2Q 2015 Commentary
by Richard Siegel, CFP®
Over the past few months the top financial news has been focused around the timing of Janet Yellen and the Federal Reserve raising interest rates and Greece’s continued fiscal struggles. The likelihood of an interest rate increase is getting more realistic based on economic data, led by improving employment metrics. A Greek debt default and exit from the European Union has been an issue for several years and has reared its head once more as Greece has delayed a debt repayment of their bailout program. Although these issues are getting a tremendous amount of attention and seem to be coming to a head, the stock market has reacted rather benignly. The bond market on the other hand has been under significant price pressure as rates across the globe have been rising under the backdrop of improving economic data and the imminent shift in U.S. monetary policy.
Aside from Greece and interest rates, we are watching U.S. GDP for Q2 and corporate earnings very closely. These two data points are of tremendous significance at this point in time. Most analysts and interim economic indicators are pointing to a recovery in GDP for Q2, but if this is not the case, the U.S. may experience a very shallow recession for the first time since 2009. Corporate earnings saw a contraction last quarter based primarily on a rapidly rising U.S. dollar and falling oil prices. Over the past few months, the price of the dollar has moderated and oil prices have grinded higher making it easier for energy companies to regain their profitability. Without earnings growth, it is hard to justify stock prices at these levels.
Source: Bloomberg. Data as 6/24/2015. *Represents consensus estimates.
Broadly speaking, stock prices delivered a small decline during the second quarter as measured by the S&P 500 Index. However, a closer look into various sectors and regions of the globe illustrate why broad diversification in equities is so important.
As interest rates spiked over the past few months, rate sensitive sectors like utilities were significantly impacted. The energy sector has continued its slide, albeit at a tamer pace than earlier in the year when oil prices plummeted. Health Care has been one of the bright spots, as these companies are trading at reasonable valuations and are relatively sheltered from rising rates.
Foreign equities have continued their outperformance versus U.S. stocks during Q2. We continue to stress the importance of holding at least 20-25% of our clients’ stock allocation overseas. Although these markets carry slightly higher risk and volatility, lower valuations and the tailwind of quantitative easing make these markets attractive and hard to pass up.
Looking out longer term, the case for stocks in general is firmly grounded on the ability for the economy to deliver positive growth and corporate earnings to recapture their upward trend. We feel this is the base case scenario, but with stocks at all-time highs and valuations in the fairly valued range, returns will become more difficult to come by than the last few years.
Fixed Income Overview:
Easy come, easy go. Just as bonds were a positive contributor to our strategies during Q1, they were a detractor from returns during Q2 as interest rates spiked globally*. Half way through 2015, the U.S. bond market has delivered slightly negative returns. The good news is that higher rates equal higher bond dividends and a better hedge against equity risks.
*The 10 year Treasury yield rose during the quarter from 1.89% to 2.36% (a 25% increase) while the U.S. Aggregate Bond Index fell by 2.0% during the period.
Currently, the yield curve is very steep in the U.S., which bodes well for the economy. A positive sloping curve typically is indicative of a healthy economy and a tailwind for stock prices. A flat or negative sloped yield curve (short term rates are higher or equal to long term rates) is indicative of a recession.
The chart above exemplifies the flat/inverted yield curve just before the tech bubble burst in 2000. From March of 2000 for the next couple of years the equity market dropped significantly, the economy contracted, and bond prices spiked while rates were lowered by the Fed to stimulate the economy. Today’s environment is quite different. Money is still incredibly cheap with historically low yields, and you can see in the above illustration that long-term rates are a full 3% higher than short-term rates. Over the past 50 years, there have been seven recessions. In every instance, the yield curve has inverted, a very powerful indicator. According to Jeffrey Kleintop of LPL financial, “The yield curve inversion usually takes place about 12 months before the start of the recession, but the lead time ranges from about 5 to 16 months. The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits.”
“The four most dangerous words in investing are: ‘this time it’s different.’” – John Templeton