INVESTMENT COMMENTARY 2nd Quarter 2023
by Neville T.T. Hicks CFA on Jul-31-2023
Investment Commentary
Through Q2/2023 market performance across asset classes and sectors have been the exact opposite of what we experienced in 2022, noting July was 5th straight consecutive "up" month in equities and with all major asset classes showing year-to-date positive gains. This has been a welcomed change from 2022 where there was nowhere to hide.
North American equity markets caught a renewed bid after the looming debt ceiling crisis was narrowly averted and the latest macro data highlighted the resiliency of the world’s largest economy. Democrats and Republicans reached a deal early June to suspend the debt ceiling and consequently eliminated the risk of an economic catastrophe stemming from a US federal default. However, the continued strong sentiment during the quarter appeared to be largely driven by the moderating pace of inflation and the resultant pause in the Federal Reserve’s most aggressive monetary-tightening cycle since the 1970s. In addition, much of the equity index gains have been driven by the large cap tech stocks and AI mania (Apple, Nividia, Amazon, Google, Meta, Tesla & Netflix), which now make up ~28% of the S&P500 and have larger combined market capitalization of France, China, UK & Japan combined! Whilst we cannot underestimate the strong momentum in equity prices in 2023, there is possibility of near-term weakness in the coming month as all the good news (no recession and lower inflation) appears to be priced in.
As we have mentioned in previous commentary, we do not foresee a US recession in the near-term given the strength of the labour force and the resiliency of the consumer. Our main macro concern is that inflation continues to be stubbornly higher than the Central Bank's 2% target leading to more restrictive monetary policy in the coming quarters. Only a year ago we had the highest inflation rate in the US since 1981 at 9.1%, but since then, we’ve seen 12 consecutive declines in that inflation rate as the June 2023 inflation has been reduced to 3.0%. This trend was reversed in July with inflation increasing year-over-year to 3.2%, which was largely expected by the market. With oil prices increasing +20% over the last month, elevated housing costs and strong nominal wage growth (consumer driven economy), we do not see inflation hitting the 2% central bank target any time soon.
After 10 consecutive interest rate hikes, the Federal Reserve decided to leave their target rate unchanged at a range of 5.0% to 5.25% in June, marking the first policy meeting at which the FOMC had not raised interest rates since it began its monetary tightening cycle in March 2022. This was short lived with the Fed only “skipping” one month as they increased Feds Fund Rate another 0.25% in July. The bond market is now pricing in only a 15% chance of another rate hike in 2023. With the July hike, the good news for investors is that they are now earning their highest yields on cash since January 2001, with the 3-month Treasury bill moving up to 5.55%. In addition, with inflation continuing to trend downwards, the yield is now 3% above market-based inflation expectations (10-year breakeven rate), the highest real yield on cash that we’ve seen in the last 20 years. This is great news for anyone who holds assets, noting all investment decisions must take into consideration the opportunity cost of capital when the risk-free rate is this high and earning a positive real rate of return.
INVESTMENT COMMENTARY 1st Quarter 2023
by Neville T.T. Hicks CFA on Apr-28-2023
Investment Commentary
The most significant news during the quarter was undoubtedly the rapid development of a banking crisis and the resulting uncertainty that came with it. The sudden collapse of a number of US regional lenders, including Silicon Valley Bank, and the failure of Credit Suisse in Europe fuelled concerns about the health of the global financial system. In addition to persistently high inflation and restrictive monetary policy, investors were forced to grapple with turmoil in the banking system, potential contagion across the financial industry, and a deteriorating growth outlook amid more restrictive credit conditions. This unexpected banking crisis presented the Federal Reserve (Fed) with a new dilemma: cut rates to alleviate market angst and risk spurring inflation higher, or persist with the rate hiking path, but risk spreading the crisis within the broader financial system. Ultimately, the decision to hike rates by 25 basis points at the Fed’s March meeting enabled them to maintain their focus on inflation while also acknowledging the financial stability risks. While few believe this to be a repeat of the systemic crisis that swept through markets during the Great Financial Crisis of 2008, it certainly put the Fed in a much more difficult position as it attempts to balance its fight against inflation and injecting enough liquidity into the system to restore confidence. It is worth noting that Five Continents does not have any exposure to the failed regional banks or any Credit Suisse and that all our client assets are held off balance sheet in segregated custody accounts.
Higher interest rates have impacted the banking sector, but the job market showed no signs of slowing down with March’s nonfarm payrolls report rising by 311,000 (after surging by 517,000 in the prior month), resulting in the unemployment rate remaining at a near record low of 3.5%. It is hard to have a recession without a downturn in the labour market and the March job reports showed 27th consecutive months of gains.
Headline inflation continued to ease, rising 5.0% from a year earlier (its lowest increase since September 2021) but core inflation rose by the most in five months, prompting Jerome Powell to state that the Fed was likely to lift interest rates higher and potentially faster than previously anticipated. The market is currently pricing in one final 0.25% rate hike during the May 3rd meeting, which would bring the terminal rate of this tightening cycle to 5.25%. After the May 3rd rate hike, the bond market is anticipating the Fed to completely reverse course and start cutting rates by July and ending the year with a Fed Funds Rate of 4% (-1.0% from current levels)! Either the bond market is right, and the Fed will change their course or the bond market is wrong and yields will continue to rise over the near-term. We believe it is the latter and remaining short on the curve (<2 years) is a prudent strategy. We have set key targets to extend bond maturities opportunistically as rates creep higher.
Despite the ongoing uncertainties with inflation and a potential recession, US markets again lead global equity markets, the S&P 500 gained 7.5% with dividends during 1Q 2023, while the 10-year U.S. Treasury yield fell from a peak of 4.1% in early March to 3.5% at the end of the quarter. 2023 thus far has been the complete opposite of 2022, with nearly every major asset class seeing gains, which is a welcome change from 2022.
At the time of this writing, the S&P 500 is at 4,150 which equates to a Shiller Price to Earnings ratio of 29.6x, noting the average is approximately 17x. With the run-up in equity prices in Q1/23, it is our view that equities are priced to perfection given the challenging macroeconomic backdrop. The markets and the underlying economy are not equals. What drives the equity markets is less about fundamentals and more about liquidity in markets. With the Fed / government rapid intervention during the latest banking crisis, it is clear they will make all tools available to support market stability. It is safe to assume that during the next crisis the Fed will be there to cut rates or pump liquidity into the system. We believe the real risk to equities is not a crisis, but rather a slow burn with the Fed keeping rates higher for a longer period in order to kill and avoid double-dip inflation. We remain cautiously positioned in equities and expect higher volatility in the coming quarters as this scenario plays out. With short-term high quality fixed income now earning +5% we are comfortable being patient and strategic during these uncertain times.
INVESTMENT COMMENTARY 2nd Quarter 2022
by Neville T.T. Hicks CFA on Jul-31-2022
Fiscal stimulus programs in 2020 and 2021 increased consumer spending in the face of the supply shocks caused by Covid-19 and government lockdowns. These imbalances between supply and demand caused inflation to begin rising in Q1 2021. U.S. inflation continued to accelerate, with consumer prices up 9.1% from last year, the fastest pace since 1981, as U.S. gas prices, rent and grocery bills continued to soar. The pickup in prices was broad and faster than expected. The Federal Reserve Board has changed their stance on inflation, with the Governors now committed to aggressively raising interest rates to combat the rising consumer prices. Higher prices act as a tax on growth as money spent on necessities such as energy and food are not available to spend on discretionary items. Higher prices in the commodity space, exasperated by the conflict in Ukraine, also raise the input costs for goods across the economy, ultimately reducing economic growth in the medium term. As market interest rates have risen dramatically in anticipation of Fed actions, the higher discount rate for asset prices, expectations of lower economic growth, and the fear of possible recession have resulted in the worst calendar year starting returns for both stocks and bonds. The S&P 500 was down 21% in the first half of 2022, and fixed income investors saw rates increase from 0.73% for the 2-year and 1.51% for the 10-year bond to 2.96% and 3.02%, respectively. The value of a fixed rate bond will always decline with rising rates, but a high enough starting yield will often enable the bond to earn enough interest during the period to offset the price decline and net a total positive return. As previously stated, this was not the case, which is why bonds also experienced such a dramatic loss during the first half of 2022. Returns should be better for fixed income investors in the second half of 2022, now that interest rates have reset higher.
As mentioned above, the Fed has taken a hawkish stance to fight inflation, increasing the benchmark overnight rate by a cumulative 1.5%: first by 0.25% in mid-March, then by 0.5% in early May, and then by 0.75% in mid-June. A further increase of 0.75% is expected next week, as the Fed acts to catch up with the market yields which are anticipating an overnight rate of around 3.5% by the end of the year. Historically, bond traders overestimate the expected path of Fed rate increases as the economic impact of their actions usually force a pause earlier than intended. In other words, they raise rates until something breaks. In the middle of June both the 2- and 10-year yields set their highs for this current cycle so far. However, as of now, the yield curve appears inverted with the yield of the 2-year note higher than the yield of the 10-year note. This is often viewed by markets as a sign that a recession is imminent.
Analysts who were expecting a 1.0% increase in US GDP for the first quarter of 2022 were surprised as growth fell -1.4% for the period due to the factors discussed above and including trade imbalances as wholesalers built up their inventory during the period. Economists, however, are still not expecting a recession in the short term as growth is expected to rebound slightly to 1.0% growth in Q2 due to the continued strength of consumer spending, the backbone of the US economy. Taking a global perspective, the IMF has reduced their 2022 global growth forecast which now stands at 3.6%. The recent reduction was attributed to the direct effect of the invasion of Ukraine on both the Russian and Ukrainian economies as well as global spill overs from the conflict. Continuing Covid-zero policies in China will also weigh on GDP reports in the coming months. This slowing growth and current persistent inflation means that fiscal and monetary authorities face a difficult path in the coming months. Higher interest rates and the ending of Covid-era fiscal support programs are triggering demand destruction that left unabated would ultimately result in a global recession. Further stimulus will extend inflation pressures which are quickly becoming political headaches for those seeking re-election. Our fixed income strategy will therefore be to invest bond maturities into fixed rate bonds targeting the area of the curve where rates have already increased and where further yield increases will be limited by the lack of commensurate increases at the longer-term maturities. Our equity strategy will be to adjust our strategic allocation to stocks based on our models but stand ready to rebalance opportunistically on significant market declines.
