Market Commentary First Half 2016

| About: SPDR S&P (SPY)

By Dr. Chenjiazi Zhong, CFA, CAIA, FRM

This has been an exciting year for investors, but in a bad way. First, we had the recession scare in January following the second Chinese currency depreciation in six months and oil fell to $25 a barrel, roiling credit markets. Then, the Bank of Japan followed the European experiment with negative interest rates, which called into question global central banks' ability to help in the event of a real slowdown.

Now we are faced with numerous political events, which are hard to analyze from an investment standpoint. The result has been the unfortunate combination of higher volatility and lower-than-expected return for the year to date.

Equity Markets

The second quarter of 2016 was a winning quarter for the Dow Jones Industrial Average (DJIA) and the S&P 500 (SPX), up 1.4%[1] and 1.9%[2], respectively. For the first half of 2016, DJIA and the SPX were up 2.9%[3] and 2.7%[4], respectively. The Nasdaq Composite, on the other hand, was down for the second quarter, off 0.6%[5], and in a 3.3%[6] hole for the first half of 2016.

Stock market gains picked up on June 23 after Bank of England governor Mark Carney said the central bank would likely have to inject fresh stimulus this summer to offset the downside economic risks of the Brexit vote. Wall Street was also looking beyond Brexit, and began shifting its focus to key coming events stateside, such as the June employment report on July 8, 2016 and the start of the quarterly corporate earnings season. Uncertainty still abounds in global markets given the still high level of political and economic risks in the U.K. and Europe following the Brexit vote.

While a more dovish U.S. Federal Reserve may lead to some short-term boost to risky assets, stocks still face several obstacles, including the elevated valuations, particularly in the U.S., and the fact that the Fed is still on course for raising interest rates though the pace it expects to do so continues to be pushed back.

In addition, the U.S. markets have typically experienced some volatility when a president is leaving office after serving more than one term. I believe U.S. equities will continue to outperform other global equities, and I prefer developed markets to emerging markets.

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Fixed Income Markets

Regardless of the number of rate hikes this year, a smattering of exogenous risks remain, including a calendar brimming with difficult-to-forecast events in global politics. Furthermore, although the trend in U.S. economic data has been positive, the weak May employment report reminds us that we remain in a low-growth environment.

In addition to the weak headline numbers, wage gains continued to firm, a sign that the labor market may be tightening to levels that precede an uptick in inflation. Weak pricing power and ability to generate revenue growth, when combined with higher wages, suggest that margin pressures and a rolling over of corporate profits could follow, although this could be partly offset by a softer dollar and higher oil prices.

Investors should be more cautious on risky assets in general. On the U.S. side, I favor U.S. Treasuries and Treasuries Inflation-Protected Securities (TIPS), as negative rates outside the U.S. are increasing demand for longer-dated Treasuries, and TIPS can help investors diversify their portfolios as well as protect them from potential future inflation.

After staying stubbornly low for the past few years, U.S. core inflation is currently running at 2.1%[7] while the 10-year break-even inflation rate remains at approximately 1.6%[8]. From another perspective, I am neutral on duration and commodities; I favor credit but suggest diversifying further from U.S. high yield bonds into investment grade. Going forward, corporate bonds will remain a good source of yield and income, though further price appreciation will likely be limited and volatility will remain. I also like gold as a diversifier.

Emerging Markets

Emerging markets stocks exhibited strong performance from mid-February to late April, but the environment reversed somewhat in May. Investors' zeal for emerging markets assets waned, in particular, when the U.S. Federal Reserve signaled it was going to raise rates again this year. Yet, in the short term, a delayed Fed rate hike, a benign outlook for oil prices, a softer U.S. dollar and Chinese growth should create a stable backdrop for many emerging economies.

Moreover, assets in many countries continue to display attractive valuation levels. That said, political risk and structural challenges, such as high levels of debt, remain elevated. Keep in mind that the mixed outlook highlights the importance of being very selective when investing in emerging markets assets. Certain countries that stand out are offering attractive prospects for long-term investors.

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The Brexit

In June, the U.K. held a referendum on whether they should remain in or leave the European Union (EU) - the Brexit. In some respects, this vote was a gamble by the incumbents as a means of quieting the growing public outcry against what has been a recovery without broad participation among its citizens. The historic decision by Britain to terminate its 43-year-old relationship with the EU by a narrow margin of 52% to 48% vote was shocking and provocative.

The surprise results produced stunning market volatility and volume. On June 24, the day after the vote, the British pound, which rallied strongly into the referendum, plunged as much as 11% before recovering enough to finish down 8.1%[9]; the euro lost 2.4%[10] while the US dollar and yen jumped as safe-haven trades. By June 30, the pound had been down another 3.2% and the euro lost another 0.5%[11].

Sharp Sell-Offs for the Pound and the Euro in the Aftermath of the Vote to Leave the European Union

Standard & Poor's (S&P) and Fitch Ratings (Fitch) both downgraded the UK's credit ratings on June 27, 2016, citing potential economic drop-offs as a result of the U.K's June 23 referendum, as reported by BBC. S&P lowered U.K.'s rating from AAA to AA, while Fitch dropped its rating from AA+ to AA. In lowering their outlooks for the British economy, the two rating agencies joined Moody's Investors Service, which dropped its outlook for the U.K. from STABLE to NEGATIVE the day after the referendum. The results of the British referendum have created aura of uncertainty in global financial markets.

