Benchmark Returns through 9/30/2016
T-Bill 3-mo (Cash): 0.19%
Barclay’s Aggregate Bond Index: 5.80%
Barclay’s Municipal Bond Index: 4.01%
S&P 500: 7.84%
Russell 2000: 11.46%
MSCI EAFE (International Stocks): 1.73 %
MSCI Emerging Market Stocks: 16.02%
Credit Suisse Hedge Fund Index: -0.03%
Data provided by Orion
Financial Market Performance
Market participants started the year skeptical of the ability of the Federal Reserve to achieve four interest rate increases in 2016, and now the market expects a better than 50% chance of an increase in December. This very slow path of rate normalization has been positive across asset classes. Equity and fixed income assets, with the exception of foreign developed stocks, have performed very well in 2016. Crude oil prices recovered near the end of the quarter as OPEC declared their intention to force prices higher. This may be effective over the short run, but the dynamics of the oil market have changed such that OPEC is no longer in the swing producer role. Shale Oil drillers in the United States have taken over that role making controlling prices difficult for OPEC over the longer run.
A World with slower growth
Global growth has been slowing over the past few years and 2016 appears to be no different. The causes are predominantly structural as evidenced by the falling long term growth rates of the U.S. economy along with many others. According to the Conference Board Economic Outlook, developed economies are expected to growth at a rate of only 1.5% in 2016, with the total global economy growing at a rate of 2.9%.[i] Their estimates are calculating Chinese GDP growth at a lower rate than is stated by the government, but the trend of decreasing global growth appears to remain well entrenched.
This trend alone is concerning from a global macroeconomic perspective, but the implications this has for American household incomes and corporate profits is significant. As economic growth slows down, the fragility of the economy increases. Economic tailwinds that have been enjoyed over the course of the business cycle cannot be expected to contribute to the future as they have in the recent past. Asset prices and many valuation metrics are at or near historical highs. Typically this would be expected in an environment with strong future growth prospects, but presently growth expectations are deteriorating. Significant domestic and global macroeconomic imbalances have been left uncorrected creating a list of potential economic shocks that may have the strength to stall this slow and aging expansion.
Political Polarization driving rhetoric over policy
Central bankers have frequently mentioned over the past few years that monetary policy alone is unable to offer a full-scale solution to economic issues. The inaction and gridlock in many governments has unfortunately forced many central bankers to stand alone. The former Federal Reserve Chairman Ben S. Bernanke has mentioned this frequently during his tenure as Chairman with his oft-stated remark that “monetary policy is not a panacea”.[i] Many economists, financial market participants, and central bankers understand this. Regardless, monetary policy has been forced into filling the void of fiscal policy. Absent fiscal policies, the major central banks have been given the sole responsibility of policy making. This is a responsibility that monetary policy has never been meant to assume, and it is a responsibility that requires a toolset outsize of the scope of a central bank.
The results of the Brexit vote, growing internal division in the two major American parties, and the deteriorating support of many ruling leaders in the Eurozone marks the continued trend towards a governmental landscape that is losing the capability for coordinated and decisive action. Japan remains an outlier in this regard as the popularity of Shinzo Abe has unified the government around the ‘Abenomics’ reforms. The stated goals of the reforms have not been achieved, and some doubt the ability for structural reforms to ever be fully achieved. The critical aspect to focus on is the remaining political capital available to change existing reforms or enact new ones. Increasingly polarized electorates greatly increase the difficulty inherent in reaching consensus or creating coalitions within a government. Polarization often incentivizes political opportunists to spread provocative rhetoric rather than offer measured and reasonable policy solutions, effectively gumming up the cogs of an effective democratic government. This effectively creates a scarcity of political capital due to the absence of consolidated political power within party hierarchies causing consensus and compromise to be far less common.
Outside of Japan, many sovereign governments struggle to amass the political capital required to enact meaningful fiscal policy reforms. This is a major concern for developed economies for both cyclical and structural reasons. The role that governments are often advised to assume during recessions is a counter cyclical role. This concept was created by John Maynard Keynes and is designed to mitigate the effects of a recession by utilizing increases in government spending to match the decreases in private spending to maintain steady output in an economy. Structural reforms focus on longer term economic growth with a longer time horizon than the business cycle. Examples of these long term economic growth factors include productivity gains, population demographics, and tax burdens. Governments don’t have full control over all of these factors, as is the case with demographics, but government policies can have a meaningful effect. The current environment of political polarization has not appeared to reverse in any capacity. This presents a meaningful risk to the ability of many western democracies to enact reforms to mitigate long term economic imbalances, or to utilize any meaningful stimulus in the form of Keynesian style deficit-spending.
Emerging markets face pressure from slowly rising interest rates, and the commensurate appreciation in the U.S. dollar. The current environment is still difficult for many of these economies though the long term prospects remain compelling. As these economies stabilize, the sector will inevitably offer opportunities in the future, however this is not likely to occur quickly. US stocks have recently struggled along with international equities. Although valuations remain high, they are cheap compared to most fixed income investments. Corporate profits may continue to be pressured as profit margins are still near historically high levels. Fortunately, revenue growth and share repurchases are expected to continue which will be supportive for valuations on an earnings per share basis. International developed equities continue to look attractive relative to other equities. The headwinds of a higher dollar continue to have a negative effect on U.S. exporters and this has driven stock prices lower of those companies most effected. European stocks are more attractive from a valuation viewpoint and offer potentially higher upside as Europe has further ground to regain in its own recovery. The continued fall in interest rates has continued to surprise those investors expecting higher interest rates. Bonds have rallied over the past six months as investors return find appeal in the safety of high quality bonds. While we still expect interest rates to eventually rise to a more normal level, we expect this process will be slow and target level will be lower than historical norms.