INVESTMENT COMMENTARY 1st Quarter 2022
by Neville T.T. Hicks CFA on Jul-29-2022
In 2022, financial markets continue to look ahead and price in the risks of our world post Covid-19. Fiscal stimulus programs in 2020 and 2021 increased consumer spending in the face of the supply shocks caused by Covid-19 and government lockdowns. These imbalances between supply and demand caused inflation to begin rising in the first quarter last year and have now risen to the highest levels in forty years. While the Federal Reserve Board initially called the higher inflation rates transitory, the Governors are now committed to raising interest rates to combat the rising consumer prices. Higher prices act as a tax on growth as money spent on necessities such as energy and food is not available to spend on discretionary items. Higher prices in the commodity space, exasperated by the conflict in Ukraine, also raise the input costs for goods across the economy, ultimately reducing economic growth in the medium term. As market interest rates have risen dramatically in anticipation of Fed actions, the higher discount rate for asset prices, expectations of lower economic growth, and possible recession have resulted in the worst calendar year starting returns for both stocks and bonds since the 1930s. This picture, however, describes the past and while uncertainty remains in the inflation and risk asset outlooks going forward, fixed income investors are earning yields at four-year highs and equity indicators are suggestions that most of the selling may be behind us.
Looking to the fixed income markets, the Fed, as expected, has now increased the benchmark overnight rate by 0.75%: first by 0.25% in March and then by 0.5% earlier this month. Further 0.5% increases are expected in June and July as the Board of Governors acts to catch up with the market yields which are anticipating an overnight rate of around 2.5% by the end of the year. Earlier in May as high as 3.0% had been priced in for the same period. Historically, bond traders overestimate the expected path of Fed rate increases as the economic impact of their actions usually force a pause earlier than intended. In other words, they raise rates until something breaks. In the first week of May both the two- and ten-year yields set their highs for this current cycle so far. Curiously, the levels set were below the peaks set in the fourth quarter of 2018, the last cycle top. If the four-decade bond bull market is truly over, new highs in yields will need to be reached. The yield curve beyond two-year maturities remains quite flat with the difference between two- and ten-year yields holding around 0.25%. While the inflation and growth outlooks remain uncertain, the much higher current yield being earned and the reduced expectation of further dramatic increases in rates means that bond portfolios should return their current yield through the rest of the year.
Analysts who were expecting a 1.0% increase in US GDP for the first quarter of 2022 were surprised to the downside as growth fell -1.4% for the period due to the factors discussed above and including trade imbalances as wholesalers built up their inventory during the period. Economists, however, are still not expecting a recession in the short term as growth is expected to rebound back to 2% growth in this quarter on the continued strength of consumer spending, the backbone of the US economy. Taking a global perspective, the IMF has again reduced their 2022 global growth forecast which now stands at 3.6%. The recent reduction was attributed to the direct effect of the invasion of Ukraine on both the Russian and Ukrainian economies as well as global spill overs from the conflict. Continuing Covid-zero policies in China will also weigh on GDP reports in the coming months. This slowing growth and current persistent inflation means that fiscal and monetary authorities face a difficult path in the coming months. Higher interest rates and the ending of Covid-era fiscal support programs are triggering demand destruction that left unabated would ultimately result in a global recession. Further stimulus will extend inflation pressures which are quickly becoming political headaches for those seeking re-election. Our fixed income strategy will therefore be to invest bond maturities into fixed rate bonds targeting the area of the curve where rates have already increased and where further yield increases will be limited by the lack of commensurate increases at the longer-term maturities. Our equity strategy will be to adjust our strategic allocation to stocks based on our models but stand ready to rebalance opportunistically on significant market declines.
Investment Commentary 2nd Quarter 2019
by Christoph Barnett, MSc, CPA, CFA on Jun-30-2019
The risk-on rally continues across the major asset classes. While May saw stocks decline sharply, markets rebounded strongly in June leading to another quarter of gains. Remarkably, for the second month this year, all major asset classes rose in the month of June; this also occurred in January. US equities have continued to achieve all-time highs erasing memories in investors’ minds of the losses in the fourth quarter of 2018. The rally in bonds has also continued as traders are no longer discussing whether interest rates will be cut but by how much they will be cut. With no real progress in trade deal negotiations and no improvement in the outlook for global growth, it is this ongoing accommodative central bank policy that is driving markets higher.
Looking closer at fixed income markets, the Federal Reserve Governors are being bullied into cutting rates by 25bps at the end of July. Now that bond traders have fully priced in a rate cut, Chairman Powell will be very hesitant to disappoint the market after what occurred in December when his comments that rates would continue to rise caused stocks to experience the worst December in decades. Some commentators have called for a 50bps cut, but recent comments from the Governors have indicated that 25bps is more likely with another 25bps cut to follow in September. Our view is that the Fed is being bullied into these cuts as markets are near all-time highs, unemployment is at a multi-decade low, and inflation remains muted. When a recession does inevitably come the Fed will need as much capacity as possible to stimulate the economy back to growth. These “insurance” cuts will use up some of that spare capacity. One area of capacity remains the Fed balance sheet where quantitative tightening continues at a rate of $50 billion per month. The size of the balance sheet has now declined to just over $3.8 trillion although communication from the Fed earlier this year stated that the run-off will be halted around September. When the economy ultimately weakens, the Fed will cut rates back to zero and restart the quantitative easing (bond buying) program.
While the Fed has yet to lower the benchmark overnight rate, longer term interest rates have fallen dramatically with only thirty-year Treasury bonds now yielding higher than the overnight rate. The now inverted yield curve is most extreme at the three-year maturity with a yield of 1.78%, 0.62% less than the overnight rate. The yield on ten-year government bonds has also dramatically fallen finding some support in its current trading range around 2%. Given the expectation of lower rates going forward, bond investors are seeking to lock-in “higher” interest rates while they are available. Without any meaningful consumer price inflation as measured by the Bureau of Labor Statistics, it seems that fears of a slowing economy and market pressures will confirm the Fed’s new interest cutting path. The current growth rate of the US economy does not explain the Fed’s new path. After 3.1% growth in the first quarter, economists are expecting another quarter of greater than 2% growth as of the end of June. The ongoing streak of monthly job growth continued with the June employment report indicating that over 1 million jobs have been created so far in 2019.
US-China trade negotiations remain stalled. American consumers are now paying tariffs on $250 billion worth of Chinese imports, more than half of the goods that China sells to the US. The knock-on effects are that countries that export to China including Germany as well as across the South East Asian region are reporting export declines. As a result, China’s second quarter growth was reported at 6.2%, the lowest in 27 years. Further, the IMF for the third time in six months has lowered their forecast for the growth of the world economy to 3.3%, the lowest since the financial crisis. As part of the retaliation to the tariffs Chinese investment in the USA has plummeted by almost 90% from the highs in 2016 showing that the US will not be immune to the trade wars effects. No significant progress in the talks are expected for the next several months and the Chinese are looking increasingly content to try to wait Trump out. With President Xi now leader for life, he will see social and political unrest as the main concern while President Trump fears the impact of a potential slowing US economy or stock market decline on his 2020 re-election campaign.
Economic growth in Europe, while positive, continues to disappoint. Italy is now in recession and Germany is flirting with recession if not in one already. With inflation also low on the continent, the European Central Bank policy makers have committed to further monetary stimulus. This is concerning as the benchmark rate is already negative at -0.4%; however, bond traders are now expecting rate cuts to begin as early as September. The main concern is that if interest rates at zero or negative in Europe for the last seven years has failed to achieve meaningful growth and inflation, how will even more negative rates achieve those goals now? Looking to Britain, like the US-China trade talks, BREXIT negotiations have also failed to show meaningful progress since the resignation of Prime Minister May was announced. Boris Johnson, a supporter of an independent United Kingdom, will be the new Prime Minister and faces a difficult task up to the October 31 deadline. Reflecting the current state of talks, the British Pound exchange remains near $1.24 per Dollar closer to the bottom of the $1.2 - $1.4 range we defined as “hard BREXIT”.
For the remainder of 2019, the financial market performance will be driven by two competing forces. On one hand, global trade tensions are putting strains on global growth and driving some countries to recession. However, central banks have signalled that weakness will be met with lower interest rates and monetary stimulus programs that should support asset prices. Our fixed income strategy will be to invest some bond maturities into longer dated government bonds that will benefit due to capital appreciation from lower interest rates. Looking to equities we will maintain a globally diversified portfolio of equities that will benefit if trade resolutions can be achieved but will also be supported by additional central bank stimulus if the economy weakens further. If long term stock markets turn down, we will look to focus our holdings in markets and sectors with attractive valuations and positive or relative momentum.
Investment Commentary 1st Quarter 2019
by Christoph Barnett, MSc, CPA, CFA on Mar-31-2019
The risk-on rally continues across all major asset classes. Stocks around the world have had their best start for a year in decades. US Equities have achieved new all-time highs giving hope to investors that the ten-year bull market will continue. Bonds also rallied as the expected path of interest rates turned downward. In spite of concerns of slowing growth in Europe and Asia, the rally has been driven by a shift in Federal Reserve Policy back to patient mode and continued hopes of a major trade agreement between the USA and China.
Looking to the fixed income markets, the Federal Reserve Chairman Powell has confirmed that the Governors have paused seeing no imminent catalyst to raise or to lower interest rates. The overnight rate will now stay at 2.5% for the near term with experts predicting no action for the rest of the year. Historically, the Fed does not pause and subsequently resume a series of further hikes, but instead are usually forced to ultimately cut rates due to a recession or financial market turmoil. In spite of Powell’s comments, bond traders are actually betting on the first cut occurring in January of 2020 with more than 70% probability. In the meantime, bonds held by the Fed continue to mature without full reinvestment. The assets held are now less than $3.9 trillion; this level was passed at the end of 2013 on the way to $4.5 trillion during the last extended round of quantitative easing. Comments from the Fed Governors have indicated that the balance sheet run-off will be halted later this year which should provide further relief to the bond market.
Longer term interest rates have fallen in line with the expectations of lower overnight rates. The yield curve has inverted further with the six months yields now 0.20% higher than yields on three-year bonds. The yield on ten-year government bonds has settled into a range of 2.4% to 2.6% having fallen dramatically from 3.2% back in November. In several prior commentaries we have pointed to the spread between the two and ten-year yields; the spread remains below 20bps. However, since the two-year yield is less than the overnight interest rate, in this commentary I want to point to the spread between the overnight rate and the ten-year yield. Since 2.4% is the current overnight interest rate this level is key for the ten-year term and means that investors are willing to invest for ten years to earn the same interest rate as lending overnight. This is consistent with the market expectation that the Fed will cut overnight rates so prudent investors want to lock in long-term rates at today’s levels. Consumer price inflation remains muted and close to the Fed’s 2% target so only continuing late-cycle economic growth can give Chairman Powell the rational he would need to return to a rate-raising path.
After 3% full year growth for 2018, the US economy printed 3.2% growth for the first quarter of 2019. This is positive for the economy as the first quarter has often been the weakest of the year throughout this ten-year cycle. For the 103rd straight month, April saw job gains in the US. 820,000 jobs have been added so far in 2019 and the unemployment rate is now down to 3.6%. With the economy effectively at full employment, more and more discouraged workers will have to re-join the labour force in order for this rate of job gains to continue. As we look to the US-China trade negotiations we see that President Trump is willing to use the strong US economy and the stock market all-time high as a negotiation tactic in the trade war. He is wagering that further tariffs with harm the Chinese market and economy more than at home. We have therefore seen a recent escalation of the tariff rates and on the amount of imports. So far Trump’s wager has been correct with the S&P 500 within 3% of the highs. The danger of this gambit is that a strong economy is needed for Trump to be re-elected in 2020, and additional tariffs and Chinese retaliation could lead to slowing growth and rising costs for US consumers. Negotiations continue with both sides still motivated to ultimately reach a deal.
