Mid-Year Market Update

Now that we’re half-way through 2017, it’s time to take a look at market and economic trends year-to-date. The big picture view is that asset classes across the board have delivered strong returns through June. This is despite interest rate hikes by the Federal Reserve’s Federal Open Market Committee (FOMC). In fact, Treasury yields have actually fallen in the face of two interest rate increases this year, pushing bond prices higher. International stocks and bonds have also risen in 2017, boosted by stabilizing global growth rates, depressed yields world-wide, and improving corporate earnings.

Looking a little more closely at the U.S., stocks continued their upward trajectory early in the year following the post-Presidential election results in November. While the new administration has not made much traction in passing new legislation, relatively healthy economic data – including good jobs growth, higher wages, and a strong housing market – have supported stocks. At the time of this writing (June 15, 2017), the S&P 500 Index is up 8.5% on a price-basis and up 9.7% on a total return basis (which includes dividends).

Technology stocks have led U.S. equity markets this year. Within the S&P 500 Index, the sector is up over 17% year-to-date given healthy earnings growth expectations for the group. The more tech-heavy NASDAQ Index is up a whopping 14% this year, almost 6% ahead of the S&P 500 Index. However, we’ve started to see some signs of weakness among tech stalwarts recently and are watching the group closely. On the flip side, energy and telecom stocks have lagged the index, with price declines of 13% and 9%, respectively. Of note, energy and telecom stocks were two of the three best-performing sectors in the S&P 500 Index last year, with prices returns of +24% and +18%, respectively. This marked turnaround in performance provides a cautionary tale on the pitfalls of market timing: last year’s leaders may well become this year’s laggards. In general we’ve found that it’s difficult, if not impossible to predict which sectors or industries will outperform in any given year. As a result, we recommend maintaining a diversified portfolio through all market cycles and rebalancing regularly.

Another wide disparity arose among growth and value stocks. Year-to-date, growth stocks (as measured by the Russell 3000 Growth Index) are up almost 14% on a price return basis versus a 3% return for value stocks (as measured by the Russell 3000 Value Index). Much of the outperformance by growth stocks stems from strong returns among technology stocks – many of which are growth-oriented and trade at higher valuation levels.

After years of underperforming U.S. stocks, international equities have outperformed year-to-date. In aggregate, developed stocks from Japan, Europe, and Australia are up 14% on a price return basis through June. While this group has lagged U.S. stocks over the past four consecutive years, improving economies in most of these regions, positive consumer sentiment, and accommodative central banks are starting to turn the tide. Likewise, Emerging Markets stocks are up over 17% on a price return basis so far this year. The marked turnaround comes as corporate earnings growth for many of these countries is starting to improve and global growth is stabilizing.

Other interesting observations for 2017 include record-low stock volatility levels, lower yields despite higher interest rates by the FOMC, and an eventful (if unproductive) six-months in Washington.

Looking forward, we see risks and opportunities. The Federal Reserve is set to reduce its bloated balance sheet later this year which could pose a risk to above-average stock valuation levels. Despite the potential for unintended consequences, we view the move as a vote of confidence in the U.S. economy and as a much needed step towards more normalized monetary policy. While a more restrictive Federal Reserve is a headwind to asset prices, interest rates remain very low (with no signs of rising) and the U.S. economy remains on stable footing. These factors, along with improving U.S. corporate earnings growth, bode well for continued stock gains over the long-term.

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What’s Ahead for Fixed Income?

After more than thirty years of falling interest rates and thus rising bond prices, yields may be moving higher.  While trends are often short-lived, this new trajectory could persist into 2017 and beyond given recent changes in the political landscape as well as a less accommodative Federal Reserve (Fed).  We’ll take a look at what this new monetary and political environment may mean for bonds and how to best-position your fixed income portfolio for the long-term.

A proxy for the bond market, the 10-year Treasury note yield hit an historical low of 1.36% in July 2016 only to jump 100 basis points (or 1%) by the end of November.  The move came as investors responded favorably to the surprise U.S. Presidential and Congressional election results, in anticipation of higher growth levels in the years to come.

Part of the optimism stemmed from the new administration’s promise to cut consumer and corporate taxes and spend on infrastructure projects.  This picture presents a mixed bag for bonds, however.  Increased fiscal spending and lower taxes are positive for economic growth and a healthy economy is generally good for lending and credit activity.  But stronger economic growth would push yields higher and thus bond prices lower.  On the other hand, higher yields would provide investors with higher current income, acting as a partial offset to lower bond prices.  Rising interest rates or yields would also allow investors to reinvest into higher-yielding bonds.

Duration is an important characteristic to consider when reinvesting at higher yields.  A bond’s duration is the length of time it takes an investor to recoup his or her investment.  It also determines how much a bond’s price will fall when yields rise.  Longer duration bonds such as Treasury or corporate bonds with long maturities experience sharper price declines when yields rise.  Likewise, shorter duration bonds are less volatile and will exhibit smaller price declines, all else being equal.  Because we can’t predict the exact direction or speed of interest rate changes, it’s important to have exposure to bonds with a mix of durations.  In this way an investor is able to respond to any given environment.  For example, when yields are rising, an investor can sell her shorter-duration bonds, which are less susceptible to prices changes, and reinvest into longer-duration bonds with higher rates.

