Island Light Quarterly Commentary (July 2017)
“Believe none of what you hear and half of what you see.” Benjamin Franklin
These days, we are inundated with fake news, market commentary by analysts who parrot the opinions of their peer group, overwhelmed with data but little information and unable or unwilling to make hard choices based on daily changing news. Franklin’s truisms, while intended for the reader of the eighteenth century, are still relevant.
When we invest then, should we ignore the news? The answer is, yes and no. Some news is important, such as the level of interest rates and inflation, corporate earnings and expectations for changes in tax and economic policy. The daily spin on market direction is irrelevant and dangerous. Forecasters might forecast the direction and strength of markets but not the timing. Best, in our minds, to listen to the forecasts but temper them with our own judgement, experience, observations and investment process.
Global equity markets continued their positive trend since the November Presidential election due to positive earnings for the internet giants in the US, strong manufacturing data and better growth in Europe and most of the emerging markets. The MSCI ACWI (All World) index, which measures all developed and emerging markets, including the USA, returned 4.3% for the quarter and 11.5% for the year.
Non-US developed and emerging markets continued to outperform US equity markets in dollar terms, helped by the weakening of the dollar, improvements in expectations of economic growth and expansionary monetary policy. The MSCI ACWI ex-US Index returned 5.8% for the second quarter and is up 14.1% for the year through June 30. By contrast, the S&P 500 was up 3.1% for the quarter and 9.4% for the year. All performance figures are through June 30, 2017.
Fixed income returns were stable and modestly positive as interest rates returned to beginning-of-year levels in the second quarter. Despite the US Federal Reserve tightening monetary policy, the European Central Bank and Bank of Japan continue monetary easing policies. The Bloomberg Barclays US Aggregate Bond Index was up 1.4% for the quarter and 2.3% for the year-to-date.
During the quarter, markets grew with low volatility or major movement, except for a three day two percent drop and increase in the middle of May. This was consistent with the first quarter’s pattern and gives credence to the old saw that stocks rise like an escalator and fall like an elevator. Growth stocks outperformed value stocks as the largest internet stocks (Facebook, Amazon, etc.) led the markets. Towards the end of the quarter, financial stocks outperformed as expectations of rising interest rates dominated the headlines.
Global Equity Markets
The S&P 500 was up 3.1% for the quarter and 9.4% for the year. US Value stocks returned 1.4% for the quarter and 4.7% for the year while US Growth stocks were up 4.7% and 14.0% for the year (Russell 1000 indexes). Small Cap stocks (Russell 2000) returned 2.5% and 5.0% for the year-to-date. By any measure, these are very good returns, particularly for the growth segment of the markets. The pro-growth policies of the Trump administration (reduced regulation, expanded energy production, lower tax rates) have thus far succeeded as measured by the equity markets. Health care and technology stocks returned the best year-to-date in 2017 (15.8% and 14.0%, respectively) while the energy sector is down 12.7% for the year as US production dampened oil prices. Real estate (REITs) has been a flat performer, up 1.6% for the quarter and 1.2% for the year. MLPs remained on a downward trajectory, off -6.4% for the quarter and -2.7% for the year, with the Alerian MLP index off 40% of its value since the beginning of 2015. Gold rallied in the first quarter and stayed flat in the second quarter, returning 7.2% year-to-date.
In overseas markets, the developed world markets were up 13.8% for the year (MSCI EAFE) and 6.1% for the quarter. Emerging markets (MSCI Emerging) returned 6.3% for the quarter and 18.4% year to date. Returns in European markets were helped by the weak dollar (off 6.4% relative to a basket of currencies) and expectations of a stronger economy and aggressive monetary policy. European stocks were up 7.4% for the quarter and 15.4% for the year as measured by MSCI. After years of economic stagnation, annual growth is table at around 2%. In the Euro zone, consumer sentiment is higher than at any time in the last 10 years, despite political uncertainty in Britain and France. ECB monetary policy remains expansive while the labor market recovery continues, particularly in Germany. There appears to be little reason for the ECB to raise rates any time soon as inflation remains low. The Pacific region of the developed world economy returned 3.9% for the quarter and 11.1% for the year (MSCI). The Japanese economy grew at 1.3% annualized in the first quarter while inflation remains low at 0.4% year-over-year. The Bank of Japan also held monetary policy steady with a negative short term rate of -0.1% while the 10 year rate remains near 0%. Even tepid growth in Japan is cause for celebration. Emerging markets, dominated by China (up 25% YTD), have been market darlings in 2017. Fears of the Chinese debt levels were shrugged off and nearly all larger emerging countries, with the exception of Russia, were up in the year. Russia was again hurt by drops in oil and a stagnant economy under Putin.
