2016 Benchmark Returns through 6/30/2016
T-Bill 3-mo (Cash): 0.12%
Barclay’s Aggregate Bond Index: 5.31%
Barclay’s Municipal Bond Index: 4.33%
S&P 500: 3.84%
Russell 2000: 2.22%
MSCI EAFE (International Stocks): (4.42%)
MSCI Emerging Market Stocks: 6.41%
Credit Suisse Hedge Fund Index: (1.52%)
Data provided by Orion
Financial Market Performance
The second quarter of 2016 was marked with a period of significant volatility near the end of June. However, many asset prices quickly recovered. Domestic large and small capitalization stocks finished the quarter higher, unlike foreign stocks which finished slightly lower for the quarter. Emerging markets performed well in the second quarter, but not as well as it had at the start of the year. Benchmark interest rates in the United States continued their decline as the entire U.S. Treasury yield curve fell dramatically. Expectations for interest rate hikes by the Federal Reserve diminished causing U.S. Treasury bonds to fall. The 10 year Treasury fell from 1.83% at the start of the second quarter to 1.49% at the end of June and the 30 year Treasury fell from 2.65% to 2.30% during the same period.[i] This led the Barclay’s Aggregate Bond Index, a widely recognized index representing investment grade bonds, to a highly attractive quarter. High yield bonds also performed well as interest rates fell and credit spreads tightened.
BREXIT and Political risk
Chinese stimulus measures have continued to increase as Beijing attempts to manage a growth slowdown across their economy. The primary benefactors of this stimulus continue to be the “old-economy” state owned enterprises in the industrial sector. While the service sector in China is showing encouraging growth, the industrial sector of the economy has not rebalanced as it still has significant oversupply. The stimulus is driven primarily by increased lending to these already inefficient and struggling industries. This will be positive for the short term as risks are pushed out further into the future, however these continued imbalances are only growing and the risks of a future crisis in China has risen. As investors have witnessed over the past several quarters, China has continued kicking the can down the road hoping to avoid having to make the hard decisions now to enjoy the benefits later. This doesn’t only apply to china, but seemingly most of the world. It seems as though short-term thinking is in vogue and few are willing to be left out.
Financial markets were rocked on June 23rd and 24th as the British voters elected to leave the European Union. Although markets have since recovered, the vote created an immense degree of uncertainty. Rather than create answers, the vote raised a significant number of questions that were largely absent from the public dialogue. There are a number of major European economies that are closely watching the British as their own polls show a meaningful segment of the voting population want to leave the EU. In many ways, the effects remain unknown as many politicians still must determine how the United Kingdom might leave the European Union. What has been an undeniable effect of the Brexit vote is the added pressure now placed on the European banking system. Signs of stress have
appeared in European lending markets, and the stock and bond prices of European financial services companies have fallen considerably. The European banking system has not fully recovered from the global financial crisis and it is currently under meaningful pressure. This is an area we continue to monitor closely.
Economic data for the United States remains decent. Economists have slightly decreased the 2016 GDP growth estimates from 2.0% down to 1.7% as of June 15, 2016. Though there is a decrease, investors should not be alarmed by this change in the full year estimate. Labor markets continue to broadly improve and while certain industries struggle, the US consumer is still slowly recovering. Real consumer spending is expected to rise this year at a pace of 2.5%, which is encouraging given the downward growth revision.[i]
Inefficient markets are a policy tool
Central bankers have a number of policy tools, though in order to succeed they all require a meaningful effect on financial markets, and prices of assets within the financial market. As many central bankers continue to engage in significantly easy monetary policy, they quietly and consciously acknowledge that they are driving markets towards inefficiency and mispricing in order to achieve their own goals. Many major buyers in financial markets are not “profit maximizers’ meaning that their goal is not to maximize their own return on invested capital. Institutions such as central banks are not designed to be profit maximizing. Central banks operate to achieve their stated goals that generally revolve around: maintaining steady prices as defined by 2% inflation, maintaining monetary policy regimes designed to improve sluggish growth, and maintain stable financial conditions. The mechanisms employed are typically: large scale asset purchases of sovereign debt, short term interest rate policy, banking regulation, and communication policies. Central banks have not only purchased government debt, but also company debt, mortgage debt, foreign stocks, and domestic stocks. These purchases are not small in scale and have a significant impact on the price of financial assets. Banks and insurers have also been forced to adhere to the Basel III and Solvency II regulatory structures that are designed to limit the risks taken by firms in these industries. The effect of this legislation has been to incentivize the purchase of government debt by these institutions and disincentive the purchase of other types of debt, regardless of the objective riskiness of each individual investment. These institutions are forced through this legislation to be partially profit maximizing by nature, because now these companies are forced to optimize for regulatory compliance before they can become rational profit maximizers in their investment decisions.
Efficient markets require that the market participants be profit maximizers in order for price discovery to properly occur. This is the critical assumption that drives markets towards the efficient pricing of markets. Although the number of non-profit maximizing market participants is small, they have a disproportionate amount of capital to deploy, and commensurately they have an outsized effect on the price discovery process in the financial markets. The most fundamental policy tool for central bankers is the benchmark interest rate or the risk free rate. This is a very short term interest rate on a country’s government debt that, by its nature, has offers the minimal amount of risk available in that country. These risk free rates are the foundation of all financial asset prices and they are the most directly targeted by central bankers. Every type of risk added onto an investment above the risk free rate has an associated level of risk and return. Through this mechanism, known in the finance industry as risk premia, every asset price is affected because all financial assets are priced using the risk free rate as a key input variable. Therefore, the ‘fair value’ of essentially all financial assets cannot be discovered through the typical market mechanism because the fair value of the risk free rate and nearly all sovereign yields has not been able to trade at equilibrium. Currently financial assets are not trading at so called fair value. Financial assets are trading at a conditional fair value built upon the market discounting the future prospects of the assets against the underlying condition of extremely easy monetary policy. The question that appears is how or when the conditional fair value converges with the true fair value defines as an environment with a market pricing economic fundamentals over central bank activity. Market commentators have bemoaned the continued easy monetary policy by the fed and the affect it has on creating the conditional fair value, but markets have historically shown an ability to trade away from fair value for some time. These instances have rewarded those investors that stuck to patient and rational behavior. This particular instance appears to be no different in that regard.
Emerging markets have performed well this year and the long term prospects remain compelling. While headlines still make the current economic environment still appear negative for many of these economies, they are being forced to undergo many badly needed reforms. This creates a window for investors to invest in cheap assets with an attractive future over the long term. Bonds have continued their relentless rally as investors find appeal in the safety of high quality bonds and expectations for more monetary easing return. While we still expect interest rates to eventually rise to a more normal level, we do not expect this to occur immediately. Expectations for further Easing by the Bank of Japan, Bank of England, and the European Central Bank have caused asset prices to rally and we expect this to continue. We maintain confidence in our current allocation and we continue to vigilantly monitor the global economic and political developments with asset prices at historic highs.
These are the opinions of James Regitz and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Diversification and asset allocation strategies do not assure profit or protect against loss. Indices mentioned are unmanaged and cannot be invested into directly. Past performance is not a guarantee of future results.
Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Newport Advisory, LLC and Cambridge are not affiliated.