QUARTERLY MARKET UPDATE July 2015
ASSET CLASS PERFORMANCE Equity Markets - Both domestic and international equity markets added to their year-to-date returns, though the magnitude of the increases was slight. The Standard & Poor’s (S&P) 500 Index and the Dow Jones Industrial Average netted out to an approximate zero percent gain, with the Nasdaq Composite being the outperformer of the domestic categories. Small and midcapitalization equities, still exhibiting outperformance in total, were basically flat. Even developed and developing (emerging markets) international equities, which still demonstrate substantially greater returns year-to-date, slowed in the pace of their gains, also only registering fractional returns.
Fixed Income Markets - Domestic fixed income markets reversed their production of slow but steady single digit returns in the second quarter of this year. Corporate, High yield and Government debt securities all posted negative results with interest rates broadly moving higher. High yield corporate bonds still display the best domestic returns year-to-date, with credit risk outperforming rate risk. Emerging market debt also continued its trend of significantly greater results relative to domestic sectors as US Dollar momentum diminished.
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CAPITAL MARKETS OVERVIEW Key Economic Theme - Rising Interest Rates
The second quarter of 2015 saw the gradual but very conspicuous increase in interest rates on maturities of two years and beyond (steepening of the yield curve). The prospect of interest rate increases can generally be viewed as either positive for equity markets or as a potential hindrance to their return prospects. The distinction between the perceptions involves not only the magnitude of the rate increases, but more importantly, the inference as to why they are rising. The reasons interest rates have maintained at very low levels for a lengthy period are numerous, though none is more conspicuous than the Federal Reserve’s (Fed) designed suppression of long-term rates through its purchases of Treasury securities. Other influences responsible for the prolonged tendency include: • An investor flight to safety in the aftermath of the financial crisis and stock market crash. • Pension funds rotating into bonds trying to protect material gains achieved in the bull market run for equities off the 2009 lows. • Baby Boomers shifting to favor income investing to ensure a return of capital in retirement years. • Interest rate differentials and weaker foreign currencies that have sparked inflows from foreign investors. • New regulations that have boosted liquidity requirements for banks, which many have attempted to meet with the purchase of Treasury securities. • Fear of deflation (or lack of inflation). • The fear of another stock market meltdown/financial crisis triggered by the ill effects of major central banks holding policy rates too low for too long. Given the aforementioned list, the steepening of the yield curve has provoked the interest of all market watchers, as many of those causes (save valuation concerns) have not been materially resolved. Further, the increase is occurring when the probability of Greece defaulting on its debt and possibly exiting the Eurozone has increased markedly, not to mention the slow growth economic environment we continue to experience (in fact GDP growth contracted 0.7% during the first quarter).
QUARTERLY MARKET UPDATE July 2015 | Page Three In other words, it is occurring precisely at a time when investors might not expect an asset class known for its safe haven status to lose its attractiveness, given the current political and economic backdrop. The meaning of the increases is of course being pondered, but there are two primary lines of reasoning offered: • The increase in rates reflects the market’s assumption that economic growth and inflation are poised to accelerate, thereby inviting the first rate hike from the Federal Reserve since June 2006. • The increase in rates is simply a function of air being let out of an overvalued market that has been crowded with the same thinking that rates will stay near historically low levels for some time due in part to demographics, weak economies abroad, and the US economy continuing to grow below its potential. The arguments for both schools of thought are not without basis. The former implies the move higher in rates is the start of a new trend consistent with a strengthening economy, whereas the latter implies it is a transitory price weakness soon corrected. Absent support from current economic data to lend confidence to the accelerating strength theory, and knowing that a spike in rates in 2013 turned into a big buying opportunity that took the yield on the 10-yr note from 3.00% to 1.65% earlier this year, assignment of cause to the rate increases at this point is admittedly difficult. Forthcoming economic data will ultimately clear up the confusion, but what we can surmise at this time is that stock market participants are favoring the acceleration view. This is because rising interest rates are more often than not indicative of an improving economy. Higher employment, strengthening wage growth, and increased consumer and business spending expectations are providing investor optimism consistent with that interpretation. Externally, events in Greece (and Europe more broadly) may cause some interim market adjustments - in which asset sectors and to what degree no one yet fully knows. The consensus argues that the potential effects could be quite disruptive, yet we are not convinced the long-term real impacts will be too harmful. Greece is not a large country and represents a small percentage of the European economy. If the entire country shuts down, which it largely has, it will barely be noticed economically. The next few weeks will certainly be interesting and the excitement will not be confined to Greece or the continent. Volatility will increase as uncertainty is not well regarded by capital markets. Again, though, the real effects to US investors should in the long run be minimal as exposure is almost non-existent. However, Puerto Rican debt is a different situation, with municipal and high yield bond funds owning ample portions as well as some hedge funds that are no doubt leveraged. A default or restructuring by Puerto Rico could cause real losses to US investors. If the US economy were growing at 3 or 3.5% the Puerto Rico and Greece problems would likely be ignored. But that isn’t the case; GDP growth has been 2 to 2.5% for several years and the first half of this year looks considerably lower. One can’t help but wonder if this slow growth is actually decelerating, not accelerating as many presume. With productivity growth turning negative and work force participation continuing to make multi-decade lows, it certainly isn’t out of the question; then a shock like Puerto Rico and/or Greece looks more ominous. The combination of potential external shocks (magnitude aside) along with the continued anemic macro data makes us skeptical that the rise in interest rates is durable and resultant of imminent accelerating growth.
