Market & Economic Review - Third Quarter 2017
The 2nd quarter was highlighted by the lack of tax and health care legislation, and the Feds’ plan to reduce the balance sheet over the next couple of years. We saw a continuation of International stocks outperforming U.S. stocks, with Emerging markets up over 18% YTD and the yield on the 10 year Treasury down for the quarter. Any uncertainty from a policy perspective was more than offset by the strongest quarterly earnings growth since 2011. In terms of volatility, the markets were fairly boring, with a slight dip in Mid-May amidst the resignation of FBI Director Comey. In fact, U.S. equity volatility (as measured by the VIX) recorded its’ second lowest average quarterly reading in the history of the index. The Fed raised rates .25% as expected in June, but also laid out a plan to start shrinking their balance sheet which has ballooned to $4.5tn from around $900bn in 2008. The Fed presented a plan of initially letting $10bn of securities roll off each month increasing by the same amount each quarter until reaching $50bn a month. The breakdown of the initial $10bn is anticipated to be made up of $6bn of Treasuries and $4bn of Mortgage Backed Securities. While the idea of reducing the balance sheet is not new (2013 Taper Tantrum), the actual plan is. In 2013, Chairman Bernanke laid out the idea of how the Feds’ balance sheet would be normalized and the impact on interest rates was pretty dramatic. In the month after the 2013, speech the 10 year Treasury was 50b.p.’s higher and after 3 months it was over 100b.p.’s higher in yield. The June announcement was much more muted, as it was anticipated and the speed of shrinking the balance sheet is likely to be gradual (More in Fixed Income section below). The quarter continued what has been just enough growth and continuation of easy monetary policies to keep asset prices moving gradually higher. Eventually we will see a normalization of policy (higher rates), and find out if the global economy can withstand it or not.
Within equities, we saw a continuation of the previous quarter, with International Markets outperforming and Small Caps underperforming Large Cap names. Emerging Markets were the leader again for the quarter with a YTD return of 18.43%. A weakening dollar helped, as did the strongest inflows into Emerging Market funds since 2012. In the U.S., Large Cap Growth continued to outpace Large Cap Value, while Large Cap outperformed Small Cap across both styles. Across S&P 500 sectors, we saw a fair degree of dispersion with Health Care and Industrials up 6.65% and 4.16% respectively while Energy and Telecom were down 7.02% and 8.14%. In 2017, we have seen a rotation from the Trump rally leaders (Financials, Small Cap, Value) towards Technology, Healthcare, Large Cap and Growth. While we have seen a continuation in the long term outperformance of Growth over Value, we started to see a movement towards top line revenue growth and quality balance sheet companies (Value), versus the less quality balance sheet and momentum driven stock outperformance that has occurred for most of the bull market. This is likely why even with such strong market performance, we are seeing active managers keeping up better than in the past couple of years. Our active managers tend to be attracted to better quality companies that focus on sustainable growth rather than the levered and momentum driven names.
In June, we did see some signs of what could come with a change from accommodative Central Banks to less accommodation through the removal of Quantitative Easing (QE) policies. With the announcement by Fed Chairman Yellen of balance sheet reduction and ECB President Draghi echoing similar comments about Europe, the markets rotated very quickly with Financials and Value stocks rising while Technology and Growth stocks sold off. While the rotation was fairly short lived, it did give a glimpse to how certain stocks are dependent on interest rates remaining low. Going forward we are likely to see interest rates slowly move higher and equity markets to experience more volatility. Currently, we are slightly overweight to Value Stocks, and will move further in that direction when it becomes more likely that Central Banks are ready to move away from the accommodative policies of the past eight years.
Rates on the 10 Year U.S. Treasury bond ended the quarter lower, as core inflation fell below 2% for the 3rd straight month and little traction was made on President Trump’s plan to accelerate growth. The Fed laid out their initial plan to reduce the size of its balance sheet to a more normal level. One question that has arisen is, “what is a normal level”? It is very unlikely that we go back to the level seen in 2008, before expansion. Many researchers are focused in on the level of currency growth in the U.S. as a target for the Fed’s balance sheet. In 2008, when the Fed had $800bn of assets the currency in circulation was around that level. Today, the currency in circulation is close to $1.5tn and likely to continue growing. The likely assumption is that the balance sheet will not be reduced below the level of currency in circulation and so a range of $1.5tn to $2.5tn has been thrown around as a likely target. At the pace laid out by the Fed, we would reach the $2.5tn level sometime in 2020. The next question that arises is, “what happens with interest rates and more specifically the 10 Year Treasury and the shape of the yield curve”?
With Quantitative Easing, it is believed that for every $500bn of bond purchases we saw a 20 basis points decline in the yield on the 10 Year Treasury. In addition, we saw dramatic reductions in the yield on Mortgage Backed Securities,
Corporate Bonds, High Yield, and Emerging Market Debt. The substitution effect greatly came into play, as the Fed and other Central Banks stepped in to buy up Treasuries which drove down yields and forced institutional investors to invest in riskier assets to achieve return targets. With Central Banks looking to start shrinking their balance sheets, it is not as much of a risk that Treasuries and Government bond yields will rise dramatically, but that the other assets begin to look less attractive relative to the amount of risk being taken. High Yield corporate bonds are an area we view as a poor risk/reward investment. On the surface, everything looks great with historically low spreads (chart below) and defaults, but this is in the context of historically low interest rates and historically high corporate profits. In addition, we have seen Corporate Debt to GDP and Corporate Bond issuance at all time highs. An increase in rates and slowdown in profits could have a significantly negative impact on High Yield.
Source: Morgan Stanley
We continue to like quality names in the Corporate and Municipal bond markets. We believe those issues with strong balance sheets that are not as reliant on low interest rates and leverage will provide better protection from rising rates and ultimately higher defaults. Our bond portfolio duration continues to be below that of respective benchmarks at around 4.5-6 years, as we expect interest rates to slowly move higher.
We continue to be in an environment where economic growth is not great, but it is positive and likely sustainable. Asset values continue to be at historically high levels, but are supported by a continuation of lower interest rates. The last pieces of economic indicators continue to show lower than targeted inflation with improving employment numbers. For awhile, it looked like there could be an additional rate increase by the end of the year, but with lower than expected inflation and the Fed’s announcement of their balance sheet reduction plan it is less likely that we will see another hike this year. It is likely they will see how markets react to the actual plan being put in place before continuing to hike on the short end. While we are anxious about asset valuations we are also mindful that they can continue to move higher for longer than may seem rational. We have designed out portfolios to be invested for the long term, but look to rotate away from areas of fundamental richness into areas of fundamental cheapness. An example would be adding to companies with quality balance sheets and reducing exposure to those with highly levered balance sheets that are priced to perfection. In addition, we will continue to look for diversifying strategies as we believe the next downturn will be typical rather than the once in a generation sell off of the previous cycle. In most downturns there are pockets that can hold up and even move higher while broad markets sell off. As always we will adjust where need be and continue to focus on the long term.
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
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