The trade tensions discussed above are weighing on global trade leading to forecasts for lower but still positive growth for the rest of the year. Europe and Japan GDP grew at 0.4% and 0.5% for the first quarter respectively. These low levels of growth and the lack of meaningful inflation mean the accommodative central bank policies by the European Central Bank and the Bank of Japan will continue for the foreseeable future. These policies along with the 2019 rally in bonds have led to the total negative yielding government debt to jump back above $10 trillion dollars; the level was down to only $6 trillion in September 2018. BREXIT negotiations have failed to show meaningful progress over the last two months. As we expected the can was kicked down the road with the March 29th deadline being postponed for six months. The uncertainty of a no-deal BREXIT is rightfully seen as irresponsible by both sides so further postponements are possible if a deal cannot be reached. Reflecting the current state of talks, the Pound exchange rate has fallen to $1.27 per Dollar closer to the bottom of $1.2 - $1.4 range of we defined as “hard BREXIT”.
For 2019, the stock market has started the year with the best start in decades after ending 2018 with the worst December since 1931. Bonds have also rallied as yields have declined now that the Fed has stated that they will be patient going forward. For the year, we expect bonds to earn the higher current levels of yields that have been reached in this rate cycle while being supported by accommodative central bank policy. Equity markets although up for the year remain volatile as trade war escalations are threatened; however, both sides are aware that stock market declines can also trigger economic downturns and political consequences. Any extended market declines with lead to more conciliatory trade progress and support for stock prices. Our fixed income strategy will be to continue to invest bond maturities at longer maturities and seek to lock in these higher rates where appropriate using fixed rate bonds. If long term stock market downtrends resume, we will look to reinvest into markets and sectors with attractive valuations and positive momentum. These actions will balance our dual objectives of preserving capital in declining markets while taking advantage of lower prices of risk assets.
Investment Commentary 4th Quarter 2018
by Christoph Barnett, MSc, CPA, CFA on Dec-31-2018
At the beginning of 2018 in our full year commentary we reported on the record low levels of volatility and gains across almost all asset classes for investors during 2017. For the year ending 2018, in dramatic contrast markets across almost all asset classes declined for the year. With interest rates now at the highest level since the financial crisis, cash was the only major asset class with a positive gain for the year. After the double digit decline in February, world equity markets had rebounded through the end of September with US stocks even achieving new all-time highs. The Fed was regularly increasing interest rates, but continued trade tensions, global growth concerns, and falling corporate earnings growth were causing market participants to expect a slowing in the rate of increases. However, at the end of September Federal Reserve Chairman Powell stated that rates remained below neutral and there would be three additional rate increases in 2019. This divergence between expectations and stated policy thus triggered the declines in stock prices that resulted in the worst December since 1931, the worst quarter for equities since 2008 and the first annual decline in the S&P 500 in ten years. With an exhaustion of selling on Christmas Eve and a softening of the Fed’s policy, equity markets have rebounded strongly to start the year with the best January of gains in thirty years. Even with the rebound the longer-term trend for US stock has joined the rest of world and turned down. With the Fed now in patient mode, we will look to the fundamentals including continued economic growth and corporate earnings to deliver investment returns in this new year.
Looking to the fixed income markets, as expected the Federal Reserve Governors once again raised the benchmark interest rate by 0.25% to 2.5% at their December meeting. This was the fifth quarter in a row of increases and nine increases since December 2015. This move was expected by the market; however, due to the declines in equity prices described above, market participants were expecting a pause in the schedule of interest rate increases. Chairman Powell shocked the market during the ensuing press conference when he stated that the Fed would raise rates twice in 2019. This appears to have been the catalyst that lead to the further equity selloff that bottomed on Christmas Eve. In the weeks since, various Fed Governors have softened the tone of the central bank to a more dovish stance culminating at the January press conference at which Chairman Powell stated that the Fed would be patient going forward signalling that, in line with the market’s expectations, there would no longer be a predetermined path of increasing rates. It remains to be seen whether improving economic conditions will prompt the Fed to resume the path of raising rates or whether we have reached the peak of this cycle, but Chairman Powell, in spite of the those who believed he would truly be data-dependent, has shown that the Fed put is alive and well. Central banks including the Fed will continue to support capital markets by providing accommodative monetary policy.
The unwind of the Fed’s balance sheet continues at an annual rate of $600 billion. With the US federal budget nearing $1 trillion, government bond investors will have to buy the increased supply of Treasuries to prevent increases in market interest rates. Because of these supply pressures at the close of the January meeting the Fed also indicated that the Governors are prepared to adjust the rate of the unwind going forward. Borrowers throughout the economy will breathe a sigh of relief as the outlook for increase rates has faded, but savers and fixed income investors will be disappointed that historically low interest rates will remain.
The yield on ten-year government bonds rose above 3.2% in both October and November, the highest level since mid-2011, before falling dramatically into year-end. As investors sold equities in December they sought the safety of government bonds driving yields as low as 2.6%. In several prior commentaries we have pointed to the spread between the two and ten-year yields; the spread reached a new post-crisis low of 10.7bps, and while it has recovered the spread remains below 20bps. This is one reason why the Fed has paused as another 0.25% hike would invert the yield curve by causing overnight rates to be higher than yields for longer maturities. In early December, the Treasury bond market did partially invert as yields on five-year bonds dropped below yields for one and two-year bonds; the yield curve remains inverted from one to five-year maturities. This indicates how difficult it will be for the Fed to resume rate hikes now that they have paused. Inflation would drive up yields on longer maturities, but after staying above 2% for over a year December’s inflation printed at 1.9% and January is forecasted at 1.5% as oil and other commodities fell into year end. Chairman Powell along with long term investors as a whole will be hopeful that a growing economy prevents further disinflation and extends the current cycle.
The record long partial government shutdown has delayed several economic reports including Q4’s GDP results. As we pointed out in last quarter’s commentary, the 3.4% growth rate for Q3 has raised hope for a full calendar year of growth at over 3% for the first time since 2005. Absent any negative shocks it appears that in a few short months this will become the longest economic expansion in US history. For the 100th straight month, January saw job gains in the US. Over 300,000 jobs were added to the economy as the shutdown did not appear to impact continued hiring. The effect of the shutdown was seen in the unemployment rate which increased reflecting the status of the furloughed federal workers. The rate is back to 4% which, while above the 3.7% rate in September, remains historically low. With the headwinds of rising interest rates on hold for now, global trade tensions and slowing growth outside the US have risen to the fore. US-China negotiations are ongoing with new tariffs on hold until March 1. Both sides are incentivised to reach a deal. President Trump is seeking to declare another “win” and President Xi will want to stem the declines in China’s growth rate which at 6.4% is the lowest in 28 years. Even if a deal is reached, it is clear that we have entered a new climate of with regard to global trade that will cast a shadow over global growth. Because of these and other concerns, the IMF has continued to lower their growth forecasts.
In the fourth quarter, economic data in Europe showed Italy entering a recession and Germany’s manufacturing data at the end of 2018 is indicating that they may join their Italian counterparts shortly. With an Q4 GDP of only 1.2% in Europe it seems unlikely that the European Central Bank will be able to raise their interest rates by the end of 2019 as they had indicated. The benchmark rate has been negative for almost five years, and with continued political uncertainty, BREXIT, low growth and low inflation the ECB will be forced to continue their accommodative policies. BREXIT negotiations have stalled as the British Parliament failed to approve the deal that Prime Minister May had struck with European negotiators. The most likely short-term scenario is for the March 29 deadline to be postponed as the uncertainly will be too much for both sides to stomach. The Pound exchange rate remains near $1.3 per Dollar in the middle of the $1.2 - $1.4 range of we defined as “hard BREXIT”, an outcome both sides will seek to avoid.
One bright spot in the fourth quarter was gold. With the US Dollar strengthening, the prices of commodities were generally down, but the yellow metal bucked the trend and responded to the changing expectations of monetary policy. Compared with negative interest rates in other developed currencies, US interest rates are actually relatively high. This had contributed to the strength of the Dollar as investors converted their currencies to invest in the higher yielding US Treasuries. Now that further hikes are off the table investors have turned back to gold in anticipation of resumed monetary easing. While over $1,300 per ounce, the price will have to rise to 1,360 to confirm a new breakout but “lower for longer” in global monetary policy should provide a tailwind in the coming months.
For 2019, the stock market has started the year with the best January since 1987 after ending 2018 with the worst December since 1931. Bonds have also rallied as yields have declined now that the Fed has stated that they will be patient going forward. For the year, we expect bonds to earn the higher current levels of yields that have been reached in this rate cycle while being supported by limited if any further rate increases. After returning in 2018, volatility will remain in equity markets going forward as stocks react to the drags of lower earnings and slowing global growth offset by the tailwinds of central bank policy. Our fixed income strategy will therefore be to continue to invest bond maturities at the higher rates and seek to lock in these higher rates where appropriate using fixed rate bonds. If long term stock market downtrends are confirmed, we will reduce exposure defensively and rotate into markets and sectors with attractive valuations and positive momentum. These actions will balance our dual objectives of preserving capital in declining markets while taking advantage of lower prices of risk assets.
Investment Commentary 3rd Quarter 2018
by Christoph Barnett, MSc, CPA, CFA on Sep-30-2018
October’s historic volatility has returned to equities overshadowing the third quarter gains in developed stock markets around the world. Like February, the price declines this month have been sharp as have the rebound days when they have occurred. US equities have again outperformed by declining less than other markets as the US Dollar remains strong. In our first quarter commentary we pointed out that these moves, while uncomfortable, are a return to normal for the risk and volatility that is expected in equities. Since the beginning of the current bull market in March 2009 there have been over twenty pullbacks of at least 5% of which seven were over 10%. Equity markets have delivered the high historical returns because of the risks inherent in the asset class. What has changed in the latest market decline is that the long-term trend has begun to turn down. The trend had already turned down for non-US markets earlier in the year, but we remained largely invested to due to the continued relatively attractive valuations of those countries. However, if the downtrend is confirmed in the US at the current high level of valuations, this will lead us to reduce US exposure tactically in our equity holdings.
