US & Global Balanced Q2 2016
Frank Mersch & Rick Brown
Welcome to the summer of 2016. The violently flat paradigm that the U.S. and, to a lesser degree, global markets have been stuck in for the past two years, continues following the U.K.’s vote to exit the European Union (“Brexit”). Brexit perplexity, an enigmatic U.S. Federal Reserve Board and U.S. presidential theatrics are scaring investors away from the facts once again. Yet, with all this uncertainty, we are very close to new highs. To be sure, these are confusing times, with many negatives including Brexit, negative interest rates, Trump uncertainties, protectionism, immigration, U.K. recession risk, ISIS, employment rates, Middle East instability, central banks out of ammunition, high frequency trading, ETF’s and China risks, etc.
While we do not disagree that this summer noise will unnerve markets, we do believe that a contrarian approach may be warranted. It seems a good time to invest when there are many negatives and investors are bearish. We believed prior to Brexit, that we would see some improvement in earnings in the second half of 2016 and that the U.S. economy would continue to improve. More importantly, with firming oil prices, many global risks have also improved, as defaults became less of a concern. Post Brexit, many developments have occurred to explain why global markets have rebounded.
The response has been as follows:
- The Bank of England offered $345 billion in liquidity
- Japan took foreign exchange steps
- Italy offered €40 billion injection to its banks
- The European Central Bank may loosen the rules for bond purchases
- Bank of England indicated that it will likely have to ease policy in the summer
- A tsunami of mergers and acquisitions transactions
- Brent crude oil has held close to $50/bbl
- The U.S. dollar move has been moderate
The results of Brexit, while still not totally known, will likely bring further monetary easing in Europe. Coming into Brexit, the market was assigning a rate increase for July and September. That now appears to be off the table.
The bottom line is, Brexit is ultimately a political crisis and one that is not likely to be resolved in a hurry. There will be many twists and turns in the path to ultimate resolution. There may yet be circumstances that give rise to bigger systemically risky events. For now, we don’t think we are quite there and we can now focus on stocks again.
The S&P 500 has rebounded from the uncertainty caused by the U.K.’s vote to exit the European Union (“Brexit”), reinstating stocks as the more attractive risk/reward value over bonds. With central bank supported rotation into risk assets—likely due to continued stimulative actions and expectations of better growth in later 2016/17—we have overcome some of the concern that plagued market sentiment over the third quarter.
U.S. economic growth is running at 2.4% and expectations that the Fed will not raise interest rates until 2017 are helping keep credit spreads tight and are supporting stocks. Improving economic growth is a support for cyclicals relative to defensive stocks, but with continued pressure on U.S. treasury yields, it is unlikely that defensive stocks will come under significant pressure.
In early 2016, the U.S. Dollar Index (DXY) increased to 99.6, prompting worries about U.S. corporate earnings, commodity prices and trade flows. The Fed managed to push the Index lower by reducing its forecasted path of interest rate hikes and introducing international financial conditions into its decision making process. By doing that back in the first quarter, the Fed put demand for commodities and emerging market investments back into the markets. The DXY has crept higher over the past few months and is +2.7% since Brexit, though still lower than in January.
The ISM Manufacturing Index has been rising all year and is now above 50, indicating expansion. Stronger labour data and gains in economic activity have reduced recession risk.
On another positive note, China seems to be stabilizing and commodity demand has picked up as the government’s directive to build an innovation-driven economy from the top down has sparked a rush to construct new buildings. However, this building activity may not be sufficient to support a longer demand cycle for base metals, as it is not broad in its scope.
To be sure, we have been somewhat surprised by the resilience of the market. For all intents and purposes, U.S. stocks have essentially gone nowhere since late 2014. From our perspective, the weak earnings environment has been largely responsible for this. However, the main growth detractors – commodity prices and the U.S. dollar – have stabilized, and forecasts for upcoming quarters suggest a sharp turnaround. If this is the case, it will limit any further significant downside from current levels.
Finally, pessimism remains quite high, and institutional cash levels are high. In fact, cash is at record levels. If we get any good news, we could see a stampede back into the markets.
As we progressed through the second quarter of 2016, uncertainty over the impending Brexit vote gave way to fear and negative sentiment as the results came in on June 23. Remarkably, the market started to recover quickly afterward, trading higher as June closed.
Market volatility was elevated for the period. The U.S. 10-year bond started the quarter with a yield of 1.77%, and traded as high as 1.93%, before dropping sharply after the Brexit result to 1.36% before ending the quarter at 1.47%.
At the moment, globally, one-third of all sovereign debt is trading at negative yields, meaning investors are willing to invest in assets that guarantee they lose money if held to maturity, rather than taking a risk that could lead to losing more money. These are truly unprecedented times, with equity markets at new all-time highs and interest rates at all-time lows. In such a low-yield environment, investors are being forced to take on more risk than they historically have in the hopes of achieving their financial goals. For many, the idea of investing sovereign debt at historically low levels is absurd, so money will continue to flow into assets classes like equities and high yield.
Longer-duration assets performed best as investor scrambled for the safety of bonds. The risk now is that those same assets may suffer as cash and risk appetite returns to the market. Interest rate sensitive products, such as government bonds, performed better than most sub-asset classes of the bond market on the back of lower interest rates and Brexit fears. In addition, European assets came under pressure because of Brexit uncertainty. We believe that money will flow back into the market and into corporate debt given that investors’ appetite for yield cannot be achieved in sovereign debt.
During the second quarter of 2016, the Front Street Global Balanced Income Class registered a -0.6% return. After a difficult first quarter, in which we incorrectly positioned for a rise in interest rates, we have adjusted the portfolio for the new reality.
The fixed income portion of the fund continued to be focused in high-yield investments, while the equities portion maintains a definite large-cap bias. During the quarter, the Canadian dollar appreciated 0.61%, which detracted from the fund’s performance. However, we have recently seen a rebound in both high-yield investments and stability in the equity markets.
Finally, we want to reiterate that our global funds do not invest aggressively in cyclicals. Given that we at Front Street have so many resource products, we have positioned our non-Canadian funds with little-to-no oil, base metals or gold exposure. While this has obviously hurt our near-term performance, we believe that over the long run, these funds provide geographical and sector diversification that you cannot get in Canada.