Quarterly Commentary

2Q 2016

Resilient in the face of uncertainty would be an apt description for financial markets in 2016. We entered the second quarter marveling at how quickly US stocks had rebounded from the alarming January/February plunge… and hoping for more upside. Concerns about US and global economic growth were receding. Chinese authorities had asserted control over the value of their currency. Oil prices were recovering.

April’s good start unraveled as the Fed indicated an intention to raise interest rates in June or July. Even as the current bull market officially became the second longest advance in history, investors were registering their lowest level of optimism for stocks since 2005. Indexes marked time through May and early June as polls indicated that the Brexit referendum could go either way.

Then came June 23rd and the UK vote to leave the EU, triggering an immediate and across-the-board surge of selling. We suspect that a good portion of it was initiated by trading systems that automatically sold shares in response to the loss of momentum or because of increases in other risk indicators.

The uncertainty was compounded by the bewildered response of UK leaders – and the concern that other European nations would follow Britain in considering an exit from the EU. The political confusion was accompanied by proclamations of economic doom from journalists and fund managers – not exactly disinterested parties.

Then, just as the quarter was coming to a close, stocks whipsawed higher, taking three days to retrace the 6% decline registered in the prior two trading sessions – testing the nerves of even the most seasoned investors. When the dust settled, indexes registered a 2.5% gain for second quarter, leaving them up almost 4% year-to-date. Bonds provided similar returns. The yield on the ten-year US Treasury fell to 1.4% from 1.8% at the end of March. While paltry in any historical context, consider that thirty percent of global government bonds are now yielding less than zero!

The immediate stock market damage has been reversed, but Brexit is likely to have long-lasting implications for the world economy. Assuming the UK does follow through on leaving the EU, it will likely be many months before trade pacts are renegotiated. The political uncertainty will weigh most heavily on the UK and EU economies, as businesses and consumers pare their spending in fear of what might be next. Reduced global trade portends lower global growth and a profit haircut for multinational businesses.

With lower growth comes the expectation that bond yields will be “lower for longer.” Central banks in the UK and EU have already signaled continued monetary stimulus. The rate hike expected here in the US may be off the table until 2017. The decline in long term rates is especially bad for banks because it compresses the spread between their lending rate (which is going down) and the rate they pay on deposits (already at zero).

November draws ever nearer – should we worry about this election? Many people believe that one or both of the candidates are a market/economic disaster waiting to happen. While there are reasons to worry, markets have survived many anticipated and actual calamities over the years. Riding it out has always worked in the long run. Irrespective of the election outcome, we should expect incremental rather than transformational policy change regarding fiscal stimulus, trade policy, and tax reform, although there are reasons to hope for something better. Incrementalism means less market risk than many fear. But there will be volatility along the way, especially as campaign rhetoric flares.

Could US voters follow in Brexit’s footsteps? On the face of it, UK “Leave” supporters voted against their pocketbook. The decision appears to have been driven by two interrelated issues: trade and immigration. To generalize, many “leave” supporters were frustrated by years of watching others capture the bulk of the benefits of globalization. Many of the world’s poorest and richest were lifted by growing global trade while a large number of developed countries’ lower and middle classes experienced economic stagnation. The belief that new arrivals would find jobs and a better way of life even as they were stuck in neutral was the last straw.

Populism has played a large role in the election cycle thus far, on the left and the right. No matter who wins the election in November, those who feel left out of the current system need to be brought back in to the fold. Whether it be displaced coal miners or inner city families struggling to afford health care, everyone needs to see the opportunity to benefit from global trade and economic growth or they will act and vote against it.

Market internals
The expectation that interest rates will stay lower for longer has once again motivated investors to seek out alternatives to bonds – such as dividend-paying US stocks. Worries about economic growth have led many to embrace “safe” areas like utilities, real estate (REITs) and consumer staples, and to avoid tech and material stocks, as well as banks. This strategy makes sense, until the time comes when the prices for “safe” dividend stocks have been pushed up so far that future returns will be constrained (this is called “overbought” territory). Likewise, the desire to minimize exposure to out-of-favor areas like tech, materials and banks can push prices down to the point where they are real bargains despite the risks. We think there are already examples of overheated “safe” stocks that may be riskier than unloved economically-sensitive ones.

We find it helpful to group portfolio equity holdings according to currently relevant risks. All of our multinational large caps operate in the UK and Europe to varying degrees – but not a level that is worrisome. We are assessing two holdings that are significantly exposed to Europe (but not the UK). Each of the domestic small-caps in our portfolios has its own risk factors that we expect will drive returns over the balance of the year. We don’t think Brexit will impact their US dollar-denominated cash flows, and we have already observed a share price rebound.

We are long-term investors, but we have been active in response to the opportunities created by the abrupt shifts in market psychology. Current circumstances demand confident analysis of risk and reward, which facilitates sound and sometimes rapid decision-making (most often to not act). Also essential is a willingness to go against the crowd where valuations may be near extremes.

Stocks are making new highs as we commence the third quarter. The remainder of the year may be every bit as exciting as the first half. Our mission is clear: to navigate through current conditions to help you achieve your long-term financial goals.