Market & Economic Review - Third Quarter 2015
Second Quarter Review
During the second quarter, we saw increased headline risk as Greece’s possible exit from the Euro, Puerto Rico’s potential default, China’s slower growth and stock volatility, and the Fed’s possible rate hike, all play a part in a more volatile market. The result was that stocks ended the quarter essentially flat, and interest rates moved modestly higher. The possibility of a Greek default affected markets, not due to its overall size, but the fear that the rest of the European periphery (Spain, Portugal, Italy) would be next in line to negotiate better terms at the detriment of the Core (Germany and France). At the end of the day, Greece was playing a game of chicken in which they could not afford to win. Going forward the deadline risk will give way to a gradual working out of the Greek economy. Puerto Rico found itself in a similar situation due to a shrinking economy--low tax collection and looming debt maturities. Their response was different with a willingness to work with investors by increasing tax revenue and working out the debt over a period of time. Puerto Rico already gave a big hit to investors in late 2013, as retail holders of debt have swapped ownership with hedge funds.
The China affect seems to be the one that could linger on, as growth rates are slowing and have the potential to disrupt many areas including commodities and world equity markets. Over the past decade, China has become a bigger destination for exported goods. China imports twice as much from the U.S. and Germany as it did in 2008, and emerging markets are very dependent on the export of commodities to China. Any significant slowdown has the potential to hit large U.S. large stocks, as well as those of the Emerging Markets. The odds that the Fed will raise rates in September has oscillated between 40% to 60% during the quarter, with the lower probability coming in late in the quarter. This lead to short term rates being anchored while the 10-year Treasury increased in yield by about 50 bps to 2.3%.
Aside from Long Term Bonds and Commodities flipping places, most major asset classes moved up slightly. Oil bounced back in the second quarter pushing the S&P Commodity index up 5.4% for the year, while the Barclay LT Treasury index ended down 4.7%, and the Barclay’s Aggregate ended down 1% for the first half of the year. Equities were little changed with the S&P 500 up only 0.28% for the quarter, while the MSCI EAFE was up 0.80%. The dollar, which had started off to a very strong year in the first quarter, gave back a little less than 3% as the odds of Fed tightening fell towards the end of the quarter. Many sectors got hurt by the increase in rates on the long with Utilities and REIT’s getting pretty hard.
We believe the extraordinary policies set in place by the Fed and the beginning of macro policy divergences will be the primary drivers of interest rates. While we think it is likely that the Fed will raise rates sometime between September and December, policy will continue to be extremely accommodative, and the speed and magnitude of the Fed raising rates will be slower and flatter. Due to the Fed’s various liquidity facilities put in place starting in 2008, a large increase in excess balances has developed as bond securities and excess reserves held by the Fed are at unprecedented levels, and the normalizing process is a bit more unknown than previous cycles. The expansion of excess reserves put additional downward pressure on the Fed Funds Rate. The Fed decided to pay interest on excess reserves—starting in October 2008—to better able target the Fed Funds Effective Rate. Theoretically all short-term rates should be pulled toward the interest on excess reserves rate (IOER), but they have not because only deposit institutions have access to this rate, so the Fed Funds Effective Rate and other short-term rates have traded below the IOER.
The Fed Funds Effective rate is essentially obsolete as there are only about $60 billion in outstanding federal funds transactions compared to $2.5 trillion in excess reserves. The Fed will essentially be raising the IOER to raise the Fed Funds Effective Rate, but the issue is that the Fed Funds rate has continued to trade below the IOER rate. Many believe a floor will need to be set—using reverse repos—at the same rate as the IOER and accessible by non-deposit Institutions. A reverse repo is implemented by a financial institution placing cash with the Fed in return for a security (Treasury Bill) that pays implied short-term interest. The reverse repo would be available to banks and others who do not have access to IOER. The concern is that we could see large increases in flights to quality, which would push up rates on short-term corporate debt while money market funds would prefer the safer repo over commercial paper. The Fed will be setting the Fed Funds Target using a corridor between the IOER and the reverse repo rate. There is likely to be volatility as the Fed has to focus, not only on when to raise rates, but how. All of this is likely to keep the yield curve steeper longer than many expect. We continue to like intermediate-term quality muni’s and corporates (4-6 yrs) and only the highest quality money market funds.
Energy and Rates were big drivers of equity performance in the second quarter and first half of the year. Lower energy prices pulled down performance in the energy sector, as well as Industrials. On the rate side, higher rates on the middle-to-long end of the curve hit Utilities and REIT’s. Consumer Discretionary and Healthcare continue to lead the way. From a factor standpoint, we have continued to see small and growth factors significantly outperform large and value with growth significantly outperforming value. We are at the point in the cycle where investors are willing to chase growth, causing some distortions in the market. For instance, four stocks in the NASDAQ make up nearly one-third of the market cap in that index, and the number of stocks in the S&P 500 hitting 52- week highs is only at 5%. As it is likely that the Fed will raise rates sometime this year, we are interested in how that is likely to not only affect bonds, but equity markets as well.
We have continued to overweight U.S. Large Cap, but are looking to move towards International and Small Cap. Currently we are underweight Emerging Markets while we wait for the Fed to begin to raise rates. We believe this will continue to be disruptive in the short term with a strengthening dollar and weak investment inflows. Once the process has started and markets adjust, this is a long- term area in which we want to have exposure.
In the second quarter, we tactically took a position in Emerging Markets but quickly exited as China and Greece came back into the headlines. We continue to stay in Developed International, Small-Cap Growth, Dividend Growers, and added Financials. We believe the trend of a strong dollar and relatively better opportunities overseas will continue. With the Fed likely to start raising rates by year-end, we also think that financials are attractive. Within Fixed Income we continue to like municipal bonds and quality corporate bonds while minimizing high-yield exposure. In Alternatives, we are looking at distressed opportunities, especially in Energy and Europe. Longer term we believe Emerging Markets to be attractive, but we are waiting for an adjustment once the Fed begins to raise interest rates, before making the final decision to add. Fed policy is likely to affect both bonds and equity in the near future, and we see Alternatives as an area that has potential to outperform.