As stated in previous blog posts, we have felt that the markets would remain in a tight range for the first half of the 2015. Certain periods showed great promise, including when the markets touched new highs in May. Other times displayed significant weakness, such as when the market corrected in January and June. Thus far, the S&P 500 has remained range-bound with a max gain of 3.5% and a max loss of -3.2%. Based on price movement alone, the midpoint of the year resulted in the Dow Jones Industrials and S&P 500 indices returning -1.14% and 0.2% respectively. For the same period, the broad bond market experienced a slight decline, with the Barclays US Aggregate index down -0.10%. For investors, returns have been flat. There is good news, however, for if history is a good indicator the rest of the year should shape up for a positive returns. We feel the economy is healthy and still growing.
We believe that much of the market volatility and flatness of returns is due to overreaction to a few news headlines in particular. In today’s fast pace global world of nonstop data, it can be overwhelming to try and keep up with everything important. A recent report by ZenithOptimedia showed that, on average, people spend more than eight hours a day consuming media. This information explosion is taxing all of us, all day, every day, as we struggle to come to grips with what we really need to know. With instant access to unlimited information at our fingertips and all of this information whizzing by at a ferocious speed, it’s no wonder that people often choose to follow the gospel of “the almighty headline” in an attempt to simplify their lives.
In regards to financial news specifically, the risk of only reacting to the “emergency” of the moment presents the dangers of headline risk. Often elicited by strong and sudden emotional forces (the “fight or flight” survival component of being human), these types of reactions shut down the more cognitive processes that allow for a more comprehensive analysis of the situation. Sensationalism from the media as a tool to grab viewers’ attention is nothing new, as they are interested in helping their marketing departments sell advertising and less concerned with helping you reach your financial goals. Once it is understood that these outlets may be skewed with an ulterior agenda, it is best to combat headline risk by slowing down and gaining context through opposing sources. With this in mind, we would like to briefly discuss background information and our take on a few topics that have recently garnered a significant amount of time in the media: Greece, China, and the rise of US interest rates.
1. What’s going on in Greece? Should I be concerned about financial contagion?
On June 30, Greece became the first developed nation to default to the International Monetary Fund (IMF), the global institution that provides financial assistance and advice to 188 countries, by failing to repay a loan worth $1.8 billion. A few days later, on July 5, Greek voters chose to reject the fiscal and structural reforms set out by its creditors as condition for additional aid, a move that keeps Greece’s future in the Eurozone in question.
The good news is that the risk of financial contagion has been greatly diminished from the threat posed a few years ago. The ECB has liquidity programs and other tools available to help soothe markets during this period of tumult, and the Eurozone economy is much better now than at any point since the financial crisis. During a similar crisis a few years ago, yields on 10-year sovereign bonds in Spain, Italy, and Portugal rose above 7%. Today, these bonds have yields around or below 3%, and they haven’t spiked even as Greece’s bond yields have risen dramatically. At this point, the Greek financial saga will continue, but it is much more political than anything else. Economically speaking, Greece is to Europe what Miami is to the US, roughly 1.8% of GDP. Furthermore, a rejection of monetary union does not imply an exit from the European Union. Denmark and the UK represent current examples of EU members with their own sovereign currency. We have and will continue to treat these volatility events as buying opportunities.
2. Is China in a recession?
China is in the midst of a difficult, multiyear transition to a slower-growth economy. It appears that their past decades of 10% annual GDP growth should average closer to 5-7% in the future. As the world’s second largest and formerly fastest-growing economy, China’s muted trajectory is serving to reinforce a global environment of slow growth and low interest rates. These fundamental changes are occurring as the nation transitions from a planned economy driven by infrastructure to a consumption based economy driven by individuals. The government has supported the economy along the way through monetary expansion, leading to a central bank balance sheet that is now the world’s largest and has grown more quickly than the Federal Reserves.
The stock markets of China are divided into two types: Mainland stocks, known as A-shares, are driven by local individuals, while H-share stocks trading in Hong Kong are traded primarily by global institutional investors. At its early June peak, the Shanghai Composite (A-Shares) was up over 150% year-over-year and up over 100% just since the end of November 2014. The rout that began after the peak took the index down 32%, although it has since bounced back from the lows. The main culprit for such wide swings in stock prices has been an unprecedented surge in margin usage, up 4 times as much as one year ago. This entails borrowing money to purchase assets. Basic investing knowledge illustrates that this type of strategy will magnify gains and losses, and things can unravel quickly. To quell concerns and limit losses, Chinese authorities have enacted several measures, including: cutting interest rates and bank reserve requirements, suspending trading in a large percentage of “A-shares,” cracking down on short sales, buying stocks through national pension funds, and banning shareholders with stakes of over 5% from selling for six months. These constraints are examples of the nation’s promise for a rising stock market as part of the “China Dream.” They are also reminders that China still operates by very different economic and political rules from those in open markets.
For US investors, it is important to realize that the correlation between the Chinese stock market and the US stock market is low-to-nonexistent. Furthermore, Chinese government restrictions on foreign stock ownership has resulted in less than 2% of the stock market being owned by foreigners. Chinese individual investors own more than four-fifths of all these Chinese stocks, but that amounts to less than 15% of household financial assets (compared to around 50% in the US). The Chinese markets are still fairly expensive and we expect volatility to persist. We will focus on the fundamentals behind the economic slowdown, which has helped cause another downturn in oil and commodity prices and may mean continued strength in the US dollar.
3. The Federal Reserve is going to raise rates eventually. How does this impact stock and bond markets?
In anticipation of the first interest rate hike in over 9 years, the Federal Reserve will continue to dominate the market narrative domestically. However, the Fed has taken great measures to prepare investors for this action and has provided reassurances that any moves will be gradual in nature. Interest rates have never been artificially held this low, for this long before beginning their ascent. Nor has central bank policy played such a large role in the markets’ reaction to the timing and size of potential hikes. Since the Fed is tasked with maintaining financial stability, it recognizes that the longer it keeps interest rates at these extraordinarily low levels the greater the possibility for bubbles to form and burst. By starting a gradual rate renormalization process this year, as its latest minutes suggest, the Fed is hoping to keep itself from falling behind on inflationary pressures and create a buffer for future easing measures, should they be needed down the line. At this point, the market anticipates interest rates to rise to 0.5% in 2015, 1.5% in 2016, and 2% in 2017. We expect 0.25% at most for this year because of China and low-to-no inflation.
When the Fed first starts to hike, it is usually taken to be a sign of a strengthening economy and a bullish sign for the value investing style. While it is true that some more defensive sectors tend to underperform during rate hikes (i.e., utilities) and high-dividend stocks that have served as “bond market proxies” may suffer, we have already updated portfolios to reflect our investment expectations. Short-term bonds will be most affected by higher rates, but longer-term bonds will be kept down by global demand.
Earnings season for the second quarter, with overall results being quite mixed, has proven that stock selection is paramount. There are areas that show promise, such as the financial and tech sectors. Financial companies have seen a reduced amount of legal expenses and some improvement in core profitability. Many technology companies have healthy growth potential with limited interest rate and energy sensitivity. In addition, we are seeing strength across housing, construction, and consumer spending and other leading indicators.
We feel that the market will end the year near the peak of the trading range. As such, high quality stocks are still the best bet to meet long-term financial goals. National headlines are screaming just the opposite, of course, just as they have during the last 7 years.