Market Watch - July 2015
Written by Rick Welch on July 1, 2015
We are pleased to provide you with our quarterly newsletter featuring the status of our investment class weightings, our interpretation of recent data and our near term outlook for the future. If you have any questions about any topic, we hope you will not hesitate to contact us.
Status of our Investment Class Weightings
Changes from our April 2015 Market Watch are noted in italic.
US Large Cap Sectors –
Overweight – Financials (↑), Healthcare (↑), and Technology
Neutral – Consumer Discretionary (↓) , Consumer Staples, Energy, Industrials (↓) and Materials (↓)
Underweight – None
No Weighting - Utilities
US Mid and Small Cap – Maintain all weightings.
International Developed Markets – Maintain all weightings.
Emerging Markets – Maintain all weightings.
Alternative Strategies – Maintain all weightings.
Multi-sector Bond Funds – Maintain all weightings.
Investment Grade US Corporate Bonds – Maintain all weightings.
High Yield US Corporate Bonds – Maintain all weightings.
Investment Grade Municipal Bonds – Maintain all weightings.
Data – With financial markets focused on the June FOMC meeting and the possibility of Grexit (default by Greece, followed by exit from Eurozone), the equity markets were range bound during Q2. For 2015 we see the following YTD results: US Large Cap - S&P 500 (+0.20% ), US Small Cap - Russell 2000 (+4.08%) and International - ACWX (+2.69%). Volatility, as measured by VIX, rose during Q2 to end at 18.41, below the long term average of 20.0. During Q2, the yield on the benchmark 10-year US Treasury rose from 1.93% to 2.33%. Q1 GDP showed a contraction of -0.2% continuing the pattern of weak growth in the winter quarter. Recent economic data has improved suggesting that this weak performance was the result of transitory factors, rather than structural ones. Job growth in April and May was strong and the national unemployment rate continues to hover around 5.5%. New weekly unemployment claims averaged 274,000 during Q2 (compared to 295,000 in Q1) suggesting a continued firming of the domestic job picture.
Our earlier concerns about weak price inflation have eased as we have now seen small increases in the CPI over each of the last four months, however, the most recent 12-month reading of 0% remains far below the Fed target of 2.0%. Consumer confidence, as measured by both the Conference Board and the University of Michigan Consumer Sentiment Survey, is good and rebounded in June after a slight dip in May. The June Business Outlook Survey by the Federal Reserve Bank of Philadelphia showed a slight improvement and increased optimism (both in current and future conditions) in the manufacturing sector.
Outlook – The big question for the remainder of 2015 will be when will the U.S. Federal Reserve begin hiking the federal funds rate, and by how much? Prior to the June 17-18 Federal Open Market Committee (FOMC) meeting, most economists predicted we would see two hikes in the federal funds rate target (currently is 0%) in 2015. That now seems unlikely. At her June press conference Fed Chair Janet Yellen suggested that there would probably be only one hike this year and that the initial hike would not be in July. That leaves the September, October and December FOMC meetings as the likely candidates. Most analysts predict with a 50% chance that the first hike will come in September and, if it does, only about a 25% chance that a second hike would follow in 2015. In her press conference, Chair Yellen emphasized that even after the initial rate hike that Fed monetary policy will remain accommodative for some time even as the process of rate normalization begins and that the longer term pace of rate increases will be gradual. Ms. Yellen also suggested that even after Fed targets for employment and inflation are met, that the Fed will keep its target rate below levels historically consistent with full employment and 2% inflation.
While we expect short term market volatility surrounding the onset of tightening, we do not fear the Fed. When tightening does occur, that should be an affirmation that the domestic economy has recovered to the point where it is strong enough to withstand the shocks of external forces and pressures (a renewed slide in crude prices, a strengthening US dollar, a slow growing Europe and a weakening Brazil are examples). We acknowledge that even a gradual pace of tightening could upset the markets, however, believe any negative impact to be short in term and that the current bull market will continue into 2016.
We think this next cycle of interest rate hikes will be different. A recent Market View article (6/22/2015) of Lord Abbett Funds said it best. “Historically, the Fed has raised rates to temper excessive economic growth and contain or lower inflation. The Fed’s current objective is instead to normalize interest rates without adversely affecting economic growth. Arguably, this more economy-friendly objective could favor equities and other economically sensitive securities more than past rate hikes have, when slowing the economy was a primary objective. Thus, if the Fed is successful in its implementation of rate hikes, interest rates can move gradually higher without seriously affecting economic growth that supports corporate earnings and, in turn, equity valuations.”
Which asset classes do we expect to best weather the storm associated with the upcoming interest rate hikes? One method to assess the potential impact of rate hikes is to look at data from the last five (5) rate hike cycles: 2004-06, 1999-00, 1994-95, 1988-89 and 1986-87. Using data from the above referenced article, we calculated an average annual return for different asset classes during these periods.
US Large Cap (S&P 500) +15.22%
10-Year US Treasury Bonds -2.47% Barclays Aggregate +1.08%
US Corporate Bonds - Short Term +3.25% High Yield US Corporate Bonds +3.52%
The average annual return for US Large Caps is somewhat deceiving as the returns during the three most recent rate hike cycles have been just +3.90%, +9.65% and +0.67%. An outsized return of +47.13% was seen during the 1986/87 cycle. For fixed income, the performance picture improved significantly as you move from the government-bond sector into the corporate bond sector with an eye on keeping duration under about 5-years.
