The Markets This Week

by Connor Darrell, Head of Investments
The last few weeks have finally brought some stability back to markets, with the S&P 500 now up 5.86% year to date. Q2 earnings season begins this week, and investors are expecting more strong growth in corporate profits amid a strong economic backdrop. On the bond side, yields remained relatively stable last week, though the trend of yield curve flattening remains firmly intact.

Now May Be a Great Time to Rebalance
Since emerging from the depths of the financial crisis in early 2009, the S&P 500 has produced a total return of over 360%. Disciplined investors who stuck through the turmoil of the great recession and were able to maintain exposure to equities have been richly rewarded for their patience. However, while the US economy remains on firm footing and the risk of recession in the near future remains relatively low, the next 10 years for investors are likely to look very different from the last 10 years. Investing is about achieving goals, and it is likely that the market’s strength over the past several years has put many investors ahead of schedule in terms of their long-term plan. Additionally, that strength in equity markets has likely pushed equity allocations toward the upper end of many investors’ target range, which can lead to a riskier portfolio. Nobody will ring a bell announcing when the current market cycle finally comes to an end, and the official “top” of the market may not be officially identified for quite some time after it occurs. But we can say with a reasonably high degree of confidence that we are much closer to the top than the bottom.

All of the above suggests that it may be prudent for investors to take a step back, evaluate their long-term asset allocation targets, and rebalance to ensure that their portfolio is properly tuned for the road ahead. 2018 has already presented investors with a number of new risks to consider and managing these risks will become increasingly difficult as the environment becomes less accommodating to the complacent investor.

The Markets This Week

by Connor Darrell, Head of Investments
Markets managed to climb higher during the abbreviated holiday week, bolstered by the June jobs report, which provided evidence of further strengthening of the U.S. labor market, but not quite enough to suggest the Federal Reserve would need to accelerate its policy tightening. Although the official unemployment rate pushed back up to 4%, the U.S. economy added another 213,000 jobs in June and the increase was due primarily to higher labor force participation (a higher percentage of the population is looking for employment). Wages, which are being watched closely by economists due to their logical connection to inflation, rose 2.7% from a year earlier.

Monetary Policy Update
While they pose challenges over the short term for both stock and bond investors, rising interest rates aren’t all bad. As a result of the Federal Reserve’s policy tightening, the yield on a one-year treasury bill is now roughly even with the core rate of inflation (core inflation removes more volatile energy and food prices from the measurement) for the first time since before the financial crisis. This is good news for savers, as it means that those invested in short-term treasuries are no longer “losing” out in real terms. This will be an interesting area of focus over the next 12-24 months, since inflation expectations are also heating up due to the low rate of unemployment and overall health of the US economy.

As rates rise, the opportunity to earn a higher yield on short-term bonds without increasing credit or interest rate risk will be a welcome change from recent years.

The Markets This Week

by Connor Darrell, Head of Investments
After a bumpy start to the week, markets ended the first half of the year on a high note, with financial stocks leading equity indices higher. The Federal Reserve’s annual stress tests revealed that banks appear to be on sound financial footing, and bank stocks rallied on the news. However, Friday’s rally could not erase losses from earlier in the week, as global equities traded lower amid ongoing trade tensions.

As geopolitics and trade have dominated headlines in recent months, U.S. small cap stocks have managed meaningful outperformance due to their more domestic focus. The Russell 2000, which measures the returns on a broad basket of US small cap stocks, has outperformed the S&P 500 by about 5% year-to-date.

Tech is Taking Over, and It’s Given the S&P 500 a Serious Boost
As technology has become an increasingly important part of our daily lives, it has also become an increasingly dominant influence of stock market returns. The S&P 500 currently has a total market capitalization of about $23 trillion, and technology stocks make up about 23% of that number. The index’s four largest constituents (Apple, Microsoft, Amazon, and Facebook) are all deeply entrenched in the tech community. Those four stocks make up over 12% of the index, up from 5.9% just five years ago. The rapid rise of the so-called “FAANG” stocks (which include Facebook, Amazon, and Apple along with Netflix and Google) has been a major driver of S&P 500 performance over the last several years.

The proliferation of passive investing in recent years has largely coincided with tech’s dominance, and it begs the question as to whether there are risks lurking beneath the surface. Portfolio managers often seek to minimize the risk that any one (or four) stock(s) dominate the risk profile of a portfolio. Historical data suggests that the average annualized volatility of a single stock is more than double that of a typical diversified equity portfolio.1  As a result, portfolio managers will tend to underweight the largest stocks in an index in an attempt to more efficiently diversify risk across different stocks. As these tech giants have grown into tech behemoths, that underweight has been a difficult hurdle for stock pickers to overcome.