Global Fixed Income
A stronger US economy led the Fed to continue its raising the Fed funds rate to 1.25% from 1.0% during its June meeting in line with market expectations. Policymakers kept forecasts for one more rate hike this year while increasing growth projections and lowering inflation expectations. In addition, details on how the central bank will start reducing its $4.5 trillion portfolio were also provided. At the end of June, the 10 year treasury bond had a yield of 2.31%, down from the beginning of year rate of 2.45% and little changed from March 31 (2.40%). As a result, longer duration fixed income performed well, with the Bloomberg Barclays aggregate bond index up 2.3% for the year. Longer duration bonds returned 6.0% while shorter maturity bonds returned 1.1%.
Central Bank policies overseas remain stimulative, with the Bank of Japan joining European markets to offer bonds at zero or below interest rates. The ECB recently discussed taking out their “easing bias” as the Euro area is expanding at a faster rate than expected and deflation risks have largely dissipated. Our non-US sovereign hedged bond holding returned 0.7% for the year.
Credit spreads tightened during the year as institutional investors continue to search for yield and fears of widespread defaults fade and recession indicators drop. The Barclays High Yield Liquid Index returned 2.2% for the quarter and 4.7% for the year to date. US TIPs returned 0.9 for the year, reflecting their longer duration and low inflation expectations.
The US dollar weakened versus most currencies during the quarter and year, providing a tailwind to unhedged foreign bond returns. The yen gained 3.8% versus the dollar as investors sought its safe-haven status. The euro was also stronger versus the dollar (7.5%) on the back of Draghi’s comments that rates were unlikely to fall further. The British pound also gained 5.1% for the year versus the dollar.
So, stronger (if not yet strong) economic growth, loose monetary policy, stable oil, and expectations for pro-growth fiscal policies have fueled the increase in world equity markets this year. Strong earnings in the first quarter affirms our view of current global profits growth and we expect global earnings growth to continue. While the US economy is late in its economic cycle, we believe that the risk of recession remains low and thus expect solid US corporate earnings growth to continue for the next year or two. This earnings growth translates to overseas companies where valuations are not as stretched as in the US. Potential risks include high equity valuations globally, particularly in the US, slowdown in emerging markets (China) economies and the termination of monetary easing first by the US and then by other central banks.
Should these sources of growth continue, particularly real GDP growth and corporate earnings, we feel that markets could continue generally upward. However, there are some good reasons to remain cautious, particularly in the US market. The major sources of equity market growth has been the expansion in multiples over earnings; that is, stocks are pricier, relative to their earnings, than their long-term averages, rather than growth in earnings themselves. These higher values give us less ability to withstand a drop in earnings, or more importantly, drop in expectations of earnings growth. If Adam Smith’s ‘animal spirits’ are tempered by any number of reasons, then we could see a future drop in equity prices. On the other hand, overseas valuations in both developed and emerging markets are lower than in the US. European equities could grow faster than the US counterparts.
Republican plans to lower corporate and individual tax rates and stimulate the American economy are also fueling positive expectations in equity markets, despite the failure to pass anything to date. So long as future developments conform to these expectations, equity markets will continue their trend. Otherwise, expect higher volatility and lower returns for the rest of the year.
Market expectations for US monetary policy revolve around one more interest rate increase in 2017 coupled with the Fed initiating a systematic long-term bond selling program in the fourth quarter. Neither of these policies should help fixed income in the short run. However, with inflation remaining below the Fed target rate, there is some sentiment to keep current policies in place for the foreseeable future.
Should we listen to Ben Franklin, ignoring what we hear and believing only half of what we see? We’re not sure that this is entirely valid investment advice. Certainly, there is a lot of data and precious little information that we can believe in. However, we do know that US stocks have had a very good run for nearly eight years now while non-US stocks have lagged in total return. We have observed strong corporate earnings, particularly in technology stocks, and see little reason for earnings to lag in the short term. Non-US economies have also experienced earnings growth and it is valid to look at recent relative global returns and be motivated to increase non-US exposures. Fixed income remains subject to monetary tightening and is still not overly attractive.
Diversified strategies have typically had excellent year to date results, validating our long-term outlook and investment approach. While cautiously optimistic, we cannot ignore the risk of becoming complacent or moving emotionally in one direction or the other. Our commitment to broad diversification in asset classes mixed with a longer-term outlook temper our reactions to sudden changes. Over the very long term, we believe that this approach will serve us well.
Matthew V. Pierce
July 19, 2017