Looking back to the third quarter, the US market was again the best performer for the period and even attained new all-time highs both in August and September. US stocks at one point were responsible for more than 100% of the gains in the global stock benchmark as all other countries were down in Dollar terms year-to-date. After a strong rally in the second quarter, the Dollar paused in the recent quarter removing the foreign currency headwinds for US investors in non-US assets allowing positive moves in market that remain down so far this year. Continuing trade tensions and rising rates are concerning holders of risk assets as even their overall bond returns have been negative in 2018, an unusual state given the decades long bond bull market. Like the first half of the year this represents a continued return to normality for risk assets and the unpredictability which must be endured to receive the higher expected returns over time. World equity markets followed the same themes in the third quarter that had driven the second quarter results. Markets drifted higher but US stocks outperformed again despite the high valuations. The Dollar paused from its run-up earlier in the year ending holding through the quarter. This provided respite to emerging markets which also consolidated throughout the period.
Looking to the fixed income markets, as expected the Federal Reserve Governors raised the benchmark interest rate to 2.25% at their September meeting making it four quarters in a row and eight hikes since December 2015. They have indicated a further increase in December and three more in 2019; this forecast has not change since our last commentary. What has changed are bond traders’ expectations of the pace of Fed moves. Interest rate futures are now starting to price in a 2019 year-end rate of 3% versus the 2.75% indicated last quarter. Even three-month LIBOR, which had been slumbering since April, began to creep up confirming the above expectations. President Trump’s has escalated his criticism of the Fed from “not thrilled” back in July to insisting that the Fed has “gone crazy”. The President’s comments have so far not deterred Chairman Powell who in recent speeches pointed to low unemployment and inflation over 2% and confirmed that monetary policy will be data dependent. The unwind of the Fed’s balance sheet is also continuing having been reduced just over $340 billion from the 2015 peak level. As of this month we have reached unwind cruising speed of $50 billion per month; the ramp up has now completed and going forward the Fed will reduce their holdings at $600 billion per year until the Governors believe their holdings have returned to a “normalized” level. We continue to monitor this tightening cycle as while increasing yields benefit savers, they also represent costs which must be borne by corporates and consumers and will inevitably place downward pressure on economic growth.
Looking further out on the interest rate curve, we see that the ten-year yield has held above 3% since the first half of September, the longest time spent here since 2011. We continue to point to the ten-year rate as it has historically been a measure of future growth and inflation expectations. A sustained breakout above 3% is important as the spread between the two and ten-year yields had set a new post crisis low of 18.75bps at the end of August. As discussed above, short term rates are continuing their upward march so longer-term rates must also move higher for the Fed to move ahead with the planned rate increases without inverted the yield curve. Inflation has now printed above 2%, the Fed’s target, for twelve months including an annual rate of 2.9% in July. Chairman Powell will be hopeful that a growing economy prevents disinflation in spite of the current monetary tightening cycle.
President Trump celebrated the 4.2% US GDP growth rate for the second quarter; however, we have seen several quarters with growth over 4% during the last decade. Analysts are looking at today’s third quarter estimate with keen interest. Growth was reported at 3.5% and positions the US economy to achieve a possible year-end milestone of 3% growth for a full year, a level not seen since 2005. The next goal would then be to sustain growth through mid-2019 to make this the longest expansion in US history. The US unemployment rate fell in September to 3.7%, the lowest level since 1969, and while there are reasons to critique the current methodology of employment statistics the US economy has so far been resilient through the current cycle. Areas of concern, however, remain present and we expect the headwinds of rising interest rates to eventually impact economic growth. US household debt had declined from 2008 to 2013, but as of the first quarter of 2018 a new all-time high was reached. As interest rates continue to rise this will result in higher levels of interest payments and put pressure on consumer spending. Credit card delinquencies have begun to rise at smaller banks and the equity index of homebuilders, companies in an interest rate sensitive industry, has fallen 30% from its January high and did not participate in the general stock market recovery from the February lows. Curiously, the equity index of banks has also not recovered and is now down almost 15% from the January highs. Higher levels of interest rates would traditionally allow bank more capacity to earn interest margin, but stock investors are clearly doubting the banks’ ability to capture this spread.
For the fourth quarter of 2018, we expect bond and equity markets to react as global central bank liquidity transitions from net easing to net tightening. Our fixed income strategy will therefore be to continue to invest bond maturities at the higher rates but to maintain the overall portfolio duration at the current level to prevent capital declines if interest rates rise quickly. We expect volatility in world equity markets to remain elevated as historically normal fluctuations return to risk assets. These moves will allow us to take of advantage of funds raised taking profits when exposure was reduced from the equity limit and invest in the markets and sectors with attractive valuations and a positive momentum. We are willing though to tactically reduce exposure in markets with high valuations and falling momentum in order to protect the portfolio from extended declines.
Investment Commentary 2nd Quarter 2018
by Christoph Barnett, MSc, CPA, CFA on Jul-16-2018
Following the return of volatility to the equity markets in the first quarter, the second quarter saw continued divergence of returns among countries and sectors as equities around the world reacted differently to rising rates, US Dollar strength and rising trade tensions. US markets have been buoyed by the Dollar and relentless performance of the FANG tech stocks which rallied to new highs. This contrasts with financial stocks in the US and non-US stocks overall which have struggled to hold on to gains for the year as fund flows have turned towards America due in part to greater yields and the repatriation of profits held offshore. Like in the first quarter this represents a continued return to normality for risk assets and the unpredictability which must be endured to receive the higher expected returns over time.
Looking to the fixed income markets, as expected the Federal Reserve Governors raised the benchmark interest rate to 2.00% at their June meeting and have indicated another two increases for the remainder of this year and three more in 2019. Expectations from bond traders diverge from the Fed’s guidance after the upcoming September meeting. Traders are pricing in only two increases from September to the end of 2019. Three-month LIBOR, which had functioned as a leading indicator for the Fed rate increases, has now been flat since April echoing the traders’ reticence on the pace of rate increases. Even President Trump has commented that he is “not thrilled” with the Fed’s plan. Since central bankers value their independence, the President’s comment may in fact strengthen the Governors’ resolve to follow through. The unwind of the Fed’s balance sheet is also continuing having fallen almost $225 million from the 2015 peak level. Current forecasts set the balance at $3 trillion by early 2019 which will add a trillion dollars of supply to the bond market in addition to the ongoing trillion-dollar annual US federal budget deficits. In his latest Congressional testimony, Fed Chairman Powell emphasized the gradual and data dependent path of both the balance sheet unwind and interest rate increases. We continue to monitor this tightening cycle as while increasing yields benefit savers, they also represent costs which must be borne by corporates and consumers and will inevitably place downward pressure on economic growth.
Our commentaries have regularly pointed to the ten-year yield as it has historically been a measure of future growth and inflation expectations. With much fanfare from many bond bears, the measure peeked above 3% in April and May for the first time in four years. By the end of the quarter it was clear, however, that this was not the awaited breakout as the yields remains range-bound between 2.75-3.00%. Since the short-term rates have continued their upward march as discussed above, the spread between the two and ten-year levels has now set a new post crisis low of 23.5bps. If inflation does not return to the economy to drive up long-term bond yields, one more rate increase will invert the yield curve. The last inversion occurred at the end of 2005, but this did not prevent Bernanke’s Fed from raising rates four more times. If only to build further capacity to cut rates in the future, the Powell Fed will continue with the path outlined above until stopped by extended asset market declines, a decrease in the rate of inflation, or a weakening in the current economic cycle.
On the economy, the first estimate of US second quarter GDP has printed at 4.1%, the highest level in almost 4 years. While not among the strongest, the current economic expansion as of May became the second longest in US History. This muted growth and low inflation may in fact be the reason the for the length of this cycle. Inflation has begun to pick up with the June level of 2.9% the highest in six years and the tenth month above the 2% level targeted by the Fed. Unemployment ticked back up to 4% after touching 3.8% in May, a multi decade low propelled by another quarter with average employment growth of over 200,000 new jobs per month.
Rising trade tensions in conjunction with the Dollar rally in the second quarter has had a dramatic effect on commodity markets across the board. Base metals such as copper have experienced double digit percentage declines leading to concerns that escalating trade restrictions could lead to a global recession. Copper prices have been used in past cycles to forecast economic slowdowns due to its use in manufacturing and construction. Agriculture prices have also dropped as tariffs have targeted crops included soybeans specifically. Oil had reach $75 per barrel but has now fallen back to $67, and gold like copper is at a one year low having fallen as low as $1,212 per ounce. It seems that even Gold investors are placing their confidence in Powell and the Fed’s plan to successfully unwind the years of easing.
Tightening of European monetary policy remains uncertain as economist do not expect interest rate increases from the ECB until September of 2019. The bond buying program is, however, being reduced from 30 billion Euros per month to 15 billion per month in the last three months of the year at which time the program will end. Core inflation in Europe has struggled to stay above 1% and GDP growth while stable does not show any signs of overheating. Trade concerns have also affected the continent as Trump called Europe a trade “foe” and while the UK would face a greater impact, Europe economies will suffer without a pro-trade BREXIT agreement. The UK government negotiators are running out of the time as the March 2019 deadline is now less than nine months away. If no trade deal is reached the so-called hard BREXIT will have occurred in which Britain will trade with the EU on the disadvantaged terms of a non-EU member. We use the Pound to gauge the market’s expectation as to whether a deal with be reached; at $1.31 the exchange rate is stuck in the middle of the post BREXIT vote range indicating an uncertain future. What is clear is that the recent turmoil in the British cabinet has reduced the optimism that was building though-out 2017.
For the remainder 2018, we expect bond and equity markets to react as global central bank liquidity transitions from net easing to net tightening. Our fixed income strategy will therefore be to continue to invest bond maturities at the higher rates but to maintain the overall portfolio duration at the current level to prevent capital declines if interest rates rise quickly. We expect volatility in world equity markets to remain elevated as historically normal fluctuations return to risk assets. These moves will allow us to take of advantage of funds raised taking profits in 2016 and 2017 and invest in the markets and sectors with attractive valuations and a positive momentum.
Investment Commentary 1st Quarter 2018
by Christoph Barnett, MSc, CPA, CFA on Apr-16-2018
After attaining fresh all-time highs in January, global equity markets experienced the dramatic return of volatility in February as markets declined for the first month since October 2016. The move was exacerbated by the collapse of the short-volatility strategy which profits when markets remain calm. The S&P 500 Volatility Index doubled on February 5 leading to the liquidation of funds that used their entire asset base to bet on declining volatility. Stocks initially rebounded through the middle of March but have since moved lower again through the end of the quarter. While volatile markets are uncomfortable for investors with a short term investment horizon, it is important to remember that this activity is quite normal behaviour for risk assets. It was the last year of calm that was historically unusual.