Investors moved markets in a way consistent with political shocks as opposed to financial-system shocks. This distinction is important as it speaks to the scale, scope and speed of the transmission of this event to the economy and, in turn, to the markets. What is critical is the extent to which policy uncertainty affects risk premiums and undermines consumer and corporate confidence.

Brexit Feels Like the 2011 Debt Ceiling Fiasco

No two situations are the same, but since June 23, it has been hard not to see the similarities between the Brexit and the 2011 Debt Ceiling Fight in the U.S. The key takeaway from the debt-ceiling debate was that U.S. politics had become so polarized that a layer of protection from the U.S. government was removed. S&P followed in the days after with a rating downgrade. This created deep uncertainty, which hurt the confidence of investors, and the pessimism was completely one-sided.

Merely after one month, markets and policymakers caught up to this self-inflicted wound. The great irony of that episode was that S&P downgraded the U.S. for passing legislation that significantly improved the nation's fiscal position over time. The same could be true here and there is no shortage of pessimism these days with talk of the EU unraveling over time.

Brexit Sparks Yuan Devaluation Concerns Again

The Brexit is spurring concerns about additional Chinese yuan weakness once again. Over the weekend, the PBOC announced a -0.9% devaluation to its reference rate. Chinese policymakers appear to be exercising some restraint in their reaction to the Brexit fallout, but more weakness may be coming. Policymakers are stuck between supporting an imbalanced and slowing economy on the one hand, and preventing another flow of capital out of the country on the other. The broader implications of yuan weakness is that it could reignite the currency war debate, and with it concerns about the roughly $3.8 trillion of USD-denominated debt outstanding.

Year to date, the yuan has weakened over -2.4% versus USD[12], more than most of its emerging markets peers. Chinese policymakers are once again struggling to keep up with all the obstacles that threaten their "soft landing": capital outflows, non-performing bank loans, large debt loads, the lack of new growth drivers to replace old ones, and an aging population. It seems unlikely that the Brexit will be the straw that breaks Chinese policymakers' back, but it is adding to their load. 16% of Chinese exports went to the EU last year[13], so the extent to which European growth declines will rather to China.

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Guides to Navigating the Second Half of 2016

I expect growth to improve in the second half of the year, and the path of U.S. rates and tone of Federal Reserve comments are critical drivers of sentiment for the rest of 2016. An easier U.S. financial conditions are supportive. The improvements in manufacturing were broad-based with upticks in the U.S., China and Japan. Importantly, Europe showed some high index reading of 2016; Germany paced the gains, which had its best showing in more than two years.

European consumer confidence has held steady at high levels and retail sales growth has been solid, underpinned by improving employment and total income growth that reached a 3.7% annual pace in May. Most importantly, the European Central Bank (ECB)'s corporate bond-buying program and second long-term refinancing operation have only recently begun, and they could unlock the lending channels to meet growing credit demand.

On the other hand, the next political events, including the Republican and Democratic conventions convening later this month, that France and Germany face national elections in 2017, and the next parliamentary election in 2020, will come into play as well.

Additionally, the U.S. nonfarm payroll report released earlier was just the latest reminder that the expansion remains uneven, inconsistent and prone to disappointment. Meanwhile, manufacturing is still struggling with the rapid rise in the dollar and the collapse in commodity prices last year. How can investors navigate this puzzling picture?

  1. Watch the dollar. U.S. manufacturing has been decelerating for most of the past two years and a strong dollar bears much of the blame. The silver lining of the weak payroll number is a greater likelihood that the Federal Reserve will hold off on raising interest rates, which could lead to a continued softer dollar. That, in turn, should help alleviate the pressure on the manufacturing sector, as well as U.S. corporate profits.

  2. Income matters more than confidence. The best predictor of household consumption is income growth, with wages being the most important component of income. Surprisingly, consumer confidence has had a much weaker relationship with retail spending. Outside of the 2008 recession, the level of consumer confidence has told investors very little about spending. The lesson being is consumers will spend only if their income is rising.

  3. Leading economic indicators will lead. Economies are complex and vulnerable to exogenous shocks. As a result, there are no truly reliable measures of future growth. Therefore, certain economic statistics have historically led overall growth. The Chicago Fed National Activity Index (CFNAI) suggests growth is likely to remain positive, albeit tepid. I believe the U.S. economy will continue to expand in the coming quarters.

  4. Taking quality bias in assets. I expect growth to improve in the second half of 2016 but we believe asset valuations in developed markets are too high to drive any outsized asset returns. I remain more confident on economic outcomes than on asset market outcomes in developed markets. I also expect inflation to normalize, especially in the U.S. I believe diversification and an active approach remain key portfolio goals.

  5. Opportunity sets for hedge funds. Hedge funds' struggle with performance has led to questioning of the asset class's value proposition. Hedge funds are not homogeneous asset class and should be viewed as a unique set of strategies and managers with various objectives; there are certain realities investors must face in an industry that has expanded rapidly in the past two decades that should inform how to position future allocations. I believe some of the recent volatility and uncertainties have set the stage for good opportunities for disciplined hedge fund investors.

References:
[1] Bloomberg

[2] Bloomberg

[3] Bloomberg

[4] Bloomberg

[5] Bloomberg

[6] Bloomberg

[7] Bureau of Labor Statistics Data

[8] Bureau of Labor Statistics Data

[9] Bloomberg

[10] Bloomberg

[11] Bloomberg

[12] Strategas Research Partners, as of June 30, 2016

[13] Wind