QUARTERLY MARKET UPDATE July 2015 | Page Three As confirmation of this view, we look towards Treasury Inflation Protected Securities (TIPS). They indicate that the majority of nominal growth expectations are affected by changing inflation expectations. The short end of the curve has barely budged this year, an acknowledgement that the Fed isn’t hiking anytime soon, while long rates have moved higher to reflect the fear of inflation. Further bolstering the inflation fear evident in the bond markets is the US Dollar index which peaked in mid-March. As the dollar has fallen the yield curve has steepened. It is a remarkably consistent message from the market. Real growth expectations are falling while inflation expectations are rising. If the Fed raises rates in an attempt at dampening inflation expectations, invariably real growth expectations will be diminished as well. However, if they leave rates at zero and inflation expectations continue to rise, the yield curve will continue to steepen as long-term rates will rise regardless. Because real growth expectations are flat to falling while inflation expectations are increasing, capital is migrating back to international economies, causing worry in credit markets. Whether or not the trend in interest rates continues remains to be seen, but attribution so far favors inflation over growth, and until evidence to the contrary emerges, we will remain skeptical that the rate environment signals an all clear for risk assets predicated on accelerating growth prospects.
PORTFOLIO IMPACT - Alternative Assets
PORTFOLIO IMPACT - Traditional Assets
Global Macro – Market strategy continues to be positioned net long of equity, with effective exposure decreasing slightly from 46% at the beginning of the quarter to 44% at the end of the quarter. Market strategy also continues to be positioned net short of government bonds, and the first quarter ended with a -5% net exposure compared to a -14% exposure at the beginning of the quarter. Long US high yield spread and local currency emerging markets debt exposures were unchanged for the quarter at 4% and 1%, respectively.
Stocks – Our sector exposure remains biased to those areas exhibiting the best combinations of relative value and revenue and earnings growth projections. Healthcare, infrastructure and telecom are overweight, with traditionally defensive, income oriented large capitalization issues receiving favor. We continue to hold exposure to oil, as the recent price declines from the $60 range offer purchasing opportunity as intermediate term price forecasts remain higher. Recent Eurozone and Chinese uncertainty aside, international sectors continue to look more attractive than their domestic counterparts from a valuation perspective. Near-term volatility concerns are compensated by central bank measures and improving macro factors in various regions to which our portfolios are exposed.
In terms of Eurozone equity strategy, we believe that geopolitical influences are driving a heightened forward-looking risk environment (notwithstanding relatively normal realized risk). In turn, we have modified our equity exposures and taken steps to protect against downside in the quarter, while not abandoning the bullish signal that still comes from fundamental valuation.
Bonds – The compressed duration proved additive in the outperformance of our fixed income positioning. We are currently weighted two-to-one towards credit risk over interest rate risk in aggregate. Within those two risk categories, our relative beta’s are below the broad indexes, providing a conservative risk adjusted bond profile appropriate for the current environment. Per the commentary above, as long as growth expectations remain muted, relative safety combined with modest yield on the short end of the curve is the desired current position. If evidence of growth emerges, we will roll up the curve to a longer relative maturity taking advantage of lower prices.
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PORTFOLIO IMPACT - Alternative Assets Absolute Return – Choppier equity markets with higher volatility across the globe have provided attractive entry and exit points for long/short equity strategies to exploit. We expect this dynamic to persist for some time due to continued uncertainties regarding global growth and commodities prices, the dislocations caused by higher currency volatility globally, and the fact that the Fed is no longer utilizing quantitative easing to push asset prices upwards uniformly. Lastly, once the Fed begins to raise interest rates in the US, we expect the dispersion between stocks to increase as companies that have relied on cheap financing rates to offset poor operating numbers over the past several years will no longer be able to cover up fundamental underperformance. All this written, we maintain our high conviction in long/ short equity strategies. Recent developments in the debt crises in Greece and Puerto Rico have instilled fear in the bond markets leading to higher yields across the board. On top of this, we expect interest rates in the US to continue moving higher as the Fed appears prepared to increase rates for the first time at some point later this year. Our credit long/short subadvisor therefore remains positioned to benefit from rising interest rates with a short duration profile and focus on floating rate debt. Our asset backed security (ABS) subadvisor continues to favor collateralized loan obligations (CLO) and commercial mortgage-backed securities (CMBS) over residential mortgage-backed securities (RMBS).
QUARTERLY MARKET UPDATE April 2015 | Page Five
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Copyright Š 2015 Kern DeWenter Viere, Ltd. All Rights Reserved. Investment advisory services and fee-based planning offered through KDV Wealth Management, LLC, an SEC Registered Investment Advisor. Securities offered through ValMark Securities, Inc. Member FINRA, SIPC - 130 Springside Drive, Suite 300, Akron, Ohio 44333-2431, 1-800-765-5201. KDV Wealth Management, LLC, is a separate entity from ValMark Securities, Inc. and ValMark Advisers, Inc.