Looking to the fixed income markets, as expected the Federal Reserve Governors raised the benchmark interest rate to 1.75% at their March meeting and have indicated another two increases for the remainder of the year. Traders current expectations for the timing of the next hike are at a 84% probability for the June meeting. The March meeting was also Chairman Powell’s first press conference in which he reiterated the Board’s commitment to a measured path for both interest rates and the balance sheet unwind. The balance sheet has now been reduced by $100 billion since the high of over $4.5 trillion at the beginning of 2015. As a reminder, the unwind is now proceeding at a rate of $30 billion per month increasing to $50 billion over time. Market short-term rates have been increasing even faster than the Fed’s overnight rate with three month LIBOR now over 2.3% a year on year increase of 1.18% versus the three 0.25% Fed moves. We are watching these moves carefully as tightening cycles certainly benefit investors and savers who are positioned to profit from increased yields; however, corporates and consumers will face increasing finance costs and economic headwinds
As of our last commentary, longer term ten-year yields had been failing to breakout above 2.4%. January finally saw the breakout which continued into February before reaching 2.95%, a four year high. This move had paused the flattening of yield curve, however, the ten year yields have retrace into the quarter end back to 2.75%. Since the short term rates have continued their upward march as discussed above, the spread between the two and ten-year has now set a new post crisis low of 47bps. If inflation does not return to the economy to drive up bond yields, this spread will hamper the Fed’s efforts to extend their period of rate increases. The board will not intentionally invert the yield curve so unless long term rates rebound the Fed will not be able to achieve their target of two more rate increases this year.
The US Dollar resumed its decline in January but stabilized in February and has been range-bound since, ending the quarter down 2.3%. This move affected commodity prices as expected with gold hitting $1,360 per ounce for the first time since 2016 and the price of oil touching $66 for the first time since 2014. One unintended consequence of the new US tax law is that the repatriation of Dollars back onshore will cause of a shortage of Dollars in the offshore funding market. This increased demand for Dollars in conjunction with the Fed’s tightening and balance sheet reduction will provide upward pressure for US currency. The longer term move will depend on the reactions of other central banks and whether the Fed will be able to continue their current path in the face of any weakening in the economy.
Speaking of which, US economic growth remains strong with the final 2017 fourth quarter GDP reading at 2.9% albeit lower than the prior two quarters. The Q4 report exceeded expectations and shows consumer spending as the steady driver. The current estimate for growth in the first quarter stands at 2% with the official number coming at the end of this month. This growth level is obviously below that promised by the Trump administration but would be the highest first quarter growth in three years. February saw the highest US jobs increase in almost two years and March’s positive number kept the unemployment rate at 4.1% where it has stood since October. Inflation remains muted at just over 2%.
For the remainder 2018, we expect additional guidance from central banks on their plans to unwind years of stimulus. This will outline the path to slowly renormalize interest rates. Our fixed income strategy will therefore be to continue to invest bond maturities at the higher rates but to constrain the maturities used to prevent capital declines if interest rate rise quickly. With valuations stretched, upward price momentum had remained the primary reason to stay fully invested in equity markets. The return of volatility in the first quarter and a retracement from the January highs has certainly dampened the equity market run-up. Throughout last year in general we took profits on stocks reducing our equity exposure back to neutral levels as appropriate based on client’s target asset allocations. Investment managers that follow short term strategies have already reduced their equity holdings further with mixed success. Longer term models remain invested, but we are watching closely to determine the prudence of further reducing our equity holdings. We can be confident that given any sharp or prolonged economic weakness will lead to central banks delaying further tightening.
Investment Commentary 4th Quarter 2017
by Christoph Barnett, MSc, CPA, CFA on Jan-15-2018
2017 was one for the record books. Markets gained around the world and across the asset class spectrum in US Dollar terms. While some will point out that the Dollar was in fact one of few assets which did decline for the year and thus contributed to the return of non-Dollar based assets, we point out that the almost all assets were positive for the year even in local currency terms. A US Dollar based investor would have to hold Corn or Natural Gas to show an asset line item loss in their portfolio. Volatility also broke records on the downside as measures of market jitters registered multi-year or all-time lows. The US stock market, for example, was within 3% of its high all year and experienced positive returns in every month of the year, an unprecedented calendar year streak. The oft quoted Volatility Index closed below 10 more times in 2017 than it had closed below that level in the history of the index pre-2017. In December, President Trump finally achieved the win he was hoping for all year as the Republicans pass their long-promised tax cut and included the repeal of the healthcare mandate. The President has continued to try to point to the stock market as validation of his pro-American business policies; however, the 2017 out performance of non-US equities over those in the US demonstrates that additional forces are driving these gains. Emerging Markets were the stand out with a year-end return of over 37%
Last month as expected, the Federal Reserve Governors raised the benchmark interest rate to 1.5% and bond traders are now pricing in an 88% probability of another 0.25% increase in March and about 50% for another two hikes by the end of the year. President Trump has nominated Jay Powell to be the next Chair of the Federal Reserve. Mr. Powell has served as a Fed Governor since 2012 and is expected to support bank deregulation and to continue the dovish policies of the current board. The unwind of the Fed’s $4.5 trillion has begun at a rate of $10 billion per month. The rate of decline will increase by $10 billion every three months until an unwind rate of $50 billion is reached. This additional bond supply for the market to absorb will be in addition to new debt issued by the government to fund the now larger post tax cut deficits. The pace of the unwind will be closely monitored by all market participants as analysts have indicated at $65 billion of unwind equates to a 0.25% rate increase in terms of its effect on the market.
After failing twice to break definitively above 2.6% since the election, the longer-term bond market yields are again testing the highest levels since 2014. The recent run-up has prompted the usual suspects to call for the end of the 30-year bull market in bonds as major yield trendlines appear to have been breached to the upside. Short term rates, as described above, have continued to climb as the 2017 and 2018 interest rate hikes are priced in. In our last report, we commented that the spread between the two and ten-year yields had yet to break through the 2016 low of 75bps. The spread has since dropped though this level and now stands just above 56bps, the lowest since November 2007. If inflation does not return to the economy to drive up bond yields, this spread with hamper the Fed’s efforts to extended their period of rate increases. The board will not intentionally invert the yield curve so only two rates increases in 2018 can be expected without increased inflation. This would bring us to 2.0% for the overnight rate, still low given the historical context. This will, however, give breathing room to the US government whose tax bill is expected to increase the US deficits by another 1.5 trillion over the next ten years. This is in addition to current deficits; the 2017 deficit was $666 billion and the total debt outstanding is $20.5 trillion.
As we look to commodities, oil rallied strongly in the second half of 2017 rising over 30%. The rally has continued into the new year and crude now stands at the highest level in three years haven broken above the 2015 high of $61.43. Along with the US Dollar decline, supply declines in Libya and Venezuela as well as renewed rhetoric from President Trump regarding the Iran nuclear deal have driven these gains. The main threat to the rally is increased production in Brazil, Canada and the USA as producers take advantage of the higher prices. This threat is still to materialize, however, as evidenced by the price move and the US rig count which has remained flat for the for the last seven months. Commodities like oil generally trade using futures markets with contract expiration dates set to various points in the future. For the first time since 2014 this “curve” of future prices has returned to its usual downslope with future prices lower than prices for immediate delivery. This indicates that prices have risen high enough above their costs basis for producers to lock in their sale prices rather than take the risk that oil prices decline again. Gold produced a double-digit gain for the year and its first back to back annual gain since 2012. The aforementioned weak Dollar along with the highest levels of inflation in three years drove these increase, but the price is still yet to break above the 2016 high of $1,366.
Turning to the US economy, GDP growth posted another strong quarter increasing at an annual rate of 2.6% for the fourth quarter after the 3.2% print for the third quarter. Trump and the Republican Congress are hoping their tax cut can keep growth over 3% with the most ambitious members calling for 4%. After the September jobs decline (since revised to positive), the US returned to positive jobs growth adding 261,000 jobs in October and 228,000 in November. The overall unemployment rate ticked down to 4.1%, the lowest since 2000, confirming the continued health of the job market.
BREXIT negotiations continue to grind on, but progress has been made. Last month, an agreement was struck setting the price of the “divorce bill”, outlining residency rights of UK and EU citizens, and maintaining the open Irish border. We had previously used the Pound as a barometer to gauge the market’s expectation for the progress of the talks; the current exchange rate has now passed $1.4 per Pound, an increase since the January low of $1.2. This increase, however, appears to be more a function of the Dollar’s 2017 weakness as the Pound versus the Euro has been flat since January indicating continued uncertainty on an ultimate BREXIT deal. Over on the mainland, the European central bank has now reduced the monthly bond purchases from 60 to 30 billion Euros and will continue at that level through September 2018. Economists are calling for the program to be ended entirely by the end of this year and even for the overnight interest rate, which remains negative, to be raised by the end of 2019. The European economy has achieved a GDP growth rate over 2.5% for the first time since the first quarter of 2011. Inflation, while below the 2% target, hovered around 1.5% during 2017. The economic emergency seems over but emergency stimulus remains with negative deposit rates and trillions in outstanding negatively yielding bonds. The world’s experiment with negative rates does appear to be waning as the outstanding balance on these negative yielding bonds which peaked at over $10 trillion back in September has declined below $7.5 trillion as short to medium term yield ticked slightly higher. We certainly remain in a period of credit stimulus, and these programs will continue to provide a floor to asset prices around the world.
For 2018, the Fed has indicated that it will raise rates three times; this is in line with our expectations. The roaring markets have driven equity valuations to levels seem only during the tech bubble. Fed Governors also watch assets market and do not want to accept blame by failing to raise rates from their historic lows while the economy was growing at 3%. It is also important that interest rate are high enough to be lowered meaningfully when the economic cycle turns. Equity markets have entered a euphoric state with the best start to the year in decades. When markets behave like this it is important to remember two facts: euphoric markets are some of the best times to achieve strong gains, but these periods should not be used to set expectations for the future. When these periods finally end they herald the return of volatility and lower expected returns as the underlying fundamentals catch up with the increases in price levels. Therefore, we deem it prudent to take advantage of the price levels and rebalance equity allocation to neutral levels. The fixed income market will have to digest the large yield spikes in the last few months as investors reposition their portfolios in light of better opportunities to invest at higher rates. The shape of the yield curve will matter more that the short term rates in the next few months, but the overall increase will allow us to invest the bond maturities at higher rates leading to higher returns for the portfolio.
Investment Commentary 3rd Quarter 2017
by Christoph Barnett, MSc, CPA, CFA on Oct-16-2017
Major asset classes and market around the world with few exceptions experienced gains for the quarter. Political uncertainty and global tensions remain, but so does the lack of any meaningful market volatility. Markets have shrugged off the struggle for Catalan independence, stalling Brexit talks, and North Korean nuclear tests and focused on slow but steady economic growth across the developed world. Following the failure to reform healthcare in the US, hope remains for tax reform legislation which much be completed before year end to avoid the 60-vote requirement in the Senate. These hopes and continued central bank liquidity are bolstering prices with non-US equities outperforming US equities in dollar terms. Concerns of high valuations and the reversal in direction of central bank programs in the coming month have been voice by some commentators, but theses have been so far ignored by markets.
