Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital
Uncertainty over the start of the Federal Reserve’s rate hike campaign, the possibility of a default in Greece and Puerto Rico, and the drop in China shares each weighed on financial markets in June, resulting in a quarter of flat to negative performance across most asset classes. The increased volatility and higher level of dispersion across and within asset classes has benefited active management.
The S&P 500 Index fell almost -2% in June but was able to eke out a small gain for the quarter, despite the negative headlines. The healthcare and consumer discretionary sectors continued to lead, while bond proxies like dividend-paying stocks and REITs struggled. Energy stocks continued to lose ground as well despite a stabilization in crude oil prices. From a market cap perspective, small caps are leading large and mid caps, but the margin isn’t as wide as it is between growth and value. Through the first half of the year, all style boxes are positive except for large cap value, which is modestly negative. However, dispersion is wide, with small cap growth outpacing large cap value by more than 900 basis points over that time period.
The rally in international equities slowed in the second quarter as fears surrounding Greece prompted a sharper sell-off in June; however, international markets still ended the quarter ahead of U.S. markets and continue to have a sizeable lead through the first half of the year. The U.S. Dollar Index (DXY) was weaker in the second quarter, but has still posted gains of more than 5% in the first half, dampening international equity returns for U.S. investors.
In developed markets, Japan, fueled by its expansive quantitative easing program, has been the top performer year to date, gaining almost 14%. Europe, despite a weaker second quarter, has gained more than 4%. Emerging markets soared in April, but gave most of the gains back in May and June to end the quarter in line with developed international markets. June’s significant decline in the Chinese local stock market, which had gained more than 110% since November, prompted a number of policy responses. However, for investors the vast majority of exposure is gained through listings on the more open Hong Kong exchange, which has not experienced gains and losses of even close to the same magnitude.
Anticipation of a Fed rate hike in the fall incited a rise in long-term U.S. Treasury yields, with yield on the 10-year note climbing 41 basis points during the quarter to 2.35%. As a result, the Barclays Aggregate declined -1.7% in the second quarter and is slightly negative through the first six months of the year. All fixed income sectors were negative for the quarter, led by U.S. Treasuries. The macro concerns caused both investment grade and high-yield credit spreads to widen, but due to its yield cushion, the high-yield index was flat for the quarter and remains the strongest fixed income sector year to date with a gain of +2.5%. Despite the recent widening, spreads are still at levels below where we started the year. Municipal bonds finished the quarter ahead of taxable bonds, but are still flat year to date. Increased supply weighed on the municipal market in the second quarter.
Our outlook remains biased in favor of the positives, but recognizes that risks remain. We’re solidly in the second half of the business cycle, but the global macro backdrop keeps us positive on risk assets over the intermediate term. As a result, our strategic portfolios are positioned with a modest overweight to overall risk. A number of factors should support the economy and markets over the intermediate term.
- Global monetary policy accommodation: Despite the Fed heading toward monetary policy normalization, their approach will be cautious and data dependent. The ECB and the Bank of Japan have both executed bold easing measures in an attempt to support their economies.
- U.S. growth stable and inflation tame: Despite a soft patch in the first quarter, U.S. economic growth is forecast to be positive in the second quarter and the labor market continues to show steady improvement. While wages are showing signs of acceleration, reported inflation measures and inflation expectations remain below the Fed’s target.
- U.S. companies remain in solid shape: M&A activity has picked up and companies also are putting cash to work through capex and hiring. Earnings growth outside of the energy sector is positive, and margins have been resilient.
- Less uncertainty in Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year; however, Congress will still need to address the debt ceiling before the fall. Government spending has shifted to a contributor to GDP growth in 2015 after years of fiscal drag.
However, risks facing the economy and markets remain, including:
- Fed tightening: The Fed has set the stage to commence rate hikes later this year. Both the timing of the first rate increase, and the subsequent path of rates is uncertain, which could lead to increased market volatility.
- Slower global growth: Economic growth outside the U.S. is decidedly weaker. It remains to be seen whether central bank policies can spur sustainable growth in Europe and Japan. Growth in emerging economies has slowed as well.
- Contagion risk relating to the situations in Greece and China must continue to be monitored.
- Geopolitical risks could cause short-term volatility.
Despite higher than average valuations, neutral investor sentiment and a weaker technical backdrop, we believe the macro picture supports additional market gains over the intermediate-term. However, with headline risk of events in Greece and the Fed set to normalize monetary policy, a larger pull-back is not out of the question. The S&P 500 Index has gone more than 900 days without a 10% correction, the third longest period on record (Source: Ned Davis Research). However, because of our positive macro view, we’d view a pull-back as a buying opportunity and would expect the equity market to continue its uptrend.
We expect U.S. interest rates to continue to normalize; however, U.S. Treasuries still offer relative value over sovereign bonds in other developed markets, which could keep a ceiling on long-term rates in the short-term. With the Fed set to increase the federal funds rate this year, we should see a flattening of the yield curve. Our portfolios are positioned in defense of rising interest rates, with a shorter duration and yield cushion versus the broader market.
As we operate without the liquidity provided by the Fed and move through the second half of the business cycle, we expect higher levels of both equity and bond market volatility. We expect this volatility and dispersion of returns to lead to more attractive opportunities for active management across and within asset classes. Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.
||Neutral vs. US
||Favor global high yield
||Favor fixed income AR, event driven
||Favor global natural resources
||Later in cycle
Source: Brinker Capital
Brinker Capital, Inc., a Registered Investment Advisor. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting.