Market & Economic Review - Fourth Quarter 2016
Third Quarter Review
In the third quarter we saw asset prices rebound from the Brexit vote, the Fed and ECB remain on hold, and Japan introduce a new twist on QE. European markets bounced back after the selloff in June, outperforming U.S. equities. While there remains uncertainty surrounding how the U.K. will go about exiting the EU, market participants thought the selloff was too much too soon. We will continue to see some degree of uncertainty as the EU will seek to balance maintaining an open dialogue on trade, while sufficiently punishing the U.K. enough to prevent others from fleeing. The major issue will continue to be the free movement of people within the EU and the refugee crisis. The ECB did not see a need to react with further monetary policy, despite the prospect of flat to negative GDP growth in 2017, which was a bit of a surprise to the markets. The Fed kept rates unchanged at their September meeting leaving the door open for a move higher in December. While the employment target has been met and the Fed anticipates inflation will soon reach the 2% level they are keeping an eye on the Brexit situation and a slowdown in China’s growth.
While on the surface it appeared that the Bank of Japan did very little in regards to policy action, they did implement a few tweaks that indicate they are likely to keep rates low for a long time. The first shift is a focus on the shape of the yield curve(keeping 10 yr yield at or above 0%) from purchasing bonds at a targeted maturity. This opens the door for more issuance of longer term debt with possible fiscal spending in the future. It also is a boost to banks and insurance companies in Japan, who have had to struggle with slim margins. The second shift was a commitment to achieve and maintain inflation above 2% as opposed to just reaching the 2% level. It remains to be seen if Japan can achieve its goal of digging out of their 20 year stagnation, but they seem to be willing to keep trying.
Election season came into full swing, and the market is expecting a Clinton presidency with Congress continuing to be under Republican control. While many newsletters are full of statistics and predictions about presidential elections, the reality is that who gets elected is less important to market returns than the time and effort given to it. There could be some differences in sector performance due to expected policy differences. A Clinton win would likely put continued pressure on healthcare and possibly energy stocks. A Trump victory could help defense stocks. The regulatory environment is the other area of difference that could come into play. Trump is more likely to reduce the regulatory burden on businesses, while Clinton is likely to continue with the status quo. Trump is more likely to create uncertainty in free trade, while Clinton is more likely to continue on the current path. As of now, the market is expecting a split government and any other outcome would cause some short term volatility. The scenario of the Democrats controlling all branches of government would result in the most volatile environment. We focus on the long term, and will adjust appropriately if we believe anything will have a long term and significant effect. We do continue to see volatility and have maintained higher levels of cash, but the election is just one more piece of uncertainty in the economic landscape.
In the 3rd quarter, the S&P 500 was up 3.85% putting it up 7.84% for the year. International stocks finished higher as Developed markets were up 6.4% and Emerging markets were up 9%. Small and Mid Cap continued to outperform and Growth began to outperform value in the quarter, though Value is still ahead for the year. Cyclical stocks outperformed staples and higher dividend paying stocks, as stocks correlated to rates staying low got hit with bond yields going higher. Technology and Financial stocks were the winners for the quarter, while Utilities and Telecom were the laggards. For the year Utilities and Telecom have outperformed, while Financials have lagged. As we have mentioned in the last couple of newsletters; markets are being predominately influenced by monetary policy from the Federal Reserve, ECB, and Bank of Japan.
Low energy prices and a strengthening dollar have contributed to earnings growth being negative over the past several quarters. The year over year comparables should become easier to beat, so we will likely see positive earnings growth in 2017. The major issue is how much can earnings grow beyond rebounding off of a weak base. We began to look at increasing exposure to international markets as valuations look relatively cheap compared to the U.S. Within the U.S. we have been slowly increasing exposure to small cap names, as they are less sensitive to an increase in the dollar. In the chart above we can see that small cap stocks have outperformed large cap stocks recently as the dollar has rallied.
Similar to last quarter, there was some anticipation leading up to the next Fed meeting that there could be another rate hike. With employment continuing to be strong and inflation beginning to move towards target, the Fed keyed off of the uncertainty surrounding the Brexit initiative and a weakening in China to delay once again. With more members in favor of raising the discount rate, and likely improvement in the metrics they are focused on, the odds for a rate hike in December have increased. After a decline in rates around the Brexit vote in June, rates began to rise in early July from 1.35% in early July to 1.59% at the end of September. U.S. Treasuries and Municipal Bonds had a slight loss, while Corporate and High Yield Bonds rallied. With the implementation of new Money Market Fund regulations, we saw a doubling in yield from the SIFMA Municipal swap index. The SIFMA is similar to LIBOR in setting rates for short term floating rate municipal bonds. Under the new money market regulations Tax Exempt funds will no longer maintain a $1 NAV, but one that will fluctuate. In addition they must provide for liquidity fees or redemption restrictions in times of distress. This has lead to the closing of most Tax Free Money Market funds, and thus an increase in yield for the underlying securities. This is likely a short term opportunity to buy some of the underlying securities, which are floating rate adjustable weekly or monthly at yields between .50%-1%. We are currently researching the opportunity to see if it makes sense as an additon to a bond portfolio. In addition to the dislocation in the short term muni space , we are also seeing LIBOR at the highest rate since 2009, higher default rates on high yield, and high yield spreads equivalent to senior bank debt. Historically senior bank debt has traded at a premium to high yield due to being more secure. We see the Fed rasing rates a quarter point in December, seeking to target inflation above 2% while steepening the yield curve(The difference between 2 year and 10 year yields).
Returns were positive for the aggregate hedge fund space, with those strategies more correlated to equity markets showing the strongest returns and global macro returns coming in negative. Hedge funds continue to see outflows as performance continues to lag the equity market. Large endowments who have higher exposures to hedge funds and private equity saw their weakest fiscal returns since 2009. This is likely to lead to more dollars flowing away from the strategy. While we have let our exposure to hedge funds drift lower we continue to believe there is a place for them in a diversified portfolio. We are focused on finding opportunities that are less correlated to equity markets in case we enter a period of rising rates and weaker equity returns.
In private equity, we continue to see valuations at the high end of the range with purchase price multiples above 2007 levels primarily sourced with more debt. There is opportunity in the small buyout space where there is less competition for deals and more stable multiples. The marginal increase in leverage has been through the banks, as senior debt levels have moved toward the 2007 highs, while mezzanine/sub debt has remained steady.
We see an opportunity in being higher up in the cap structure through preferred equity and mezzanine rather than the equity. Mezzanine yields are the same as they have been for the past decade (11%-13%) while equity valuations are at historical highs. We see a much better risk return profile and probability of achieving targeted return than in private equity. There are also opportunities in the secondary market in both hedge funds and private equity. With hedge funds there are massive redemptions taking place, and some liquidity mismatch. A smart and nimble manager can pick these assets up at significant discounts. In private equity we have seen the average time from investment to sale nearly double in the past decade. This means there are funds nearing the end of their life span that will be forced to sell underlying companies with likely less willing buyers.
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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