Traders in the short-term bond market are now pricing in an 86% probability that the Federal Reserve Governors will raise short term interest rates to 1.5% in December. If the board does indeed decide to make the move it will be the fifth such rate increase in a two-year period. Fed Chair Yellen’s four-year term with be up in February and President Trump will have to nominate her for a subsequent term or to nominate a new chairperson to allow time for Senate confirmation. While Chair Yellen guided the Fed off the unprecedented zero-bound for interest rates, it will be the next chairperson’s duty to guide the board as they start on the unprecedented task of unwinding the portfolio of holdings amassed in the various rounds of quantitative easing. The portfolio has held steady at $4.5 trillion for two years but stood at under $1 trillion before the global financial crisis. Initial guidance presented last month was that the first reductions would be very limited and increase over time, but no end target was given. With the US government continuing to operate under budget deficits, a Fed balance sheet unwind will require private investors to purchase an increasing number of government bonds to keep interest rates at the current low levels. President Trump, a professional borrower, will therefore likely select a chairperson who will follow a lower for longer strategy to mitigate the effects of rising interest costs on his next three budgets.
The longer-term bond market yields continue to be range bound with trading centered around 2.3% since the US election last year. The spread between the two and ten-year yields has yet to break through the 2016 low of 75bps, but the highs in the spread have been declining during 2017 confirming that the flattening trend is still intact. As it was in June, the current extra yield investors earn for loaning the US government money for ten years versus two years remains near 0.80%, just above its nine year low.
Looking at risk assets, stock markets around the world have continue their climbs ever higher. The world market index continues to achieve new highs, and the Russian market is the only major country with negative performance year to date. These gains have been accompanied by record low levels of price volatility both historical and forward looking. The US market has in recent days surpassed its record for record number days without a 3% decline from its high; we have now had no 3% declines since the day before the US election. Major commodities such as oil and gold are off their 2017 lows, but despite Dollar weakness for most of the year they have been unable to break out to meaningful highs. Oil has rallied from $42.50 in June to $53.50, but will have to move above $54 to confirm any new uptrend. After the industry shake out in early 2016 shale producers in the US have adapted to the lower price levels and have increase their production to levels near the 2015 peak. This supply will act to dampen major price moves higher. Gold broke through $1,300 for the first time in a year but ended the quarter having declined to $1,280. Commodity markets will look to inflation, the pace of Fed balance sheet tapering and 2018 interest rate expectations to affect their prices through the end of the year
For the first time since 2010, the US economy experience a monthly loss of jobs in September. The decline is expected to be a temporary disruption as the payroll figures were impacted by the hurricanes which struck Texas and Florida. The overall unemployment rate fell 4.2%, another sixteen year low, confirming the continued health of the job market. The storms are also expected to impact the third quarter’s growth, currently estimated at 2.5%, but the final GDP for the second quarter was reported at a healthy 3.1% growth rate.
BREXIT negotiations have stalled as negotiators disagree on the amounts Britain will be required to pay to complete the divorce. We have used the Pound as a barometer to gauge the market’s expectation for the progress of the talks; the current exchange rate near $1.3 per Pound is still implied a “soft-Brexit” and cooler head prevailing. On the continent, the European central bank is also looking to tighten their monetary policy as Mario Draghi, its president, announce a tapering of the continued bond buying program. In January, the monthly purchases will be reduced from 60 to 30 billion Euros and will continue at that level through September 2018. For 2017, Europe has experienced inflation levels near 1.5% and GDP growth near 2% giving the ECB Governors muted confidence that they can eventually end their stimulus programs. With rates on bank reserves and wide swaths of outstanding bond still negative, we are by no at the end of the current era of central bank stimulus. These programs will continue to provide a floor to asset prices around the world.
For the remainder of 2017, we expect additional guidance from central banks on their plans to unwind year of stimulus. This will outline the path to slowly renormalize interest rates. Our fixed income strategy will therefore be to continue to invest bond maturities at the higher rates but to constrain the maturities used to prevent capital declines if interest rate rise quickly. As in last quarter, we continue to look for volatility to ultimately return to world equity markets and for non-US equity markets to continue to outperform the US markets as they have underperformed in the previous five years and trade at more attractive valuations. This non-US outperformance has already occurred year-to-date.
Investment Commentary 2nd Quarter 2017
by Christoph Barnett, MSc, CPA, CFA on Jul-17-2017
Amid continued political uncertainty, equity markets around the world have continued to rally posting healthy gains for the first half of the year. Tensions surrounding North Korea weapons testing and fighting in Syria as well as the ongoing investigations into Russian influence in American elections and governance have all been largely ignored by equity investors. Stock prices historically climb the wall of worry and deliver returns to those with a long-term focus. Even the failure of President Trump to make meaningful progress on his healthcare, tax reform and infrastructure policy goals has not resulted in meaningful stock market volatility. The first half of 2017 has actually seen some of the lowest levels of volatility in history. The gains in the US have extended the historically high valuations which continue to dampen future return expectations, but non-US markets, which lagged US returns for the last few years, outperformed the US markets by 5% so far in 2017 fulfilling the higher expected returns indicated by their lower current valuations. Historically, the most attractive equity markets are those with relative low valuation levels and rising prices, a state which now describes non-US markets. Interestingly, the second most attractive equity markets are those with rising prices and relatively high valuations, a state which has described the US market for the last few years.
In the bond market, focus remains on the Federal Reserve Governors who have now increased the overnight Fed Funds rate by 1% since December 2015. The three most recent decisions to increase rates have occurred once per quarter since December 2016. For the first time, the Fed has now presented details of the plans to reduce the size of their $4.5 trillion balance sheet that was built during the various quantitative easing programs in which mortgage and Treasury bonds were purchased in order to maintain low interest rates. For the last three years the balance sheet size has been stable as cash from interest coupons and maturing bonds was simply reinvested. The unwind plan will slowly reduce the level of reinvestment and allow the portfolio to decline as the bonds mature. Limiting the reinvestments will remove downward pressure on interest rates so bond traders are not expecting the next Fed Funds increase until December 2017 at the earliest. In contrast with the increases in short term rates, long term interest rates have been range bound with the ten-year yield trading mostly between 2.2% and 2.6% causing the yield curve to continue its general flattening trend since 2014. In mid-June, the extra yield investors earned for loaning the US government money for ten years versus two years was only 0.79%, near its nine year low.
Employment gains continue to be the bright spot in the US economy. June saw 222,000 jobs added, a four-month high, and May saw the unemployment rate hit a sixteen year low of 4.3%. The US economy has not seen a month with a net loss in jobs since September 2010. As the current period of expansion matures wage growth, which has been muted, will become the more important marginal data point. Regarding GDP, the current estimate for growth in the first quarter is 1.4%, a relatively weak start for the year. Consumer spending, the main driver of the economy, grew at the slowest level since 2013. This slow start will make it difficult for Trump’s economic team to achieve their full year target of 3% and Wilbur Ross, the Commerce Secretary, has already issued statements walking back from the target. The IMF has also lowered their estimate for full year GDP growth due to lack of tax reform or infrastructure stimulus.
BREXIT negotiations have begun. The UK government finds itself in a weakened position as May’s political gambit of calling an early election backfired and caused the conservative party to lose their majority instead of gaining strength as was hoped. The divorce process will be long and the final outcome remains to be seen. On the European continent, the wave of populism has crested for now with the French people rejecting the nationalist politics of La Pen, and not only electing Macron as President, but electing his party to a significant parliamentary majority. These British and French election results reflect the historical swinging of the political pendulum. As voters across Europe see the results of the BREXIT vote and the Trump presidency, they will wait to see the longer-term consequences before making similar decisions in their own countries. The latest comments from the European Central Bank seemed to confirm there would be no further rate cuts from the already negative level and that the ECB Governors are carefully considering the tapering of their bond buying program which continues at 60 billion Euros per month. Low but persistent GDP growth and inflation above 1% since December have supported the decisions behind these announcements along with the European equity market outperformance referred to above.
For the remainder of 2017, we continue to expect central banks to continue with their ‘lower for longer’ strategy. At the same time they will continue to slowly renormalize interest rates where they believe it is possible. As the current economic cycle matures, they want to be ready to act if the economy weakens. Our fixed income strategy will therefore be to continue to invest bond maturities at the higher rates but to constrain the maturities used to prevent capital declines if interest rate rise quickly. We expect volatility to return to the world equity markets and for non-US equity markets to continue to outperform the US markets as they have underperformed for five years and trade at more attractive valuations. We will use the US market strength to take profits and invest in non-US markets both developed and emerging.
Investment Commentary 1st Quarter 2017
by Christoph Barnett, MSc, CPA, CFA on Apr-17-2017
We are now nearing the end of Trump’s first 100 days in office and the old Wall Street adage remains true: “buy the rumour and sell the news”. After the election results in November, investors began to look forward to the repeal of the Affordable Care Act followed by tax reform and infrastructure spending with some reduction in regulations throughout. This optimism lead to a Trump bump in equity prices as tax cuts were priced into company profits and additional stimulus spending was priced into economic growth. The bump extended into bonds yields as higher inflation expectations led to a third Fed hike in fourteen months. However, reality may now be setting in. Developing scandals, wire taping claims, and cracks in the facade of Republican unity have shown markets the “news”. Trump will find it difficult to actually achieve his campaign promises and pledges. Ten year yields are back below the level set on inauguration day, and while the S&P 500 remains positive, it is below the high set on March 1st.
After the initial pop in November, bond market traders had kept ten year yields in the range between 2.31 and 2.62% since early December, but earlier this month they dropped through the range floor and touched 2.18%. On the short end of the curve, one month LIBOR has increased 0.45% since the US election and a total of 0.63% since back in December 2015 when the Fed increased rates for the first time in almost a decade. The market rate increases in the market drove the Governors to raise the Fed Funds rate once in December and then again in March to the current upper target of 1.00%. The increasing short rates combined with range bound longer rates has cause the yield curve to resume its flattening. Although it is well off the recent low set in mid-2016 when the ten year yield dropped below 1.4%, the extra yield investors earn for loaning the US government money for ten years versus two years is only 1.04%.
In the US, the economy grew at a 1.9% annualized rate in the fourth quarter, slower than the 3.5% rate set in the quarter before. Consumer purchases again drove GDP increasing 3%, exceeding expectations, and helping to offset slower investment by business and state agencies. Our view remains that even with potential concerns regarding slowing growth, the US economy has the best growth prospects in the developed world. Jobs growth had been beating expectations in 2017 except in April, but the over six year streak of monthly job gains shows no sign of stopping and the unemployment rate has hovered at 5% or below, approaching a ten year low, for sixteen straight months.
