Market & Economic Review - Third Quarter 2016
Second Quarter Review
While the U.S. continues to show signs of gradual improvement in growth, the rest of the world continues to face
challenges that are having a large influence on asset prices. The Brexit vote was the biggest event of the quarter, and the catalyst for a move to historically low interest rates globally, as well as in the U.S. The Fed was expected to raise rates two more times by the end of the year, but after the uncertainty following the vote the probability of a rate increase in 2016 decreased significantly. Add into the mix a flight to safety in the Yen (strengthened relative to dollar) and China quietly devaluing their currency, it starts to feel as though the U.S. has limited control of its own policy.
The U.S., from a policy position, is in contradiction to the other major economies. We are experiencing gradually improving growth and eyeing the next move by the Fed to raise interest rates. Japan is mired in a decade’s long slump and is considering every possible stimulus tool including the idea of “helicopter money” whereby money is dropped into the economy to stimulate spending. The U.K. is dealing with the affects of possible capital outflows and a weak currency, while Europe is dealing with Italian bank debt and competition from China and others in Asia who continue to weaken their currencies. There is a high probability that we will continue to see easy monetary policy in Europe and Japan, which will influence rates in the U.S. and thus asset prices.
Asset Class Returns
Europe and Japan have seen yields go negative on a larger percentage of debt, with 80% of Japanese bonds trading at negative yields and Germany near 75%. According to Citibank, 35% of the world’s govt. bonds have negative yields with the two main holdouts being the U.S. and the U.K. What is interesting is that while U.S. interest rates have been heavily influenced by Europe and Japan, the spread has remained fairly constant at around 100 to 125 b.p.’s. The U.S. has likely seen about 75 to 100 b.p.’s of yield decline due entirely to weakness outside of the U.S. This could explain why asset values continue to move higher, when historically falling rates were a signal of economic weakness.
The 2nd quarter saw the S&P 500 rise 2.46% with the year to date return for 2016 at 3.84%. International stocks trailed, and small and mid size U.S. stocks saw the strongest gains. We continued to see value outperform growth and strong gains in the highest dividend paying stocks. Breaking the S&P 500 down by sector, we see Energy, Utilities, and Telecom as the biggest winners with Technology and Consumer Discretionary as the laggards. Energy recovered from a large selloff in 2015 and January of 2016, while Utilities and Telecom benefit from the search for yield by investors. The macro effects of central banks continues to influence U.S. stocks as interest rates get pushed down further, higher dividend stocks move higher relative to the rest of the S&P. High dividend stocks have benefited from lower yields, as the discount rate to value stocks gets pushed lower, the higher in value the future dividend stream becomes. It is also, why they are vulnerable to higher interest rates, as the dividend streams get lowered in value with a higher discount rate.
We continued to see success in our active managers, as value and small cap are showing signs of outperformance. Our managers tend to have a valuation discipline and look different from the indices. From a tactical standpoint, our move into emerging markets and small cap growth was a plus, while our move into International Developed was a negative. We continue our barbell approach with dividened payers and growers combined with emerging markets and small cap growth. While the dividened names continue to be overstretched, we see support as long as interest rates remain low.
Coming into the quarter, many investors believed there to be a good chance that the Fed would raise rates in June as employment and economic indicators continued to improve. Two events; the May employment report and the Brexit vote caused the Fed to back away in order to avoid adding to the fragile nature of the global economy. Interest rates continued to hit historical lows, with one Bank of England official circulating a chart showing global interest rates at their lowest in the 5000 years of civilization. The U.S. followed global rates lower, with Long Term Treasuries appreciating 6.4% and U.S. Aggregate Bonds appreciating 2.2% for the quarter. A concern we continue to have is the amount of buying not by individuals clipping coupons, but by Central Banks. This distorts the markets, and puts investors in the situation of speculating that they can sell a bond to someone else at an even lower negative yield. We continue to focus on U.S. Tax Free bonds, and quality Corporate bonds which are mostly purchased by buy and hold investors. Our duration continues to be slightly less than the benchmark, as we expect rates to stay in a lower range, but being mindful of the risks of rates sneaking higher.
We are beginning to look at Treasury Inflation Protected Bonds (TIP’s). Central banks have indicated a willingness to increase inflation, but so far most investors don’t believe that will happen anytime soon. TIP’s would be a good diversifier to add to our bond portfolio for any unexpected increase in rates, as the principal value of the bonds would move higher with inflation.
Sources: Bank of England, Global Financial Data, Homer and Sylla "A History of Interest Rates"
Note: the intervals on the x-axis change through time up to 1700. From 1700 onwards they are annual intervals. Full methodology available upon request.
Hedge funds bounced back in the quarter after a difficult start to the year. Global Macro managers and Commodity managers have been able to ride some of the global trends that have developed such as the continuation of lower interest rates and central banks maintaining easing policies. Small cap and Value strategies have begun to perform, and the amount of dispersion in the market makes it a better environment for stock pickers. We continue to see the best opportunities in the private markets, while real estate is beginning to look frothy. We have started to see some real estate deals with sub 4% cap rates come across the desk, as the search for bond substitutes persists. In the merger arbitrage space, we see some of the best opportunities going forward, due to the current regulatory environment. The markets are pricing in historically low probabilities that mergers will be allowed to go through providing a better opportunity set for skilled managers.
Synovus Family Asset Management Investment Team
Michael S. Sluder, Chief Investment Officer & Sr. Portfolio Manger
Andrea R. Parker, Senior Portfolio Manager
Zachary D. Farmer, Senior Portfolio Manager
Catherine E. Hubbard, Reporting & Operations
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