IAAM 2016 First Half
Update on the
Markets and Current Investment Strategy
July 5, 2016
Overview
The first half of 2016 was marked by a significant increase in volatility with dramatic price swings in the major financial and currency markets throughout the world caused by continued sluggish economic growth with non-existent inflation. The continued march lower in global interest rates has been instigated by the major central banks’ unconventional monetary policies which include direct purchases of their governments’ bonds to drive prices higher and yields lower. Their ultimate goal is to help spur economic growth and modest inflation by lowering borrowing costs for households and businesses as well as to stabilize financial markets. At the same time, given the uncertainty over the global economic outlook and the perceived safety of government bonds, increasing numbers of global bond investors continue to add to their foreign and domestic government bond positions driving prices to record high levels and yields to record low or even negative levels in some countries.
By the end of June, both 10 and 30 year US treasury yields dropped to their lowest levels ever in the past 200+ years, even before Alexander Hamilton was US Treasury Secretary under George Washington (Wall Street Journal). Negative yielding foreign government bonds in places like Germany, France, Italy and Japan had risen to over $12.5 trillion (36% of the $35 trillion of all government bonds in the world) with another $14.5 trillion (41%) yielding less than 1%. Only 6% of all global government bonds in the world yield more than 2%. (Bianco Research).
The United Kingdom’s (“UK”) unexpected Referendum Vote on June 23rd in favor of leaving the European Union (“EU”) initially resulted in a dramatic selloff in the global equity and currency markets only to be followed by a dramatic price recovery by the end of June. Prior to the actual vote, the consensus expectation of political pundits was that British citizens would vote to remain in the European Union given the economic trading advantages provided to both the UK and the EU. In fact, since the founding of the EU, the UK has been the EU’s major trading partner and each party has benefited from selling goods and services to each other.
UK Prime Minister David Cameron, who was staunchly in favor of remaining within the EU, nevertheless, had promised British citizens back in 2013 a nationwide referendum vote to determine whether the UK should remain a member of the EU. He never imagined that British sentiment would shift in favor of leaving the EU, underestimating the growing frustration over anemic income growth since the Financial Crisis in 2008 and early 2009 compounded by rising fears that the record numbers of foreign immigrants entering the country would further undermine job opportunities for British citizens. In addition, a rising number of UK citizens and political leaders became increasingly dissatisfied with the apparent bureaucratic and more socialistic policies of the EU and its potential dampening impact on future UK economic growth. There was also an increasing concern over the recent terrorist events that took place in Paris and Brussels which were caused by Islamic Extremists that apparently crossed into those countries via the open border immigration policies that prevail throughout the EU. The EU has maintained an open border policy on immigration between EU nations which has resulted in greater movement of immigrants into faster growing countries like the United Kingdom and Germany and out of slower growing countries in both Eastern and Southern Europe. More recently, while there has been a dramatic influx of refugees into the EU from the war torn Middle East, few have entered the UK.
This rising concern over increased immigration and the emotional fear that domestic jobs are being lost to immigrants has been being felt throughout history with the United States being no exception. Prime Minister Cameron’s miscalculation resulted in his announcing his resignation as Prime Minister effective in October with a new government to be formed at that time. While we do not believe this unexpected development in the UK will become a broader trend towards global isolationism given the interdependency of most major economies throughout the world, we will continue to monitory these developments very closely for any spillover effects caused by this Referendum decision. The UK will likely remain within the EU for another two years before formally pulling out and will need to renegotiate its EU trading agreements which will likely begin after a new government is in place later this year.
We believe the overall economic impact of the recent developments will be relatively muted with continued modest to moderate growth throughout most of the Developed economies. While the United States remains a steadfast ally of the United Kingdom and the European Union, we do not believe it is heavily dependent on trade with either entity. Moody’s Economics along with several other economic forecasting firms has estimated a nominal negative impact on the US economy of only 0.1% to 0.2% for the upcoming year as the UK renegotiates its relationship with the EU. The US household sector continues to experience relatively solid job growth, rising incomes, low borrowing costs for both home and automobile purchases and improving wealth due to the significant rebound in home prices and investment accounts over the past eight years. In addition the considerable decline in energy costs has also acted like a tax cut providing additional funds for most families.
Investment Overview
By the end of the first half, the US stock markets, while encountering significant price swings at various point in time, actually ended the period with modestly positive total returns. The foreign stock markets encountered even greater price swings with widely divergent returns across regions and generally ended the first half of the year with negative returns ranging from -4.0% for the broad MSCI EAFE Index to as much as -19.0% for the MSCI Japanese Stock Index . As mentioned above, global bond yields continued to decline to record low levels with many foreign government bond markets moving further into negative yield territory. As a result, most bond sectors generated positive returns in the +3.5+% to +6.0% range depending upon the sector with longer maturity US Treasury bonds actually generating even greater returns of in excess of +14% for the first half. We do not believe these bond returns are sustainable as economic conditions gradually improve over the longer term. Once that begins to occur, investors could experience significant price losses on their longer maturity bond investments as interest rates move up to more normalized levels from their artificially sustained levels today.
We are not alarmed by the spike in volatility in the global financial markets and remain steadfast in our overall investment strategy. We continue to favor higher quality stock investments with an emphasis on dividend growth to offset the anemic yield opportunities in the bond market. In addition, we continue to favor shorter maturity higher quality bond investments which have less downside price risk. As we have indicated on several occasions in our past commentaries, given the somewhat overvalued levels of global stocks and bonds, we have remained somewhat more cautiously postured in our overall allocation mix across all models. Our Diversified Core Equity allocation also remains focused on higher quality dividend growth stocks of larger sized companies that remain well positioned for modest global economic growth. While it is extremely difficult to determine the near term impact of these recent developments in the UK and EU, we remain committed to our overall allocation strategy of trying to manage overall risk across our allocations with a longer term goal of achieving greater performance consistency. We do believe that given these recent developments, the world’s central banks will redouble their efforts to provide additional support through even more proactive monetary policies. The net result of these efforts will most likely translate into low to negative bond yields for longer across the globe which could move global stock markets to even higher levels.
We remain confident that our time tested allocation approach will better enable us to achieve your wealth building goals. We appreciate your understanding and support in what continues to be a challenging period in the financial markets and will continue to work hard to earn your ongoing trust.
Very truly yours,
Joseph C. Parsons John C. Bianchi
President Chief Investment Strategist
Past Performance is No Guarantee of Future Results.
The views expressed are not necessarily the opinion of Royal Alliance Associates, Inc. and should not be construed directly or indirectly, as an offer to buy or sell any securities mentioned herein, or as investment advice. Opinions are subject to change without notice.
All investing involves risk, including the potential loss of principal. No investment strategy such as asset allocation can guarantee a profit or protect against loss in periods of declining market values. Past performance is not guarantee of future results. Please note that individual situations may vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice. Indexes cannot be invested in directly, are unmanaged and do not incur management fees, costs or expenses, which would have the effect of reducing historical performance results. An index is a portfolio of specific securities whose performance is often used as a benchmark in measuring the performance of a specific asset class.
Fixed Income investments are subject to various risks including changing interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other events. Securities sold or redeemed prior to maturity may be subject to a substantial gain or loss. In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Vehicles that invest in lower rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
International Investing involves special risks not present with US investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
The price of commodities, including gold and precious metals is subject to substantial price fluctuations over short periods of time and may be affected by unpredictable international monetary and political policies. The markets for commodities are widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
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