Brexit Brief (Part Two)

We urge perspective. The UK is not leaving Europe. That would be geographically impossible and economically disagreeable.  Rather, British voters are walking back from the EU. The great continent and durable culture of Europe is thousands of years old.  It continues. The EU and its flag, distinct from the earlier European Economic Community, is simply a struggling political superstructure that has been in existence for a mere 23 years.

If diplomacy’s sensible, through wit and wisdom, commerce will continue over automobiles, wine, vacations, films and financial services.  Indeed, Norway already offers a template for European trade and integration without EU membership.

Still, in the immediate fright, the pieces of the EU were no more highlighted than in the change of 10-year government bond yields on June 24th, as strong countries stood apart from weak and investors flew to safety:

To be sure, the 52% to 48% Brexit referendum causes an immediate political fallout.  Already, David Cameron announced his resignation as prime minister and Conservative party leader.  And, Britain’s exit will cost the EU one of its biggest military powers and one of its wealthiest members.

Overall though, we believe that the direct economic impact of Britain exiting the EU is likely not material to the global macro-economy.  In our view, the greater risk comes from the potential tightening of financial conditions should more countries decide to exit the trading block.

In the near term, market volatility will most likely remain elevated and central banks will be accommodative.  Such conditions may present unique buying opportunities over the next several months as equity valuations contract and the pursuit for yield continues in an ever low and diminishing interest rate environment.

Over the longer term, investment reward accumulates within a diversified portfolio that is disciplined and devoted to a risk/reward plan.

It is vital that all parties concerned, from central banks to policymakers in the major capitals, take the necessary steps to avoid a repeat of the Lehman collapse which triggered the 2008 global financial crisis.  And the UK needs to remain engaged, open and, in the best spirit, pro-European. That way lies the future.

Brexit Brief

British voters today surprised the world with their decision to change how they cooperate and share resources with their neighbors in the European Union.

While market reaction is eye-popping, it is likely that Britain will continue to coordinate its sourcing and using of resources with countries across the channel.  It is also probable that future British trade and regulation will be conducted under a familiar philosophical framework. 

To quote Walter Bagehot: “One of the greatest pains to human nature is the pain of a new idea.” Today we see that this can be true even when the new idea – that of a Britain independent of its neighbors in the European Union – is quite an old one.

While many say that change is the only constant, we believe human adaptation to change is a remarkably consistent phenomenon.  We see that repeatedly in the financial markets.  Market calm will return.

Investment Insights Q1 2016

Equity Update

On March 9th, the bull market turned seven but there was little celebration as 2016 was shaping up to be one of the worst starts to a year, ever. Broad macro concerns resurfaced to start the year with large cap stocks down -10.3% at the February low before rebounding sharply and finishing the quarter at +1.3%. Volatility has been largely driven by oil price movements as well as concerns of a China hard landing, yuan devaluation, and other geopolitical concerns such as the sustainability of the European Union. International developed equities were not as fortunate with the MSCI EAFE finishing the quarter down -2.9% among negative interest rate policy (NIRP) in Europe and Japan intended to stimulate economic activity. The MSCI Emerging Markets index bounced back off of lows finishing the quarter at +5.7% aided by stronger commodity prices, a drop in the U.S. dollar, and lower expectations for future U.S. rate hikes.

From the chart below we can see that the market has been trading in lockstep with the price of oil over the short-term. We view a stabilization of the price of oil in the $40-$50 range as still beneficial to the consumer while easing pressure on the energy companies which make up a considerable portion of the market.
 

Overall, the U.S. economy appears to be in good shape and is arguably the healthiest economy in the world right now. Job growth has been solid, auto sales and housing have been strong, and 2016 government stimulus should add .6% to GDP. While this seven year bull market has been tested recently, investors are left with same dilemma - lack of viable alternatives to achieve investment return.

From a historical perspective, this bull market is the third longest in duration as can be seen from the chart below. Based on current economic factors, we feel that the cycle still has room for growth. Typically, bull markets are killed off by rising real interest rates, inflation, excessive speculation or black swan events. While black swan events are difficult to forecast, the other three factors are still a tail wind for stocks.
 

Source: Strategas

We believe the chance of a recession over the next year is low but recommend a diversified portfolio as the best way to weather market volatility and achieve long-term investment goals. 