Article 50 has been triggered as the United Kingdom officially started the two year process of leaving the European Union. Prime Minister Teresa may has called for snap elections in June which will give the voters a chance to change their minds or to reaffirm their support for Brexit. The long term effect of Brexit on the British economy remains to be seen as economic growth is expected to match last year’s growth of 1.8%. However, the weakening of the Pound has led to the largest growth in factory orders in the last 20 years while retail sales growth has fallen to the lowest level in seven years. Looking across the channel, in the first round of their presidential elections, the French people appeared to prefer the alternative choices to the French “Trump” Marine La Pen and voted Emmanuel Macron a pro EU candidate to an initial and leading to expectations that he will win the second round as well. This has led to a jump in the Euro versus the Dollar and a pop in global equities as investors have interpreted the vote as a slowing of the populism that was seen in the Brexit vote and the election of Trump. All eyes remain on the European Central Bank whose bond buying program decreased from 80 Billion Euros per month down to 60 Billion Euros while maintaining the reserve rate at -0.4%. The Euro inflation rate has now been above 1% for four straight months, a first since 2013, but growth across the Union remains below 2%. The results of the negative rate experiment remains to be seen in Japan and the European countries, but we expect accommodative policy to continue for the foreseeable future.
For 2017, the Fed has indicated that it will raise rates three times including the March decision, but we expect central banks generally to continue with their lower for longer strategy in the face of anaemic economic growth and the lack of meaningful inflation. They will also stand ready to resume or accelerate accommodative policy if economic growth turns negative or shocks to the financial system occur. This will result in equity markets with low volatility on average but punctuated with spikes in volatility such as what we saw after the US election. The fixed income market will have to digest the large yield spikes in the last few months as investors reposition their portfolios in light of better opportunities to invest at higher rates. The shape of the yield curve will matter more that the short term rates in the next few months, but the overall increase will allow us to invest the bond maturities at higher rates leading to higher returns for the portfolio.
Investment Commentary 4th Quarter 2015
by Christoph Barnett, MSc, CPA, CFA on Jan-22-2016
In December, the US Federal Reserve finally made the long anticipated decision to raise short term interest rates off of the zero bound where they had rested since December 2008. Developed market equities, while unable to fully recover their third quarter losses, did deliver good returns in the final quarter. In contrast, the bear market in emerging market equities continued as the commodity decline showed no sign of finding a bottom and the Fed move confirmed fears that the credit cycle may be entering a tightening phase. All eyes remain focused on the Fed as investors adjust their expectation to the expected pace of rate increases in 2016. In response to the Fed decision, short term bonds yields increased while longer term yield remain relatively unmoved exacerbating the flattening of the curve that we have discussed in previous commentaries.
In 2015, cash was truly king. Price returns across all major asset classes were negative and only when dividends and interest are included in the returns were US stocks, bonds and real estate slightly positive for the year. Strength in the US Dollar, which increased by 9.3% for the year, drove much of the underperformance in non-Dollar assets. The Fed has raised interest rates and is planning to raise again in 2006 in contrast to central banks in Europe, Japan, Switzerland, England, China and Canada who plan to lower rates, continue QE, or at the very least maintain low or negative rates for an extended time. This divergence in interest rate Currency War policy is forcing investors into the Dollar as they seek to escape negative yielding and depreciating currencies.
Equities markets in January 2016 had one of the worst starts of the year in history as non-US developed markets and emerging markets entered bear markets. The US market, while in a correction, has so far been spared bear market status with the exception of small-cap stocks which have fallen over 23% from their all-time high. The speed of the decline in January has certainly been jarring, but equity investor must maintain perspective. World stock markets have not made a new high since May of last year so we are now over 210 calendar days into this decline. Since 1900 we have had 35 bear markets with an average length of 403 days. For the 5 bear markets since 1990 only the 2000-2002 tech bubble burst and recession and 2007-2008 real bubble burst and global financial crisis produced bear markets significant lower and longer than our current bear market. Every bear market is unique, but this provides context regarding potential further decline and recovery in the coming months.
Many US investors may be surprised that world markets have declined for almost three quarters since peaking in May; this is because in some ways this has been a stealth bear markets. A small number of mega cap companies with strong returns have supported the overall market covering money smaller companies that have declined. If just the top five performers of the S&P 500: Amazon, Microsoft, General Electric, Alphabet (Google) and Facebook are removed, the index performance for 2015 would have dropped from 1.31% to -1.35%. In fact, for much of the year these companies represented most if not all of the gains of the benchmark.
In the US, the economy grew at a 2.9% annualized rate as of Q4 2015; this is the lowest level since the first quarter of 2013. Consumers spending, while less than the previous two quarter, again drove the economic growth rate, but business spending on equipment and structures were a drag. The Manufacturing Purchasing Managers’ Index (PMI) is has now been under 50 for four months signalling possible further strain on GDP in the coming quarters; the PMI had not dipped below 50 since December 2012. While concerns have emerged our view remains that that the US economy has the best growth prospects in the developed world as the Fed will remain stimulative in the face of any economic decline. Job growth had exceeded expectations for the three months before the recent January report, but we have not seen a month without job gains since October 2010. The unemployment rate continues to decline and is under the psychologically important 5% level standing at 4.9%, the lowest level in almost eight years. Oil and commodity markets as a whole have continued their decline, but the effect on annual inflation is beginning to work through the consumer price data. Inflation has ticked back up to 0.7% after hovering near zero for the whole of 2015.
In January, the Federal Reserve reconfirmed that interest rate hikes in 2016 will be gradual and data dependant. Inflation far below target, low labour market participation and market volatility will give the Fed Governors pause while the continued positive GDP growth should spur them forward. The Bank of Japan has set the deposit reserve negative for the first time ever. This signals that in spite of the Fed December move, central banks will continue to lower rates and increase quantitative easing. At the beginning of the year, Fed Fund futures implied a greater than not probability of a March rate hike, but with the market decline, slightly lower economic growth and the latest BOJ move the implied probabilities show that investors do not expect another rate hike until 2017. The Fed forecasts for 2016 levels of interest rates still show four increases; however, we continue to expect short term rates to remain low in the near term as the eventual continued moves from the zero bound will be muted.
In a recent speech, the head of the European Central Bank Mario Draghi confirmed that he would not surrender to low inflation which stands at 0.4% for the Euro area, the highest level in over two years. The recent market volatility has driven investors back to European bonds driving yields back down across the continent. For maturities of five years or longer, government bonds issued by Germany, Switzerland, Sweden, Denmark, Austria, France and the Netherlands trade at negative yields. UK inflation remain positive but only just at 0.2%. These numbers will spur continued negative rates as central bankers continue to do “whatever it takes”. EU GDP growth in 2015 continued at the best levels seen in four years following the initiation of the ECB quantitative easing program.
Commodity prices took another leg down in the fourth quarter and continued to fall through the middle of January, but have bounced into the month end. Oil touched $26.19 but then recovered over 28% back to over $33 per barrel as rumours of production cuts came out of Russia and OPEC. New supply coming from Iran as sanctions are lifted and continued pumping in countries experiencing budgetary strains will have to be overcome to lead to further significant gains. It will also difficult for prices to break through the $60 as rigs will be brought back online to take advantage of again profitable wells. Emerging markets, in a bear market since August, have declined further in the last few months in sympathy with global equities; however, valuations are now indicating double digit real forward returns on average for a ten year time horizon. This is the highest expected return based on valuations among the global market regions. Gold, which has remained relatively resilient during the commodity bear market, fell in the fourth quarter but has gained in January as investors sought safety in a falling market.
For 2016, we expect central banks to continue with dovish policies in their attempts to fight deflation and promote growth. Negative nominal rates are no longer purely theoretical and are now seen as a viable option even for the Fed. While growth may slow, we do not expect a recession in the US. Recessions are occurring and will occur in the commodity producing countries in response to the slowing growth in China. The largest US stock decline of the last five years was a 19% decline in 2011 during the European debt crisis; this decline has so far peaked at over 15% down. While these market moves are definitely jarring, they are the price paid for the additional returns available in the equity market. Historically, a 10% decline has occurred in about two of every three years. With inflation rates so low, we expect central banks to provide further stimulus at any indication of a dreaded low growth/deflation combination. This will keep yields on safe assets very low but continue to provide support to the risk assets classes in diversified portfolio.
Investment Commentary 3rd Quarter 2015
by Christoph Barnett, MSc, CPA, CFA on Sep-30-2015
The bull market has faltered in the US as the S&P 500 failed to achieve a quarterly gain, breaking its streak of ten straight positive quarters. Equity markets around the world likewise are experiencing corrections with emerging markets faring worst entering a bear market on continued financing concerns and the global commodity rout. Volatility spiked dramatically in August and has remained elevated since. All eyes remain focused on the Fed as the Governors chose not to raise rates in the first three quarters of the year. In the US bond market, the yield curve continued to flatten as rates for maturities under one year increased and decreased for maturities in the medium term. This shows bond investors continuing to prepare for an eventual rate increase in spite of the Fed’s September decision not to make their first upward move in nine years.
After thirty-six correction-free months, the fifth longest streak on record, the S&P 500 experienced its first 10% decline on a closing basis in August. While the speed and volatility of the decline to the 10% mark may give concern, we should also reflect on the length of the correction free streak and the sense of complacency it has given us. Equity markets are volatile and even though they have consistently been proven to delivered the highest long term returns corrections and bear markets remain part of the equation. Philosophically, it must be so. If volatility and loss were somehow removed from the stock market and 7% annual returns achieved without variation and this fact became widely accepted investors would over time bid up the price of stock market until the expected return would be that of a bank account. It is the volatility which give rise to the greater returns.
Observing a long-term correlation between stocks and bonds of 7%, investors rightly expect bond holdings to offset declines in the equity holdings of their portfolios. However, this correlation has proved unstable throughout history swinging from positive to negative with extremes at -93% and +86%. August was one of those months when the correlation was positive with long-term government bonds declining 1%, contributing to instead of offsetting the equity declines. It is in these circumstance where the benefits of a disciplined investment approach is most critical. Where appropriate we have used the market volatility as an opportunity to rebalance client portfolios. A disciplined approach to rebalancing forces us to buy low and sell high setting up the portfolios best recover along with markets.
In the US, the economy grew at a 3.7% annualized rate; this is up from the 2.3% estimate reported by the Commerce Department in their previous GDP data release. Business and consumer spending drove the increase from the first quarter which saw only 0.6% growth. Our view remains that that the US economy has the best growth prospects in the developed world. Despite coming in below expectations, the employment report released earlier this month capped 60 straight months of employment gains with unemployment now at 5.1% the lowest level in seven years. As commodity markets struggle to find a bottom, inflation remains low at 0.2% for the last two months and has been near zero for the whole of 2015. Federal Reserve communiques continue to confirm that interest rate decisions will be data dependant. Inflation far below target, low labour market participation and market volatility will give the Fed Governors pause while the continued GDP growth should spur them forward. The Fed forecasts for the 2015 and 2016 levels of interest rates have fallen from the forecast in March and June this year. We expect short term rates to remain low in the near term as the eventual initial moves from the zero bound will be muted.