Passive investing provides a myriad of benefits to investors, including low fees, tax efficiency, and better discipline, but investors need to be aware of what’s in their index of choice. The significant boost that the S&P 500 has gotten from the successes of its largest constituents could just as easily go the other way if the market decides that valuations in those stocks have gotten too stretched.  [1] Source:  FactSet, Fidelity Investments (2017)

The Markets This Week

by Connor Darrell, Head of Investments
Global markets slid lower last week due in large part to ongoing global trade tensions.  Emerging markets stocks were hit hardest and are now down over 5% this year. On a rolling one-year basis however, they have still managed a return in excess of 10%.

Bond yields remained relatively stable, with the 10 Year Treasury still sitting at around 2.90%. The yield curve (which plots the yields of bonds of differing maturities along one line) continued its trend of flattening last week. The 10-2 Treasury Spread (measured as the difference in yields of the 10 Year and 2 Year Treasury Bond) now stands at just 0.33%, a 58% decline from just a year ago. Those in the business of trying to forecast market movements (a notoriously difficult, if not impossible proposition) typically watch the yield curve closely during the latter stages of an economic expansion, as an inversion of the curve has historically preceded a recession. An inversion of the curve occurs when the yield on longer term maturities drops below that of shorter term bonds.

The other major development in the US equity market last week was the removal of General Electric (GE) from the Dow Jones Industrial Average. GE was an original member of the oft quoted stock index but has fallen on hard times as its earnings and profitability have collapsed under the weight of its highly complex business model. GE has been replaced by Walgreens Boots Alliance, which contrary to its name is actually a retail pharmacy (of which you are likely familiar) and is not in the business of selling footwear. This was major news for markets in that GE has been a member of the DJIA for over 100 years. The fall from grace has been substantial for GE, which had the largest market capitalization of any company in the world as recently as 15 years ago.

Tariffs and Trade Wars Revisited
As a result of the Trump Administration’s hard stance on trade, it has been difficult to avoid discussing the potential implications of the policies that the US, China, and now the EU, Canada, and Mexico have been threatening each other with. The probability that rhetoric evolves into policy, and to what extent the policies under discussion change prior to implementation is extremely difficult to ascertain, and the market is having a difficult time making sense of everything as a result.  It is for this reason that we have not been able to point to one major market move while placing blame on trade tensions. Instead, we have experienced a number of smaller moves as the market reacted to the latest headlines. This is likely to continue until the market either has reason to focus on other news (strong Q2 GDP growth anyone?), or we get more clarity regarding what is a threat and what is likely to actually be implemented.

The only things we can say with confidence are the following:

  • Tariffs are an inflationary force. Any time a tax is levied on a product, regardless of its nation of origin, the price of that product is likely to increase.  Rising prices are the definition of inflation.
  • Tariffs will reduce global economic growth potential in the long run. Trade works because it creates a mutual benefit among the parties involved.  Goods and services are produced by those who can do so most efficiently.  Trade barriers create inefficiencies that lead to a sub-optimal allocation of resources in the global economy, which reduces growth in the long-term.

This is not intended to serve as a critique or endorsement of any political view. There are very real problems that need to be addressed in the way that countries do business with one another, and after all of the dust has settled, those of us with a stake in the success of the global economy may very well be better off. But our job as investors and asset allocators is to identify the key issues that can impact financial markets so that we may best position our portfolios to protect our hard-earned money. This often involves trying to gain an understanding of how economics and policy react with one another.

The Markets This Week

by Connor Darrell, Head of Investments
It was “Much Ado About Nothing” last week, as one of the busiest weeks of the year proved to be one of the least memorable in terms of market moves. The Trump Administration once again managed to make things interesting when it announced on Friday its intentions to impose a 25% tariff on up to $50 Billion of imported Chinese goods, prompting a small pullback in U.S. equities. The move wasn’t major, but it was enough to erase the small gains that had been posted over the week’s first four trading days. As is common when equity markets react to negative news, bonds produced small gains despite the Fed’s decision to increase interest rates.

There were no less than four key events last week (three of them were officially scheduled ahead of time) that had the potential to influence markets in a meaningful way. We go through the key details below:

