Data Source: Bloomberg
July 2016 Market Commentary: It's All Good
"And so with the sunshine and the great bursts of leaves growing on the trees, just as things grow in fast movies, I had that familiar conviction that life was beginning over again with the summer." - F. Scott Fitzgerald, The Great Gatsby
What Brexit? What summertime angst brought on by issues, once again, emanating out of Europe? Rather than wilting under the heat and humidity of geopolitical tensions and populist angst, markets came back to life this summer. July witnessed one of the stronger months for global risk assets (apart from commodities) where global equities rallied ~5% led by perennial laggard Japan which rose 6.5% on expectations of aggressive fiscal and/or monetary stimulus following the Liberal Democratic Party's upper house electoral victory. The rally initially started following a strong June employment release earlier in the month as well as investors processing the implications of what a 'Brexit' may look like (hint: long, drawn-out process rather than an immediate shutdown of trade and capital market access). Investors were also relieved with a weak advanced reading of 2Q GDP which helped push down expectations that the Fed would hike rates in September.
U.S. small caps outperformed large caps and growth sectors, led by technology, consumer discretionary, materials, and health care, overtook the low volatility safe havens of utilities, telecom, and consumer staples. The notable exception to this risk-on rally was commodities which dropped ~10% as oil prices fell to the low $40s from the upper $40s due to rising inventories.
Something also happened this July which we haven't seen in a while which was the outperformance of ex-U.S. markets versus the U.S. ( Exhibit 1). Granted the global market was broad-based with Asia leading all major regions. The U.S. dollar strengthened against the yen and euro earlier in the month ( Exhibit 2) but then gave back those gains on top of a weak 2Q GDP preliminary release and disappointments over the latest Bank of Japan monetary measures.
Exhibit 1 - Global Markets Rally Led by Asia
Exhibit 2 - The U.S. Dollar Rally Stopped Short in Late July
Despite some strong earnings releases from the technology space (particularly cloud and mobile focused technology), the U.S. economic picture remains muddied. Investors were surprised of the weakness in the advanced 2Q2016 GDP release (1.2% vs consensus of 2.6% and GDPNow of 2.3%) led by a contraction in business spending and inventory (consumer spending remains strong having rose 4.2%). As a result, the U.S. dollar weakened as expectations of a Fed rate hike in September dropped to 12% (versus 24% prior to the release). Indeed, the dollar had been strengthening as Fed officials voiced renewed optimism over the U.S. economy following a strong employment release in early July. Yet, the U.S. market remains resilient because 2Q earnings releases are coming in better than initially feared. According to Factset, 63% of the S&P companies have reported 2Q earnings with 71% reporting above the mean earnings estimate and 57% for revenue. The blended earnings decline is still negative at -3.8% but year-over-year revenue has stopped contracting for the first time since the 2014 oil price collapse. Analysts still anticipate earnings to recover in the 4Q with expectations of 6.3% growth on top of a recovery in revenue growth of 5.0%.
Summer of 2016 is also turning out to be favorable for risky debt. Even with the sell-off in commodities (primarily due to oil prices), U.S. debt markets remain robust with U.S. high yield leading all major fixed income sectors ( Exhibit 3). The Barclays U.S. High Yield Index yield is down to 5.26%, down from 5.81% at end of June and over 8.4% during the depths of the February market meltdown. Lower investment grade (BBB-rated) credit costs have also come down with the BBB spread over U.S. risk-free debt narrowing to 1.69% from 1.83% at the beginning of the month.
Exhibit 3 - High Yield Among the Best Performing Sectors Post-Brexit
Oil came under pressure in July as "traders [shrugged] off expectations of increasing global fuel demands in the coming year and declining North American production levels, while they focus on near glut levels of supply and the end of unplanned supply disruptions [in] Nigeria, Libya and Canada," according to analysts at Tradition Energy. The dynamics pressuring oil, namely the global supply/demand gap, have subsided but oil prices will continue to swing based on near-term supply ( Exhibit 4).
Exhibit 4 - The Energy Long-Term Supply/Demand Gap is Narrowing
One could argue that complacency is starting to set in as traders have pushed down the price of risk protection (implied volatility or the VIX) as they price up risky assets ( Exhibit 5). The VIX has broken through trough 2016 trough levels and is approaching the low levels not seen since last August prior to the August 2015 sell-off.
Exhibit 5 - Implied Volatility (VIX) Pricing Suggests 'It's All Good'
With Brexit in the rearview and China no longer dominating macro concerns, the flight to safety trade may have run its course as more growth-oriented themes emerge to drive the markets higher. Low volatility and high yield dividend investing (along with momentum which currently tracks both) lagged in July while quality and value outperformed ( Exhibit 6).
Exhibit 6 - 'Quality' Days are Here Again
This is not to discount the possibility of another August/September swoon where surprises seem to happen when the market least expects them (particularly when the VIX is trading at cycle lows). When markets care least about risk is when risk tends to 'matter' catching the markets flat-footed. However, leadership continues to oscillate between risk-on versus risk-off which is one more reason why 3D favors global diversification across not just regions and sectors, but themes as well.
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