With Euro area deflation at -0.1% in September, the ECB’s bond buying program has so far failed to achieve its stated goals. The second quarter actually saw bond yields increase across the European countries in spite of the ECB purchases. These increases have certainly not been dramatic as negative yields persist in Germany, Switzerland, Sweden and the Netherlands. After printing negative in April, inflation in the UK again came in at -0.1% for September. Based on these indicators and market reactions we expect that the European QE program will continue for an extended period of time. On the positive side, EU GDP growth in 2015 is at the best levels seen in four years.
European and Japanese central banks continue their quantitative easing programs. The Fed continues to show their willingness to remain accommodative with one governor even predicting a negative fed funds rate in the US in the most recent interest rate forward looking dot plot. These policies will continue to provide support to asset prices across the risk spectrum. Market declines will slow the timing and magnitude of hawkish monetary policies decisions, and Equities markets will continue to be the beneficiaries of these policies.
Commodity prices in general and oil prices in particular appear to have found support in the quarter as oil touched $38.51 per barrel before rebounding and settling into a $43-$50 range for the month of September. Headlines showing the financial distress at Glencore, the commodity giant, and reports of Saudi Arabia delaying payments to government contractors as deficits continue give additional indications that commodity markets are bottoming. With the Iran nuclear deal moving into the implementation stage, it is difficult to see how a significant long term increase in oil prices can materialize absent geopolitical instability. Emerging markets have taken the brunt of the equity market declines this year falling as much as 31.5% at the low point in August; however, valuations continue to show that these markets will produce the highest long term returns and demand a place in diversified portfolios. Gold and silver declined for the quarter, but strong moves in line with other commodities since the quarter end have offset those losses.
Investment Commentary 2nd Quarter 2015
by Neville Hicks on Aug-06-2015
The Greek debt crisis, Chinese stock market volatility, and uncertainty regarding central bank policy dominated the headlines for the second quarter. While steps still need to be taken to complete a third Greek bailout; the local parliament has passed legislation agreeing to the austerity measures demanded by the other European governments. Following a crash of over 34% from the high, the Chinese government has taken steps to support the local stock market including tightening regulation on leveraged accounts, banning certain entities from selling their positions, and supporting a fund to buy stocks outright. These measures are in addition to circuit breakers which have halted trading of many of the individual stock which crashed the fastest. The decline seems to have been abated for now. On the central bank issue, the world continues to watch and wait to see if the US Federal Reserve will indeed raise rates as they have indicated later this year as for the first time since 2006.
With a price return of less than 0.5%, the S&P 500 closed its tenth quarter of positive returns on June 30; this small gain came as the US market remains in the tightest trading range so far this year of at least two decades. While the tech heavy NASDAQ Composite had broken through to the upside in the first quarter, it too joined the S&P 500 and Dow Jones Industrial Average to share the same range bound fate in the second quarter. In the US bond market, the yield curve steepened for the first time since the last quarter of 2013 as all maturities showed an increase in rates. This reflects the expectation of bond investors on the timing and effect of a rate increase from the Fed.
US unemployment is now 5.3%, the lowest in seven years; average hourly earnings have also improved in the last year. This employment data is the latest in a series of generally good news for the US economy. In May, the Bureau of Economic analysis revised upward their estimate of first quarter GDP. Data on the second quarter will be released at the end of this month, but current forecasts indicated growth will be over a 2% annual rate. Increases in consumer spending and the housing market are driving this expected growth. The US Dollar has stabilized this year after its strong increase last year. While a strong Dollar remains a headwind for exports, the lack of further strengthening with reduce the pressure on the domestic economy for now. We expect that the decline in non-Dollar currencies will spur export led growth in global manufacturing countries, but our view remains that that the US economy will continue to push forward in the developed world. Janet Yellen has continued to indicate that a 2015 rate rise is likely. With the economic news mentioned above it will be difficult for the Fed to continue to delay the move. Inflation remains a sticking point; June inflation was 0.1% well below the 2.0% Fed target. This may not prevent the Governors from pulling the trigger on the rate hike, but it is definitely one of the reasons for hesitation. We do expect the Fed to start increasing rates in late 2015, but rates will be below their forecasts and future rate rises will be slow in coming as the economy and markets adjust.
When the Fed does make the first rate move higher, it will be quite significant as it will signal a turning point in the global momentum of interest rate moves. According to Bank of American Merrill Lynch, central banks have cut interest rates over 570 time since September 2008. This includes the Bank of Canada, who just lowered their benchmark rate by 0.25% to 0.50% on July 15. The benchmark Euro interest rates remain negative. The Greek debt crisis spurred sell offs in European bonds causing yields to turn back to positive over most maturities. The German 10 year yield spiked from 0.05% to over 1% in less than two months. This move represented an extreme percentage and volatility spike that cause some institutional managers to adjust their fixed income models. Euro area deflation seems to have been contained with a reading of 0.2% in June up from negative print for the first three months of the year. Economic growth in the region continues to be weak, increasing only 0.4% in the first quarter. The effects European QE program , which was launched on January 22, will be seen in the next few quarters as the ECB is hoping to stimulate a recovery like that seen in the US. The recent spike in bond yields will provide additional capacity in the bond market to invest the Euro 60 Billion that is being invested each month.
These accommodative policies predictably bolstered equity markets by forcing investors into the comparatively riskier asset classes and lowered foreign exchange rates thereby promoting growth in exporting economies. We have already seen this in the markets as European and Japanese equities have lead the developed world in returns beating the US markets year-to-date. This is line with our expectations as valuations are more attractive in those countries and their quantitative easing programs continue.
The support for oil prices held in the second quarter as prices remained in the $47-$63 range. The production rig count decline in the US appears to have stabilised, but production remains on course to set a new record for 2015. Saudi Arabia as well is continuing to maintain its high level of production. A historic nuclear deal with Iran was announced earlier this month. The deal remains to be ratified and sanctions lifted; however, the first supertanker filled with Iranian oil has set sail for Asia. If this new supply comes fully online we expect oil prices to remain capped for the near to medium term. Commodities prices in general remain suppressed as the China slowdown lowers worldwide demand. Volatility remains high in emerging markets which ended flat for the quarter; valuations remain attractive in these markets. Last month, Gold gave up the $1,200 price support and is now back to the November price lows.
Investment Commentary 4th quarter 2013
by Scott Elphinstone on Jan-10-2014
During 2013, global markets moved on waves of speculation about the timing of when the US Federal Reserve will cut back on quantitative easing or QE. In December the Fed announced it would reduce its new bond purchases by $10 billion a month to $65 billion. The Fed is engaged in a very delicate balancing act. To date the Fed has offset the deflationary effect of the weaker deleveraging economy by creating inflation through increasing the money supply, purchasing government and mortgage bonds. As a result of these offsetting forces, net inflation is low, in the 1% range. This will work as long as economic growth is weak however, the recovery of the global economy seems to be gathering momentum. A combination of moderating post crisis deleveraging, a reduction in fiscal drag from government austerity and stable to lower energy costs due to new sources of energy, especially in the US, is driving faster growth.
The Fed needs to make a difficult call. If the Fed reduces money growth in the system by slowing down or stopping QE too soon, the economy may head back into recession. If they keep up QE too long the inflationary impact of printing money will no longer be offset by a declining level of deflation in the economy and inflation may be significantly higher. While they might be lucky and manage this transition to a stronger economy correctly by withdrawing QE and increasing rates at exactly the right time, we need to consider what their most likely error will be. Given the desire by the government to have stronger economic growth and the benefit to the US deficit that comes from lower interest expense, it is pretty clear that they will let inflation increase well beyond their target before reversing all of the QE and raising rates. With the risk mostly one sided we will maintain our strategy to minimize damage that might result from inflation by holding only short term fixed income securities and by being underweight financial and highly leveraged companies in the equity portfolio.
In Europe, the recovery is significantly behind that of the US. The European economy has only now exited recession. While political risks remain they have been reduced and the equity markets will likely catch up and close their underperformance to the US over the next few years. Japan is a similar story. It is finally emerging from its lost decade due to aggressive US style QE and major structural reforms. While all of the announced reforms have yet to be enacted, the Japanese equity market like Europe has the same potential to outperform.
In contrast the developing economies appear to be way ahead of the US economy and are now starting to recover from a slowdown that is a few years away for the US. China will perform the best, but probably at a growth level lower than that of the past 10 years, as the government is making considerable investment to steer the economy into one that is less export dependent and more driven by domestic consumption. In contrast India, Brazil and other developing countries with a high level of external financing requirements are likely to have protracted slowdowns. Emerging market equities are reasonable value and have the potential to recover from this year's weak performance.
Investment Commentary September 30, 2013
by Katherine Tathum on Oct-01-2012
Market volatility continues to be driving largely by government actions, especially speculation as when the US Fed will taper its purchases of bonds. Over the summer expectation built that the Fed would ease its money printing machine in September. This put pressure on both global equity and bond markets. US 10 year government bond yields moved up from 1.63% in May peaking at 3.0% in September, before the Fed meeting (a loss in value of over 10%). The Fed surprised the market in September by leaving the pace of bond purchases unchanged. The equity markets ignored the negative implication that the Fed thinks that growth will be slower and moved to new highs. Bonds took the opposite view and staged a modest rally. Fed speakers have reassured the markets that they don’t see an end to quantitative easing for some time, we are not sure that the Fed has the luxury of too much time before they have to start withdrawing stimulus. While it is likely they will wait until the US government settles its budget early next year, if they are too slow at reversing policy they might risk very damaging stagflation. On the other hand it is clear that Fed intends to keep interest rates at current levels until late 2015 a year longer then we had previously anticipated. This will allow us to extend term somewhat to take advantage of the slightly higher yields offered by the steep yield curve without much additional risk.
Emerging market equities have been further pressured by much weaker than expected growth in China, Brazil and India. It now looks like these economies will not recover to their previous very high levels of growth as quickly as we expected. Some encouraging signs that growth rates have bottomed moved the oversold broader emerging market equity indices up by about 8% in September reversing some of the declines. At this point we see not enough evidence to add to our emerging market position.
While Europe remains a slow moving situation, equity markets have reacted positively to better economic data overall and in the hard hit peripheral nations of Italy, Spain and Ireland. The recession is Europe appears to have ended and the risk of any sovereign default has receded. The re-election of German Chancellor, Angela Merkel and the survival of the Italian government coalition in a vote of non- confidence supports our confidence in the stability of Europe. Mario Draghi, the head of the ECB continues to speak of a potential US style stimulus package that will be put in place to support the European economy if required. Japan is a similar story to Europe. Economic growth has lagged the US and is starting to catch up largely on the promise of more aggressive fiscal and monetary actions by the Abe government. With the US at all-time highs we think that Europe and Asia are more attractive markets for investment.
With the start of tapering in the first quarter of 2014 at the latest, we remain cautious as we have seen the scale of the negative market impact the start of tapering might bring. We think that the risk of a large negative development in the markets, like in 2008, is much higher than normal due to the sheer size of the amount of monetary stimulus in the global system.