|12 Mo. Change||YTD Change|
|10-yr Treas. yield||2.34%||1.93%||+0.41%||2.52%||-0.18%||+0.17%|
|Fed funds rate||0 to.25%||0 to.25%||n/a||0 to.25%||n/a||n/a|
(stock indices are before dividends; yield and rate changes are absolute changes)
The focus for the quarter can be summed up pretty easily – The Fed!! Greece!! Greece!! The Fed!! The musical chairs stopped on Greece at quarter end, and the S&P 500 eked out a tiny gain (after dividends) after hitting an all-time high close in May. It was the weakest first half since 2010 for the S&P but it continued its streak of 10 positive quarters. The NASDAQ, still driven by biotech, reached a new high 15 years after the tech bubble before dropping at quarter-end. Interest rates didn’t wait for Fed action, jumping as high as 2.48% in anticipation for a Fed rate increase.
The possibility of a Greek exit from the EU (a “Grexit”) was a crisis that has been six years in the making. The January election of a new government that pledged to end austerity measures and the June 30 deadline for a large payment to the IMF brought things to a head. Negotiations seemed to be making promise, and the European Central Bank increased the amount of a “bridge loan” to prevent a run on Greek banks. But at the last moment the Greek prime minister announced that there would be a public referendum vote on July 5, resulting in Greek banks and stock markets shutting down for six days. Depositors were limited to around 60 euros a day in ATM withdrawals, and Greek missed its IMF payment, a first for a supposed “advanced” economy. Ironically, the long slow decline has allowed European banks to reduce their exposure to Greek debt, so if Greece ultimately defaults on its debts the impact on broader Europe will be significantly less.
Housing continued to show strength, with pending home sales hitting a nine-year high, possibly in anticipation of a rate increase, new home sales at seven-year high and existing home sales at over a five-year high. First-time buyers returned, at 32% of existing home sales, but that is still below the 40-45% ideal range. Some local real estate markets have become very hot, but overall prices increased about 4.2% from the prior year, and that rate of increase has been slowing. Foreclosures were up for four months running but that is actually seen as a good sign as banks may be working through their “shadow inventory” of mortgages that were delinquent but had not been foreclosed.
The Fed recognized the strengthening economy but their new key word is “gradual” in an attempt to calm speculation that interest rates will rise quickly once they begin rising at all. Fed Chairperson Yellen suggested it will be several years before rates return to “normal” levels as the Fed removed any calendar reference for a rate hike and would continue to be “data-dependent” in its decisions. First-time unemployment claims were below 300,000 for 17 straight weeks and non-farm jobs increased by 213,000 per month in the quarter, with the unemployment rate dropping to 5.3%. Job openings hit a 15-year high but over 400,000 eligible workers still left the workforce in June and the labor participation rate dropped.
The final revision for first quarter GDP showed a drop of 0.2%, an improvement from the earlier revision of a 0.7% drop but still a disappointment from the initial estimate of a 0.2% increase. Consumer spending was revised upward, personal incomes finally started to inch up, the personal savings rate rose to 5.6% and retail sales showed strength. Overall GDP was hurt by bad weather, the West Coast port shutdown, a growing trade deficit and declining energy investment but growth is expected to return for the second quarter. Consumer confidence in June jumped 17% from a year ago. Both services and manufacturing remained firmly in expansion and May auto sales were the best in 10 years.
The Supreme Court upheld same-sex marriage and also validated the federal health care exchange, avoiding the loss of health care subsidies for Obamacare participants in 33 states. After a defeat that turned on training for workers who lose their jobs as a result of trade agreements, Pres. Obama was eventually given “fast track” authority to negotiate the TransPacific Partnership trade agreement with 11 Pacific Rim countries. China is not a party to those negotiations and the impact on Chinese trade is unclear.
April 30 was the 40th anniversary of the US leaving Vietnam, which sadly received little attention.
The Greek crisis is extremely complex and the impact on Greece and the EU won’t be fully resolved for quite a while. The large debt, possible restructuring and the extent of austerity measures are simply the immediate challenges. Regardless of negotiations, there will most certainly be changes to social welfare programs, and potential economic disruption, which could set off a humanitarian crisis. The EU must balance the fallout of Greece leaving the EU with the dangerous precedent of being too lenient, which could lead other weak members to balk at EU sanctions and penalties. US concerns are less economic than geopolitical, as it would be dangerous to unintentionally force Greece out of the western alliance and into the political hands of Russia or other players.
In addition to Greece, the flood of immigrants from North Africa and the Middle East is straining welfare systems and raising questions about the freedom of movement that has been fundamental to the EU. At the same time, the British are resisting closer ties to the EU and are talking about bringing more powers back to London. The whole affair could range from minor disruption to the collapse of the Euro as a common currency and the EU as a multi-national governing force.
With all eyes on Greece, not as much attention has been paid to the drop in Chinese stocks. After a strong run in 2015, the Shanghai Composite fell 29% from its highs in early June. China’s top stock brokerages, with the support of the People’s Bank of China, announced plans to buy over $19 billion of stock to help steady the market. Whether this will give the market breathing room, or simply postpone further drops as has been the result of many other attempts to artificially support markets, remains to be seen.
A quick look back offers a caution about trying to predict the future and acting speculatively. At the start of the quarter, three trends seemed to be pretty solid – the Euro was sinking against the dollar, yields on German government bonds (the “bund”) were down and prices were up and the price of oil was trending down. And then the dollar fell 6% against the Euro after gaining 29% in the prior nine months, the yield on bunds shot up from 0.1% to 0.5% almost overnight, with prices falling dramatically and after being down 50% at one point, West Texas Intermediate oil prices were up over 30% since mid-March. Global-trend hedge funds got hammered.
So, keep in mind that these Looking Forward segments are intended to present significant domestic and global developments that have not been resolved, and they are certainly not meant to be “actionable”.
If you have slogged through a couple of these reviews, you know that in managing portfolios we do not attempt to choose economic sectors, specific markets or, God forbid, hot stocks. We prefer to take the long view and ride out the inevitable market volatility.
So, here are a few of the factors that go into managing our portfolios.
First and foremost, the portfolio is driven by the client’s circumstances and goals. That is something of a cliché, but active trading serves more to confuse clients and mask poor results than to increase the likelihood of success. (We sometimes slice off a small part of a portfolio so the client can pursue trading on his own, and we’d be thrilled if there were a home run; that’s only happened once, and that was due to an employer stock award rather than some investment process.) Those circumstances include the time horizon for various goals, the sources and reliability of income (employment, pension, etc.), spending, additions and withdrawals to the portfolio and family issues, among other things.
Next comes the tricky balance between risk and potential return, and this is where the long view really makes a difference. In short, we try to take as much risk as necessary but not more; the potential for loss becomes greater than the potential additional gain. We recognize the risk inherent in various asset classes, as well as significant variation in returns in the short and intermediate terms, but we also rely on the underlying value of those asset classes to increase over time.
Rather than depend on questionnaires or other standardized tools (our experience is that the responses are more academic than reflective of true risk tolerance), the initial allocation is based on the client’s prior experiences, discussions of opportunities and especially risks and analysis of the probability of meeting the goals. In any process, the initial allocation is a bit of a leap of faith by the client but as time goes by the markets provide plenty of opportunities to discuss risk in real terms rather than in theory. The allocation is adjusted for risk tolerance, changes in circumstances and progress towards the goals.
Actually constructing the portfolio with specific investments is then a function of the prior steps rather than some “black box” of investments that will BEAT THE MARKET!! (sarcastic emphasis added) We determine whether actively managed funds offer potential advantage in a particular market area; if so, funds are chosen for clarity of style, consistency of performance, overall cost and manager stability. Considerations for index funds (and only broad index funds, not esoteric focused funds) include operating and trading costs, market coverage and tracking error form the underlying index.
All in all, not particularly sexy or exciting, but effective.
A Sad State (Territory) of Affairs
As the saga in Greece unfolds, Puerto Rico announced that it is not able to repay all of its $72 billion in debt in the midst of a cash crunch and an ailing economy. The governor stated plainly that Puerto Rico’s debts are “unpayable” and that the problem “is not about politics. This is about math.” As a US Territory Puerto Trico is not able to declare bankruptcy so negotiations will take place for bondholders to take losses through extending the time frame of the debt or lowering payments.
Puerto Rico’s problems have been building for decades. US military bases began to close in the early 1990’s and the expiration of corporate tax breaks in 2006 caused large companies to migrate back to the mainland. Unemployment is high at 12.4%, tax evasion is common, business investment is stagnant and the welfare programs are bloated and expensive. With many workers leaving to find work elsewhere, the population fell by 5.5% from 2004 to 2013. Puerto Rico’s debt stands at over 66% of its gross domestic product (GDP) compared to the average for all US states at 7.2% (Massachusetts is the next highest at 17.9%).
The sales tax recently jumped to 11.5% and more tax increases may be required. Though it is smaller than Connecticut, Puerto Rico has more than 120 government agencies and 78 municipalities, each with its mayor. About 40% of the population receives government help, which has created a sense of complacency and hindered entrepreneurship.
The governor’s candor is in contrast to leaders of other state and local jurisdictions facing debt woes. Lest we think Detroit was just an isolated case, Moody’s recently cut Chicago’s bond rating to junk, the seventh downgrade in two years. Around 45% of Chicago’s revenue goes to pension and debt payments.
In the worst case, Puerto Rico’s problems and their resolution could have repercussions for the $3.7 trillion municipal debt where state and local governments raise money for roads, schools and other public projects. The federal government has said there will not a bailout of Puerto Rico. Hopefully other governments will make changes while they still have more options before they find themselves in the same tough spot as Detroit and Puerto Rico.