Fixed Income Update
 
The Barclays US Aggregate posted a gain of 3.03% in Q1 and the Intermediate index gained 2.31%. The gains were a result of falling rates due to concerns of slowing global growth, overall financial stability of world markets and negative interest rates in overseas bond markets.

While rates increased in Q4 of 2015 leading up to the Fed's December meeting, the market view of the Fed's decision to raise short term rates by 0.25% in December 2015 was that it was premature. The bond markets took a short hiatus after the Fed December meeting but then as the New Year turned, yields sank again. The flight to safety from risk assets was fully in play and the spreads on high yield escalated in lockstep with the falling equity prices, especially in the energy market sector. The market reaction along with weakening data seems to have given the Fed some pause on the rate of increase as indicated in their rate forecast "Dot Plot", which now shows 2 increases in 2016 whereas the December version included 4 increases in 2016. However, the market is showing that even 2 increases in 2016 is too much as shown in the probability of increase for each Fed meeting throughout the balance of the year shown in the chart below.
 

In the credit markets, spreads in investment-grade and high-yield spreads moved higher and together throughout the quarter, as seen in the chart below, and like equities, showed increased market stress in the middle of the quarter only to return to the starting point by the end of the quarter. The wider spreads provided a short time window for buying and serve as a reminder of what happens in credit markets during times of stress and that higher quality issues provide the most stabilizing diversification in an overall portfolio context.

Source: Northern Trust Investment Strategy

Recent Market Turmoil

Photo by 400tmax/iStock / Getty Images

Equity Update
 

As expected, 2015 was a volatile year with considerable return dispersion among asset classes. Commodities and emerging market equities struggled with the rise in the U.S. dollar coupled with fears of a global slow down stemming from China. Large cap equities outperformed their small cap counterparts with a return of +1.4% in the S&P 500 versus -4.4% in the Russell 2000. Outside of the U.S., the strong dollar weighed on foreign returns for U.S. based investors, with international developed equities and the MSCI EAFE index down slightly for the year at -0.2%.
For the first time in 9 years, the Federal Reserve raised interest rates by .25%. This is a small move that we believe the U.S. economy can handle given healthy underlying fundamentals. Going forward the trajectory of future rate increases will be important. Global monetary policy will likely remain accommodative helping to stimulate economic activity.

Ultimately, we believe the consumer will continue driving the U.S. economy higher as consumption makes up roughly 70% of total output. Consumer confidence has remained in an uptrend, housing prices are back to pre-crisis levels, auto sales have been strong, job gains are positive, and interest rates remain low. The U.S. is still essentially a closed economy with exports comprising only 9.3% of total GDP in 2014 and exports to China making up less than 1%.

Despite a year filled with geopolitical concerns as can be seen from the chart above, the S&P 500 rallied 7% in the fourth quarter to eke out a small gain for the year. Part of the challenge for 2015 was the first significant slowdown in earnings growth since the financial crisis and was driven primarily by a slumping energy sector. Consensus estimates for 2016 are predicting mid-single digit earnings growth for the S&P 500. While last year's performance was largely driven by uncertainty and macro headwinds, it is important to stay invested for the long run and remember that a diversified portfolio is the best way to weather these storms. Asset allocation is key to volatility.

Fixed Income Update
 
The Barclays US Aggregate posted a loss of 0.55% in Q4 and the Intermediate index lost 0.51%. The losses were a result of short term rates rising in anticipation and confirmation of the December Federal Reserve rate increase. This pushed down the Aggregate to a 0.55% YTD gain and the Intermediate Aggregate to a 1.21% YTD gain.

The Fed's decision to raise short term rates by 0.25%, improvement in global growth expectations and strengthening in US wage rates all played a role in the overall increase in yields over the quarter as well as a flattening curve due to higher increases at the short end. This is all part of the normalization of monetary policy that we have been expecting to start for several years. It is a vote of confidence from the Fed that the economy is on the right track even if all of the numbers that they monitor are not quite at the desired targets.

There was bifurcation between investment-grade and high-yield spreads as the investment grade spreads softened and the high yield spreads widened. The degree of widening in the high yield was strongly dependent on the credit quality as the lower quality spreads widened considerably during Q4, especially in the energy sector.

The pace of Fed rate increases will be more important than the fact that rates have started to increase. Official Fed data shows rates will likely increase four times in 2016, while market futures suggest two increases as the most likely scenario. Slower rate changes result in better total returns as the price changes are more fully offset by the coupon payments.