|12 Mo. Change||YTD Change|
|10-yr Treas. yield||1.49%||1.83%||-0.34%||2.34%||-0.85%||-0.78%|
|Fed funds rate||0.25% to 0.50%||0.25% to 0.50%||n/a||0 to 0.25%||+0.25%||n/a|
(stock indices are before dividends; yield and rate changes are absolute changes)
All was relatively calm for most of the quarter, as US stocks floated in a range of about +/-2.5% and international stocks actually rebounded 5%, partly on the expectation that the UK would vote to remain in the European Union. But with the surprise referendum results to leave the EU on June 23, just about everything reversed on fears that economic chaos would ensue – gold jumped 6%, oil fell 5%, the British pound plunged to a 30-year low against the US dollar, the Dow fell 3.5% and European stock markets dropped 10%. British Prime Minister Cameron resigned, although his Conservative party is expected to retain power, and the rating agencies either cut the UK’s bond rating or went on record that the AAA rating is “untenable”.
And then, by the end of the next week, most markets had retreated from the brink and recovered most of their losses, although currencies did not. Quarterly and year-to-date market performance ended on a reasonably positive note with international stocks still lagging.
The turmoil extended to interest rates as yields on the benchmark 10-year Treasury continued to fall through the quarter-end to an historic low of 1.34% on July 5. The German 10-year bond had previously hit all-time low yields and both the Japanese 20-year and Swiss 50-year (yes, 50) bonds hit negative yields. That means investors are so concerned about risk that they are willing to lose money for 50 years. The Fed held onto their view that rate hikes were ahead but offered no clues as to when. Their position shifted from “increases would be appropriate in coming months” to a more lukewarm “there are good reasons to expect positive forces supporting employment growth and increased inflation will continue to outweigh the negative ones”. At the same time, the Bank of Japan capped monetary stimulus and declined to go further into negative rate territory, even though the market did the job for them.
There was plenty of drama on many other fronts. The “Panama papers” exposed massive offshore tax evasion, including Iceland’s prime minister (who resigned) and Russia’s Putin. Surprisingly, there were few Americans in the bunch. Both California and New York implemented a schedule to eventually reach a $15 minimum wage and rules to stop corporate “inversions” to avoid US taxes went into effect, killing the Pfizer/Allergan merger. Five “too big to fail” banks failed the “living will” test of plans to wind down their balance sheet if they went into bankruptcy. Apple’s sales fell for the first in 13 years, down nearly 13% from 1Q 2015. VW announced a $10 billion buyback program for the US diesel cars affected by their cheating scandal, plus $5 billion more for emission offsets.
The final revision for first quarter GDP growth was increased to 1.1% from the even more disappointing 0.8% based in part on improved export sales. Consumer spending, however, was revised downward to the slowest quarterly increase in two years and remained relatively sluggish in both April and May. Productivity fell for the second straight quarter after averaging an increase of 0.5% for the prior five years; productivity gains are a critical factor in wage growth, which has been illusive in the economic recovery. New home sales and pending home sales were up almost 9% over the past year but some price “bubbles” are developing in some markets.
Employment was a bright spot, with weekly jobless claims staying under 300,000 for 70 straight weeks. Over 287,000 jobs were added in June (after only 11,000 in May and 144,000 in April) and the unemployment rate actually increased to 4.9% from 4.7%. This was seen as a positive since the increase was due to more job seekers. Stronger employment, even at stagnant wages, was part of consumer confidence reaching its highest level in nine months.
Typically the same issue does not make consecutive appearances on this section, but the Brexit drama is far from over. The conservative party in power has lost its current leader, Prime Minister Cameron, and two of the leading advocates of the Leave the EU campaign have stepped down. At the same time, the liberal Labour party has voiced no confidence in its leader. The other EU countries would prefer that if Britain plans to leave the EU they get it over with but the Brits have not yet filed the formal notice that starts the two-year clock for leaving and there is no indication they will file before Cameron formally steps down.
In the meantime, the Brexit referendum was non-binding and there have been plenty of instances of politicians ignoring the voice of the voting public. (We know that too well in Arizona when the legislature ignored the vote to increase education funding.) Scotland has signaled it would rather remain in the EU, which would mean leaving the UK and becoming independent. The Scots closely decided to stay in the UK in an independence referendum just a few years ago so a similar push is now likely. And there are calls for a second referendum since many British voters have been vocal in claiming they cast their vote as a protest and did not expect Brexit to pass.
