Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital
After a weak start to the month, risk assets finished May with strong returns. Despite increased rumblings for a mid-year Fed rate hike creating uncertainty in the market, climbing oil prices and strong housing data helped uphold investor confidence and worked as a catalyst for positive gains during the month. Corporate earnings generally beat analyst expectations, but overall earnings growth is still negative year-over-year. Markets were volatile and we expect this trend to likely continue as central bank actions continue to unfold and we move closer to the end of the business cycle.
The S&P 500 Index gained 1.8% for the month, finishing just shy of the all-time high reached in May 2015. Sector performance was mixed. Energy, materials and industrials lagged for the month, but still remain in positive territory year-to-date. Technology, healthcare and financials sectors had strong performance with technology posting returns of over 5%. Growth outpaced value in large and small caps and was equivalent in mid cap. Small and micro cap stocks outperformed large cap stocks.
International equity markets lagged U.S. equity markets. Although international equities experienced a similar pullback in the beginning of the month, the subsequent rally failed to pick up the same momentum as U.S. equities. A strong dollar coupled with weak profit growth and uncertainty surrounding the potential Brexit were drags on performance. Emerging markets lagged developed international equity markets; with almost all EM countries finishing the month in negative territory. In particular, Latin America posted double-digit negative returns resulting from political turmoil in Brazil.
The Barclays Aggregate Index was flat for the month with most sectors finishing either flat or in slightly negative territory. Treasury yields fell mid-month only to rise back up as the market began pricing in the possibility of another Fed rate hike. Treasury yields ended the month relatively unchanged from beginning levels and the investment grade credit was flat. High yield spreads slightly contracted and the asset class eked out a small gain. Municipals also finished slightly positive.
We remain positive on risk assets over the intermediate-term; however, we acknowledge that we are in the later innings of the bull market that began in 2009 and the second half of the business cycle. The worst equity market declines are typically associated with recessions, which are preceded by aggressive central bank tightening or accelerating inflation, factors which are not present today. While our macro outlook is biased in favor of the positives and a near-term end to the business cycle is not our base case, the risks must not be ignored.
A number of factors we find supportive of the economy and markets over the near term.
Global monetary policy remains accommodative: The Fed’s approach to tightening monetary policy is patient and data dependent. The Bank of Japan and the ECB remain supportive.
Stable U.S. growth and tame inflation: U.S. economic growth has been modest but steady. While first quarter growth was muted at an annualized rate of +0.5%, we expect a bounce in the second quarter as has been the pattern. Payroll employment growth had been solid, but May’s report was disappointing. Wage growth has been tepid at best despite the tightening labor market, and reported inflation measures and inflation expectations, while off the lows, remain below the Fed’s target.
U.S. fiscal policy more accommodative: Fiscal policy is modestly accommodative in 2016, helping offset more restrictive monetary policy.
Constructive backdrop for U.S. consumer: The U.S. consumer should see benefits from lower energy prices and a stronger labor market.
However, risks facing the economy and markets remain, including:
Risk of policy mistake: In the U.S. the subsequent path of rates is uncertain and may not be in line with market expectations, which could lead to increased volatility. Negative interest rates are already prevalent in other developed market economies. An event that brings into question central bank credibility could weigh on markets.
Slower global growth: Economic growth outside the U.S. is decidedly weaker, and while China looks to be improving, a slowdown remains a concern.
Another downturn in commodity prices: Oil prices have rebounded off of the recent lows and lower energy prices on the whole benefit the consumer; however, another significant leg down in prices could become destabilizing. This could also trigger further weakness in the high yield credit markets, which have recovered since oil bottomed in February.
Presidential Election Uncertainty: The lack of clarity will likely weigh on investors leading up to November’s election. Depending on the rhetoric, certain sectors could be more impacted.
The technical backdrop of the market has improved, as have credit conditions, helped by a macroeconomic environment that leans favorable. Investor sentiment moved from extreme pessimism levels in early 2016 back into more neutral territory. Valuations are at or slightly above historical averages, but we need to see earnings growth reaccelerate. We expect a higher level of volatility as markets assess the impact of slower global growth and actions of policymakers; but our view on risk assets still tilts positive over the near term. Higher volatility has led to attractive pockets of opportunity we can take advantage of as active managers.
Source: Brinker Capital. 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. Brinker Capital Inc., a Registered Investment Advisor.