, consumers showed tremendous resilience and spent strongly in the second quarter, their confidence was offset by business investment which was anemic. Government spending, a third component of our GDP also fell. Although we would expect to see some pick-up in growth in the second half of the year, the recent trend has the economy running below the already tepid 2%ish growth rate that’s been the hallmark of our 7-year old expansion.
The S&P 500 has continued to push higher, having made a number of new highs in July through both positive and lackluster economic data. And, even though earnings for the second quarter are coming in slightly above expectations, the 9% gain in the S&P 500 since the post-Brexit lows of June 27th has pushed stocks into somewhat overvalued territory again. The trailing-12-month Price/Earnings ratio on the index has jumped to 20.2 times, compared to a 60-year average PE of 16.5x. Like bonds, U.S. stocks have benefitted from being seen as a safe haven and have attracted sizeable inflows from overseas investors.
As we move beyond the second quarter earnings season, we expect to see a pick-up in volatility. Markets are likely to refocus on concerns regarding global growth including any potential fallout from Brexit, the timing of the Fed’s next rate hike and the Presidential election. When our Investment Policy Committee (IPC) reviewed the market’s rising valuation at our June and July meetings and factored in the catalysts for volatility, we decided that it was a prudent time to take a bit of our equity exposure off the table. This shouldn’t be misinterpreted as a bear market call. We are not expecting a severe selloff in stocks. Rather, we see the market’s valuation having risen at the same time that we see market risks rising.
We’ve been writing, since December, about our low return expectations for 2016. The S&P 500 which has moved through 2,170, now exceeds our yearend target on the index of 2,125- 2,150. Therefore, we see little opportunity cost in taking a prudent tack and locking in some profits in stocks. Due to our belief that rates should remain low over the next 6-12 months, we’re comfortable moving those dollars into bonds, focusing primarily in short duration bonds. This move is unquestionably defensive reflecting IPC’s view that now is not the time in our 7+ year old economic expansion and bull market to take on higher levels of risk in search of higher return.
Please feel free to call or email if you have any questions regarding our comments or outlook. We value the trust that you place in First Western.
Debra Silversmith, CFA
Chief Investment Officer
July 29, 2016