  1. The Summit with North Korea
    While historically significant, there were few details emerging from the summit that caught the attention of financial markets. In post-meeting press conferences, President Trump made a case for the North Korean Government to consider opening up to foreign investment, stating that Chairman Kim has a “great opportunity” to improve the livelihood of his people. In the long run, geopolitical uncertainties tend to be overtaken in significance by economic fundamentals, and it is unlikely that (short of a war) the ongoing concerns in North Korea will prove to have a lasting impact on markets.
  2. Federal Reserve Policy Meeting
    The Federal Reserve raised the federal funds rate a further 0.25% on Wednesday. The move was highly telegraphed and was already priced into markets, so the net impact was minimal. However, we did gain further insights into how the Fed views the current state of the economy (quite favorably) and learned that two more hikes this year are expected.
  3. ECB Policy Meeting
    The European Central Bank also held policy discussions this week, and officially announced its intention to wind down its massive bond-buying program. The European economy is a bit behind the U.S. in its recovery but has undergone the same type of monetary policy “stimulus” as has been experienced here in the U.S. The ECB made clear in its communications that while the aggressive bond purchases will cease, interest rates will remain unchanged until at least September 2019. The monetary policy environment overseas remains more accommodative; a sign that the U.S. economy stands on more solid footing. Markets took the news well, and any fears that the adjustments would lead to market turmoil proved unfounded.
  4. Tariff Announcements
    The most influential “event” of the week was the only one not officially listed on the calendar ahead of time, as the Trump Administration offered details on its plans to impose tariffs against Chinese goods. China was quick to respond with its own plans, and fears of an escalating trade war were stirred up yet again. Markets opened Friday sharply lower but managed to claw back a decent portion of early losses. The concerns over tariffs continue to linger, though the market has remained resilient overall.

The Markets This Week

by Connor Darrell, Head of Investments
The S&P 500 managed to rally last week (posting a 1.66% gain), but markets have had limited time to digest the further escalation in trade rhetoric coming from the G7 summit in Quebec (which ended on Saturday). President Trump’s continued focus on economic protectionism has caused consternation among major trade partners, and the risk remains that significant changes to trade policy could hinder long term global economic growth.

The week of June 11th is likely to bring multiple events that have the potential to significantly impact financial markets, including monetary policy meetings in the US, Europe, and Japan, in addition to the historic summit between the U.S. and North Korea on Tuesday in Singapore. We will do our best to break down the important takeaways in next week’s update.

We continue to emphasize to clients that in the long run, markets are driven by the underlying economic environment and growth in corporate earnings. That backdrop remains quite favorable at this time. As investors, we need to be aware of how politics and policy impact our portfolios, but barring a major change to the forward outlook, the long-term strategy should remain largely in place.

The Markets This Week

by Connor Darrell, Head of Investments

It was a busy week for financial markets, with a mixed bag of positive economic news and disruptive political developments.  On the positive side, the US unemployment rate continued to track lower, reaching 3.8% in May.  Unfortunately, that news was offset by two major developments in the global political landscape.

First, markets opened sharply lower on Tuesday as Italian political negotiations sparked fears that Eurosceptics (those who are opposed to European Union membership) were set to take control of the government.  The political situation in Italy remains complex and the long-term outlook uncertain, but those fears were somewhat alleviated later in the week as a more favorable consensus was reached on the re-establishment of the government following March’s inconclusive election results.

Then on Thursday, the topic of tariffs once again dominated financial news headlines when the Trump Administration announced that it would allow the temporary tariff exemptions (Initially granted when the 25% steel and 10% aluminum tariffs first took effect in March) for Canada, Mexico, and the EU to expire.  According to Goldman Sachs Investment Research, those countries accounted for approximately 40% and 48% of 2017 US imports of steel and aluminum respectively.  Canada and Mexico immediately responded with retaliatory measures and stocks slid lower on the news.

Amid the conflicting signals, US equities outperformed, and bonds generated small gains as investors sought refuge from some of the volatility.

The Markets This Week

by Connor Darrell, Head of Investments
Bonds rallied last week, with the 10-Year Treasury yield dropping back below 3% and the Bloomberg Barclays U.S. Aggregate Bond Index posting gains of 0.74%. Stocks produced mixed results, with the U.S. outperforming its International counterparts.

Another By-Product of “Low for Long” Interest Rates: Corporate Debt
Moody’s, a well-respected provider of credit research, issued a sobering report earlier this month warning of the potential for “a particularly large wave” of defaults on below investment grade corporate bonds when the next economic downturn eventually arrives. The report cites the low interest rate environment as a key contributor to a significant increase in the amount of corporate debt outstanding and a subsequent rise in the number of global non-financial companies carrying below investment grade credit ratings.

Coming out of the financial crisis, with interest rates at their lowest levels in decades, many corporations took advantage of the low rates to go out and borrow additional funds to invest in their businesses. And with investors starved for yield, even many companies that were in poor financial health were able to issue debt at relatively low rates. This has been beneficial to the overall investment climate and a tailwind for the stock market, but may leave many companies exposed in the event of a prolonged economic downturn.

Default rates on corporate bonds remain very low, but the Moody’s report highlights the need to be vigilant, even in strong economic environments. We have discussed in past communications that we find ourselves in uncharted waters with respect to monetary policy, making it even more important to be on the lookout for potential risks in the marketplace. Rising levels of corporate debt is certainly one of those risks to watch.

