U.S. stocks finished the quarter fairly flat, bringing the year-to-date return on the S&P 500 index to a positive 1.2%. International stocks had a flat quarter, but were able to hold onto gains from the first quarter, keeping year-to-date returns well above those of domestic stocks. Small capitalization stocks are also having a better year than their large capitalization counter parts as the Russell 2000 index of small companies is up 4.8% year-to-date. Portfolios have benefitted from diversification among equity classes as the addition of international stocks and smaller company stocks is adding to return over a portfolio of core large U.S. stocks.
With the S&P 500 flat on the year, valuations have fallen as earnings continue to look positive outside of the energy sector. The multiple of the S&P 500 on forward 12 month earnings was 16.4 times on June 30th, down from 16.9 times earnings on March 31st. Although this multiple is above the long-term historical average, it is not excessive when taking into consideration low interest rates and average valuations during a bull market. A continued range bound market could be setting stocks up for more strength as valuations become increasingly attractive. Despite concerns over Greece and strong currency headwinds, European and other international markets performed quite well as valuations were attractive and the European economy shows signs of improvement.
Long-term interest rates rose rapidly in May, ending the quarter much higher than they started. The 10 year treasury again approached 2.5%, similar to levels in the year ago period, as European debt spiked from extremely low levels. Rising rates put pressure on interest sensitive areas such as Real Estate Investment Trusts (REITs), which were down 9.1% in the quarter after a positive first quarter. Utilities, another interest rate sensitive group of stocks, are down 15% for the year compared to an otherwise flat stock market.
Greece moved another step closer to exiting the Euro with a resounding defeat of austerity terms set forth by other Eurozone governments for another bailout in a referendum vote on July 5th. We should learn in the coming weeks whether Greece will exit the Euro, or a new bailout package is ultimately agreed upon, maintaining the status quo for at least a few more years. The underlying problem is that Greece has far too much debt to ever repay in full, and unless there is an agreement to forgive a portion of its debt, the country will remain in depression. The longer the two sides go without an agreement the further chaos will ensue as the country runs out of euros, making a parallel currency and exit more likely.
Germany is unlikely to agree to forgive any Greek debt given the precedent it would set for other highly indebted countries, such as Italy and Spain, where it has significant exposure. As an exporter to the rest of Europe, Germany has a strong interest in maintaining a common currency as it keeps German goods affordable in countries that would otherwise have weaker currencies. However, at only 2% of the European economy, there may be little incentive to save Greece. Although an exit from the Euro would be crushing for Greece’s economy and citizens for at least the short-term, the country has already been in one of the worst depressions in modern history for the past five years, with a 25% reduction in GDP. This has had relatively little effect on the rest of Europe and we don’t expect this to change. Moreover, a number of firewalls have been put into place since 2012, minimizing the risk of contagion across the rest of Europe. Foreign bank holdings of Greek debt are almost non-existent, as the European Central Bank and other public sector entities took the exposure. Although a default may cause other member countries to raise more debt at potentially higher interest rates, the systemic risk to the financial system is minimal.
Although a lot of time has been devoted to reporting the troubles of Greece, other international developments could have a bigger impact on the global economy. Most notably is the rapid decline in the Chinese stock market. Although the Shanghai market is still up almost 100% over the past year and the tech heavy Shenzhen market is up over 150%, a 25% drop over the past few weeks from seven year highs are cause for concern. China needs a healthy stock market to continue driving the economy away from an export driven model to a more sustainable one stressing services and consumption. Support from a strong stock market will also allow heavily leveraged Chinese companies and banks to pay down debt by raising equity capital. A McKinsey study estimated China’s total debt load including government, corporate, and household at 282% of GDP. There are reasons to be optimistic regarding China’s stock market as foreign investors are being allowed access to domestically traded stocks, which will increase its weighting in MSCI indexes and increase foreign money flows. The Chinese government has also taken action to slow selling pressures as it suspended initial public offerings and established a market-stabilization fund to drive stock purchases. The Chinese central bank also pledged to provide funding to support brokerages’ margin operations.
The Commonwealth of Puerto Rico is another source of potential market volatility as it seeks to restructure $72 billion of debt. Much of this is in General Obligation municipal bonds and sales tax revenue backed debt known as Cofina bonds. The U.S. is unlikely to provide direct aid for Puerto Rico, but Congress could allow it to use Chapter 9 bankruptcy protection, which now applies to local governments, but not Puerto Rico. This was used recently by Detroit and in 1994 by Orange County. Under Chapter 9, a municipality can negotiate a repayment plan with its creditors, including extending payments or reducing the principal. Puerto Rico is facing a contracting economy, fiscal deficits, a declining population, and underfunded pensions that would make it impossible to pass on tax hikes in order to repay creditors.
