Third Quarter 2016 Economic & Market Summary – October 20, 2016
‘Summertime, and the Livin’ WAS Easy…’ with apologies to George Gershwin, this summer turned out better than expected for investors. After a tumultuous second quarter during which the U.K. voted to leave the European Union, global assets rallied in the 3rd quarter. The strength was led by the riskiest asset classes of emerging-market and U.S small-cap stocks, both up over 9%. The strong rebound in asset prices in the quarter was due to various factors, including stable economic data around the world and continued expectations of additional monetary accommodation.
As discussed in the last quarterly letter, we have been concerned about monetary policy and the impact on global equity markets. During the 3rd quarter, the ‘risk-on’ environment aided the performance of cyclical equity sectors, such as information technology, financials and industrials. In addition, a rise in interest rates toward the end of the quarter, spurred by a perceived lack of monetary accommodation from the Bank of Japan and European Central Bank, as well as the Federal Reserve’s desire to raise rates in December, led to a decline in bond-proxy sectors such as utilities, consumer staples and real estate. As we wrote last quarter, the relative valuations of those bond-proxy sectors have reached very high levels on a historic basis.
Taking a business-cycle approach to sector allocation may produce differentiated returns. As we have witnessed, the bond-proxy sectors have been highly sensitive to the change in bond yields. Although those sectors exhibit earnings stability, historically high valuation levels combined with the potential for rising bond yields may negatively impact performance going forward. We continue to remain cautious in these areas of the market.
An Emerging Trend?
One of the biggest surprises this year has been the outperformance of emerging markets after recent years of underperformance. Following an extended period of turbulent economic conditions and weak earnings, negative headlines have faded and expectations have stabilized. Although trailing earnings growth remains negative on a year-over-year basis, the profit outlook has improved with positive growth in countries such as Brazil and Mexico and reduced noise out of China. After experiencing a serious global trade recession in 2015, emerging market manufacturing activity has improved dramatically as China has demonstrated a commitment to near term stabilization. The recent improvement in emerging and developed market international equities is a simple reminder for investors to remain diversified. The last five years of consistent underperformance of international equities (both developed and emerging) versus their U.S. counterparts has created a valuation opportunity. The international markets appear cheaper than their U.S. brethren and stimulus overseas has been more aggressive especially as the U.S. faces tightening measures. The missing ingredient for international markets has been the lack of stability and growth. If economic conditions continue to improve, the international markets could finally be positioned for sustained outperformance relative to the U.S. We are monitoring this dynamic closely with respect to our allocations to international markets.
The EYE of the Storm – Earnings, Yields, & the Election
As we enter the 4th quarter, investors are now caught in the ‘EYE’ of the storm. Alcoa kicked off the third quarter earnings season with a downbeat report, sending the stock down 11% and dragging the S & P 500 down more than 1% for the day. For those bearishly inclined, this report is emblematic of a market stuck in an earnings recession with earnings having declined over the past five quarters. According to Thomson Reuters, the third quarter does not offer much optimism as earnings are expected to decline 0.7% from the third quarter of 2015. Nevertheless, missing in this analysis has been the ongoing weakness in the energy patch after the precipitous decline in oil prices in 2014/2015. Removing energy company earnings would have resulted in earnings growing in three of the past four quarters with the first quarter of 2016 being the exception. Energy companies are expected to see their best quarter for revenue growth since late 2014. As oil prices have stabilized and moved modestly higher, earnings from energy firms will detract less from the overall S&P 500 Index earnings and may positively contribute in future quarters. This drag may become a tailwind and allow the broader S&P 500 Index earnings to stem the recent decline.
Analysts are predicting earnings growth of 10% next year. As we have seen, these numbers have not been very accurate in the past and we have learned to take them with a grain of salt. Currently the S & P 500 trades at almost 17x expected earnings, slightly above the 16x 25-year average. Other metrics such as price-to-book and price- to-cash flow show a market in line with the 25-year average. As Ben Levisohn discussed in a recent Barron’s article, companies are converting more of their income to free cash flow than they did 15 years ago, pushing the total shareholder yield to 4.7%. Although valuations are in line with the long term average, we will need to see earnings growth this quarter to move the market from its range.
The second part of the EYE refers to the important impact of Yields. As we have seen since the Great Recession of 2008 and the aftermath, market participants have become obsessed with the Federal Reserve and its European and Japanese counterparts. Monetary stimulus, primarily in the form of lower yields, has certainly driven asset prices higher. During the 3rd quarter, commentary from Mario Draghi, head of the European Central Bank and Haruhiko Kuroda, governor of the Bank of Japan, forced investors to confront the limits of negative interest rates and monetary easing. These comments, along with the Federal Reserve’s September meeting where three Fed governors sought to raise the Fed Funds rate another quarter point, resulted in bond yields across the world moving higher. The U.S. 10-year Treasury yielded 1.6% at the end of the 3rd quarter up from the 1.3% post Brexit low. Yields have continued to rise during the 4th quarter with the 10-year Treasury approaching 1.8%. Over the past seven years, fundamental factors such as sluggish growth, lower inflation and easy monetary policies have resulted in lower yields around the world. Just think, the average nominal yield of the 10-year Treasury from 1958-2016 has been 6.17%. Based on this long term average alone, there is concern that rates could go substantially higher if the Fed were to seek a ‘normalized’ approach.
The implications of higher bond yields are significant, yet investors may be viewing the impact out of the wrong eye. We believe the driver of higher yields might be better economic growth and this may not be a bad thing. Since 2013, riskier assets have performed well during periods of rising rates. We may have finally approached a time when good economic news may be treated as truly good news.
Moving from potentially good news to a difficult subject, which is the last letter in the EYE of the storm: the Election. In recent conversations with investors we are often asked our opinion on the election and the market impact. Investors are particularly concerned about the ramifications of a Trump or Clinton victory on sectors such as healthcare and energy. Although there has been a tremendous amount of vitriol, the U.S. is likely to survive and prosper with either outcome. In fact, there are two areas where we see some common ground—tax reform and fiscal stimulus. As the limits of monetary policy may have been reached, many economists on both sides of the aisle agree that the time has come to fix America’s crumbling infrastructure. According to the American Society of Civil Engineers, the U.S. needs to invest $3.6 trillion in infrastructure by 2020. That is a tremendous amount of money; however, the economic benefits could be enormous.
One final thought on all of this noise. It is has been a difficult period for investors and professionals alike. The market has been in a range for several years. No sectors have shown consistent leadership as the market seems to rotate on a weekly basis. Diversification has only recently been beneficial and many investors have thrown up their hands and have moved to the sidelines. We thank you for the confidence you have placed in us and we appreciate your loyalty. Markets will continue to be volatile, but we will remain steadfast in our goal to help you service and manage your client’s assets to help them best achieve their long term objectives.
Dave J. D'Amico, CFA, President
Stephen E. Johnson, JD, CFP,
Intended for investment professional use only
IMPORTANT INFORMATION: This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Firm and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor's particular objectives, risk tolerance, tax status, investment horizon, or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy cannot be guaranteed. We do not seek to endorse any investment products or financial services described herein. Any information about a product or service should be confirmed with its sponsor. Any remote links herein are provided only for your convenience and Braver Capital has no interest in, responsibility for, or control of the information on the linked website. We make no promises or warranties, expressed nor implied, including the accuracy of and fitness for a particular purpose of the content on any linked website. In no way will Braver Capital be liable for any damages resulting from use of these links under any circumstances.