US & Global Equity Q2 2016
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.
DFor the second quarter of 2016, the Front Street Global Opportunities Class registered a -0.6% return. After a very difficult first quarter, we have stemmed some of the bleeding and believe we should begin to see improvement in performance.
As a reminder, there were a few missteps and some philosophical reasons for the fund’s underperformance. Firstly, our overweight allocation to the financials sector in the first quarter absolutely killed us. Concerns of a recession and negative interest rates caused us to overreact, and we have now adjusted the portfolio to the new reality.
Secondly, we have always advised our clients that this fund will not directly invest directly in commodities. Its primary mandate is to provide an alternative to the commodity-biased Toronto Stock Exchange. As such, with little to no weighting in commodities, we did not participate in any of the big moves that transpired in the oils, golds and base metals stocks.
Looking forward, we believe that the major portion of the commodities rebound is behind us. We also believe the earnings recession we have been in for the past two years will slowly begin to improve, starting in the second half of 2016 and going into 2017. While we expect continued volatility, we have now balanced the portfolio appropriately with no large concentrations for the time being until we exit the third quarter. Certainly by the time we have a new U.S. President, many more realities and opportunities could present themselves.