The Markets This Week

by Connor Darrell, Head of Investments
Both large cap stocks and bonds ended the week marginally lower, but the heightened volatility observed over the past few months seems to have waned for the time being. Internationally, stocks traded largely in line with those in the U.S., although emerging markets stocks had their worst week in quite some time. Emerging markets stocks have faced headwinds from the increasing strength of the U.S. Dollar, which reached a five-month high last week.

US small cap stocks were a bright spot last week, and have been all year. The Russell 2000, which tracks a broad basket of small cap stocks, is up over 6% so far this year, outperforming the S&P 500 by about 4%.

Oil Prices on the Move
It is easy to forget that there was a solid four-year stretch from December 2010 to November 2014 where the average retail price of a gallon of gasoline in the US was well over $3. But a confluence of factors (including technological advances that increased US oil production, as well as a concerted effort by members of OPEC to put a squeeze on those same U.S. producers) led to a massive decline in the price of oil beginning in late 2014. From peak to trough, the total price decline was over 70%, and consumers reaped the benefits for a number of years. However, that has changed rather dramatically in the last 12 months, as prices have come roaring back.

The surge in oil prices over the past year has been driven by a variety of influences, including increasing demand driven by strong global economic growth, cooperation between Russia and OPEC, economic collapse in Venezuela, and logistical inefficiencies disrupting the distribution of US shale oil. On top of this, the Trump administration’s decision to withdraw from the Iran nuclear deal and re-impose sanctions could lead to a decline in Iranian production, which would further deepen the supply shortfall.

In the near term, the rise in oil prices has the potential to increase inflation and pose as a headwind to economic growth (albeit not nearly large enough to offset the benefits of recent tax reform). We have discussed in the past that the Fed is watching inflation closely, as it is one the key indicators that helps to dictate monetary policy. However, the Fed is unlikely to be coerced into altering its path of normalization by something as fickle (and potentially temporary) as rising oil prices. It is more likely that the worst side-effect of the recent run up in oil prices will be some pain at the pump during the summer travel season.

The Markets This Week

by Connor Darrell, Head of Investments
Stocks posted their strongest weekly gain in over 2 months last week, with energy stocks leading the way amid further increases in the price of oil.  It certainly won’t be celebrated by those of us traveling for summer vacations over the next couple of months, but oil prices are likely to remain elevated if the Trump Administration is able to reinstate economic sanctions on Iran.  International markets also posted gains on the week.

Bonds had a relatively uneventful week, but remain under the microscope of many investors and media outlets as interest rates creep higher.  We discuss some of our thoughts on what the market might be overlooking in our update below.

The Bigger Unknown in Monetary Policy “Normalization”
Likely due to their direct influence over the interest earned on savings and paid on loans, the Fed’s interest rate decisions seem to get all of the attention when it comes to discussions of monetary policy.  However, faced with the unenviable task back in 2008 of combating the deepest recession in a generation, the Fed pulled out all the stops, using every tool in its arsenal to inject life back into the US economy.  As a result, in addition to the traditional (and oft discussed) avenue of pulling interest rates down near zero, the Fed also implemented multiple rounds of Quantitative Easing, an unprecedented expansion of Reserve Bank Credit (the Fed Balance Sheet).  This was accomplished by purchasing trillions of dollars’ worth of bonds in the open market in order to inject more money into the financial system and increase liquidity in markets.  The ultimate purpose of the policy is largely the same as the reduction in interest rates, but it is widely considered to be a much more extreme approach.

Between October of 2008 and December of 2014, the value of the Federal Reserve’s balance sheet swelled from $0.9 trillion to $4.5 trillion (see below chart from Argus Research) as it continued to purchase bonds.  Since then, the balance sheet has remained largely untouched, but the Fed has made clear in its communications that this will soon change.  The consensus among forecasters is that the Fed will begin the process of shrinking its balance sheet later this year by allowing maturing bonds to roll off and ceasing its reinvestment of coupon payments, to the tune of about $50 billion per month.

Like all markets, the bond market is driven primarily by supply and demand, and with the Fed reversing its policies, the underlying balance of supply and demand will undoubtedly be altered.  What would this mean exactly?  The ultimate results are very difficult to predict.  If the Fed is able to effectively telegraph its moves (as it intends), then markets may be able to adjust gradually with no major impacts.  But if the balance shifts more than anticipated, then a major dislocation could take place.  Under such a scenario, the laws of supply and demand would dictate that the oversupply of bonds on the market would drive prices down, and yields up.

Source: Argus Research

That short term rates will increase from here is highly likely and largely assumed by most investors, so in our view, the potential impact of the Fed’s balance sheet unwind, which would occur in addition to the trends already in place, is the bigger “unknown” as we move away from the accommodative monetary policies of the last decade.  Given its current size, it may be appropriate to say that we consider the Fed’s balance sheet to be the “elephant” in the room.