It is important to note however, that the entire Puerto Rican bond market will not be affected. The high yield municipal bond fund that we hold, American High-Income Municipal Bond, has minimal exposure to the island. Most of the exposure it does have is backed by universities, which are reliant on Federal funding. With the recent headlines creating volatility among all Puerto Rico domiciled bonds, the fund has been able to pick up investment grade rated debt yielding around 6.5% tax free.
The June FOMC meeting came and went without an adjustment to interest rates. With weak first quarter economic data, Federal Reserve Governors did not feel it was the right time to increase short-term interest rates, despite giving guidance for potential interest rate hikes in the June to September time frame. This leaves the September meeting as the most likely time for an increase to short-term interest rates. Although consensus among most economists and political observers is that the Fed will indeed hike interest rates at the September meeting, there are many that don’t expect an increase to rates through the end of this year. Second quarter economic data has been good, but not quite as strong as hoped for. The June employment report indicated that the U.S. created 223,000 new jobs and the unemployment rate fell to 5.3%, however, this was slightly below the expected number of new jobs and the labor participation rate fell by 0.4% to its lowest level since 1977.
Our expectation is that barring unforeseen weakness or an external shock, the FOMC will announce an increase to the federal funds rate and overnight rate following its meeting on September 16th & 17th. Under normal circumstances, there is little reason to increase interest rates given that inflation as measured by the Consumer Price Index is running around 1.7%, below the target rate of 2.0%, and there still appears to be capacity in the workforce given the low labor participation rate and lack of wage inflation. However, with the current target rate for Federal Funds at 0%, we are not under normal circumstances. The economy is certainly strong enough for more normal monetary policy, and the FOMC would like to move rates higher, as long as it will not hurt the economy. Historically, stocks have fallen in the 8% – 9% range at the first interest rate hike, indicating the beginning of a rate tightening cycle. This time, the FOMC has clearly set expectations and the pace of rate increases likely to be so slow, that we may not experience the same magnitude of pull back in stock prices.
Regardless of what happens in Greece over the next six months, we expect the second half of the year to reflect stronger economic growth in the U.S. With the now traditionally slow first quarter out of the way, the recent trend of GDP growth in the 3% range is likely to continue. Housing data has been very encouraging as May single-family new home sales reached 546,000, the best month since February 2008. Pent up demand from favorable demographic trends, increased supply from builders, and looser mortgage lending standards should help support this trend of strong home sales.
Earnings growth should begin to reaccelerate towards the second half of the year as the drag from falling oil prices and a strong U.S. dollar begin to dissipate as annual comparisons get easier. During the first quarter of 2015, total earnings from S&P 500 companies fell 5.6%. However, this was entirely due to the energy sector, as excluding companies involved in the energy business, S&P 500 profits were up a very healthy 8.5%. This growth is even more impressive considering the 18% appreciation in the value of the U.S. dollar against our trading partner’s currencies. Although the dollar should continue to appreciate versus other major currencies, the rate is likely to slow significantly.
Given that the Federal Reserve will likely take center stage over the coming months as it considers tightening monetary policy, we expect stocks to stay range bound through the end of the year. In addition to the Fed, the situation in Greece is likely to linger through much of the next few months and debate over the U.S. budget deficit ceiling will likely claim some headlines, adding to volatility. However, with underlying economic and profit growth relatively healthy, valuations on stocks should continue to grow more attractive, setting up stocks for healthy returns once some of the overhangs are lifted.
A potential increase in short-term interest rates will have the biggest impact to short-term bonds. Intermediate to long-term bonds are influenced by market factors, such as economic growth, inflation, and yields on competing instruments. With the 10 year treasury yield of 2.4%, almost back to where it was one year ago, we don’t expect an increase in short-term rates to carry through to bonds with maturities of more than about five years out. Moreover, short-term bonds are more stable in the face of rising rates, and interest from short-term bonds should help offset price pressure from increasing rates given expectations for a slow trajectory of rate increases. Therefore, our outlook for bonds is subdued, but there doesn’t appear to be significant interest rate risk at this point in time.
COMMUNICATIONS FROM HC FINANCIAL ADVISORS, INC.
We want to meet with you at least once a year to review and update any changes in your goals and objectives. We want you to understand the decisions we are making on your behalf and be comfortable with your asset allocation. Please call us with any questions or concerns.
Stephen C. Biggs, CFP®, CFA
July 18, 2015