Likewise, while the US presidential election is always important it would not typically appear here from an economic or investment perspective. But the Brexit vote has raised the profile of a misguided protest vote and both the presumptive presidential candidates have extremely high negative ratings. There is a Libertarian candidate and there are still rumors of another conservative somehow entering the race. Hopefully the Brexit saga will cause US voters to vote for a candidate rather than against a candidate but that may be asking too much.
After 30 years of almost exponential expansion, global trade dropped over 20% during the 2008-2009 economic crisis. The opening of the expanded Panama Canal, which can now handle much larger container shipping vessels, puts a spotlight on the question of whether the trade slowdown is only cyclical or more of a structural, long-term shift.
The slump in demand for commodities has affected overall trade as well as the economies and demand for imports of emerging markets. Trade is being hindered by an increase in protectionism, with Argentina, Russia and India each introducing over 250 protectionist measures between 2008 and 2014. Russia became the most protectionist country after its ban on agricultural and food imports from the EU, US, Canada and Australia. These measures have caused countries to internalize the production of intermediate goods (the step between raw materials and finished goods), knocking an entire step out of some global supply chains.
While the cost of production in China has increased, the price drop of oil has lowered transportation costs. The strength of the US dollar has hindered US exports but has made imports less expensive. But both presidential candidates seem lukewarm to downright hostile to further trade deals so trade may take another hit in the name of protecting domestic jobs.
The Brexit shock is a good time to review our approach to our diversified portfolios. Just as we made no adjustments when it looked like the Remain vote would prevail, we did not panic when the Leave supporters won. The markets are just too volatile and unpredictable to make changes during sharp turns unless there is a conscious change in long-term goals or risk tolerance, and that kind of change must consider the broader personal financial planning analysis. Indeed, plenty of market observers feel there will be no long-term impact on US investors as any change in the UK and the EU is digested.
With the global economy, there are also observers who feel there is no longer any reason to maintain any significant holdings of international stocks because owning large US companies involves plenty of exposure to foreign economies and currencies. With the strong US dollar and slow growth in most other developed economies, it has certainly been a tough period for international stocks.
But we have maintained our allocation to international stocks through it all and we believe it will add to the probability of reaching long-term goals. That allocation has been less than the capitalization weight of non-US stocks in the global market but it has remained steady. International stocks is also an area where we utilize actively managed funds along with some index funds because there is greater opportunity for skilled investment managers to avoid countries with weak markets and economies. In practice the combination of two actively managed funds that are both focused on stock valuation but employ different tactics and investment processes has proven beneficial through market cycles.
That does not mean, of course, that we are blindly or stubbornly wed to that approach. While we don’t make changes based on short-term fluctuations, we also monitor our strategies and make changes when we feel there is a better way to add value to meeting clients’ long-term goals.
Kudzu is a climbing vine native to southeast Asia that was brought to the United States in 1876 at the Philadelphia Continental Exposition as an ornamental bush and an efficient shade producer. In the 1930’s and 1940’s Southern famers were paid to cultivate kudzu as a way to stop soil erosion. Soon, however, the fast-growing kudzu was out of control and it quickly killed other vegetation by blocking the sunlight. It has taken over many roadsides and other disturbed area across the southeastern US and covers as much as 150,000 new acres each year.
Kudzu is one of the best-known examples of an “introduced species” that soon went awry or ran amok. The investment world is full of its own introduced financial species that either did not work as intended (“portfolio insurance” during the crash of 1987), get applied far beyond their real purpose (most annuities) or have unintended consequences (pursuing high income in a historically low interest rate world).
All markets carry an element of risk and the inescapable relationship of risk and return – to pursue higher potential return requires accepting higher risk, and avoiding risk means accepting lower potential returns. When this relationship gets temporarily out of whack, such as the high returns in real estate in 2006 with little perceived risk, either the risk goes up or the returns go down, or both.
Rather than accept the fundamental risk and return relationship in the stock market, financial advisers have long introduced supposed solutions to earning market returns with less risk. These solutions are usually very expensive and almost never work, and never work for long. At best these solutions are so complicated and confusing that the investor has no real way of knowing whether they are working or not.
The next level of introduced financial species is sophisticated monitoring and analysis tools to track and measure the solutions that don’t work in the first place. By this point the investor is no longer able to even recognize the fundamental market risk because it has been obscured by layers of jargon and expenses. Like kudzu, these financial strategies have choked out the more basic, native solutions.
In hindsight, the farmers would have been much better off by not trying some unproven method to stop soil erosion or to have stopped the practices that created the soil erosion in the first place. Likewise, investors would be much better served by recognizing and accepting the inherent risk of the market or to balance that risk with lower risk markets and staying away from introduced financial species.