Another factor that affects bond prices is inflation.  Inflation expectations have started to heat up in light of low unemployment, wage growth, and expectations for increased government stimulus.  Higher inflation could also put upward pressure on interest rates and thus downward pressure on bond prices.  While inflation can erode the real returns of many bonds, some bonds, such as Treasury Inflation-Protected Securities (TIPS), stand to benefit.  TIPS are indexed to inflation and backed by the U.S. government.  Whenever inflation rises, the principal amount of TIPS gets adjusted higher.  This in turn leads to a higher interest payment because a TIPS coupon is calculated based on the principal amount.

Finally, the Federal Reserve’s shift away from accommodative monetary policy will have an impact on bond prices.  Although higher interest rates from the Fed will likely pressure fixed income prices, overall we view this change favorably.  This is because a return to more normal interest rate levels is critical to the functioning of large institutions like insurance companies and banks, which play a key role in our society.  Likewise, higher interest rates will provide more income to the millions of Baby Boomers starting to retire and would help stabilize struggling pension plans at many companies.

Taken altogether and in light of an uncertain environment, we believe a diversified bond portfolio targeted to meet your specific fixed income needs is the best way to weather this changing yield environment.  In addition to considering your specific income objectives, our Investment Policy Committee meets regularly to assess the current economic, fiscal, and monetary environment.  We adjust our asset allocation targets in order to take advantage of attractive opportunities or reduce exposure to higher-risk (over-valued) areas.  While we may over-weight some areas or under-weight others, in the long-run we continue to believe that a well-diversified portfolio is the best way to weather any market environment.

Thank you,

The Parsec Team

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Market Update Through 06/30/2016

as of June 30, 2016
Total Return
Index 12 months YTD QTD June
Stocks
Russell 3000 2.14% 3.62% 2.63% 0.21%
S&P 500 3.99% 3.84% 2.46% 0.26%
DJ Industrial Average 4.50% 4.31% 2.07% 0.95%
Nasdaq Composite -1.68% -2.66% -0.23% -2.06%
Russell 2000 -6.73% 2.22% 3.79% -0.06%
MSCI EAFE Index -10.16% -4.42% -1.46% -3.36%
MSCI Emerging Markets -12.05% 6.41% 0.66% 4.00%
Bonds
Barclays US Aggregate 6.00% 5.31% 2.21% 1.80%
Barclays Intermediate US Gov/Credit 4.33% 4.07% 1.59% 1.43%
Barclays Municipal 7.65% 4.33% 2.61% 1.59%
Current Prior QTR
Commodity/Currency Level Level
Crude Oil $48.33 $38.34
Natural Gas $2.92 $1.96
Gold $1,320.60 $1,235.60
Euro $1.1110 $1.1396
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Implications for “Brexit”

Investors received surprising news this morning, as the United Kingdom (U.K.) voted to leave the European Union (EU).  While markets will no doubt experience increased volatility in the coming weeks, longer-term, we believe the negative impact of “Brexit” will be largely contained to Great Britain and Europe.

Trade accounts for about 40% of the U.K.’s gross domestic product (GDP), with most of those exports and imports tied to EU partners.  As a result of the recent vote, Britain is likely to see higher trade tariffs from the EU and more trade staying within continental Europe’s borders.  Both of these shifts could weigh significantly on Britain’s economic growth in the mid-term and would likely weigh on EU growth as well.  One positive is that the U.K. never adopted the Euro, choosing instead to maintain the British Pound as its currency.  This is should make an exit from the EU smoother and slightly less costly than if they had converted to the Euro, and suggests it could be less detrimental than if Greece had left.

While the U.K. is likely to experience the largest negative impact by leaving the EU, continental Europe is also at risk given its relatively fragile economic expansion following the Financial Crisis of 2008-2009.  From 2010 through 2015, EU GDP has grown at an average rate of just 1.2% compared to U.K. GDP growth of 2.0%.  Thus any major shock, such as one of its strongest members leaving the Block, could derail those modest growth levels.

Turning to the U.S., Europe is one of our larger trade partners with about 16% of total U.S. exports going to the Block last year.  This is not an insignificant number, and will likely weigh on U.S. GDP growth in the near-term.  However, the U.S. consumer remains the largest driver of our economy, accounting for about two-thirds of GDP growth.  Following the Financial Crisis of 2008-2009, the U.S. consumer has gotten healthier, supported by an expanding housing market, strong jobs growth, and deleveraging.  A resilient consumer and relatively better economic growth compared to the rest of the world should position us to better weather the recent developments in Europe.

To be sure, today’s news surprised investors and markets alike.  Although the near-term economic impact will likely be limited to the U.K. and Europe, the vote has broader implications for the future of the European Union.  While we can’t predict the longer-term repercussions of today’s historical vote, we can assure you of the benefits of staying invested in a diversified portfolio over the long-term.  Markets will experience sharp corrections, as well as strong rallies, yet clients who remain invested across asset classes throughout the market cycle have a better chance of reaching their financial goals.  With this perspective in mind, market declines like the one we’re seeing today simply represent an excellent opportunity to rebalance your portfolio at more attractive valuations levels.

 

Thank you,

The Parsec Team

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