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Alan McKnight, MBA, CFP®
July 11, 2016
For the major stock market indices, the 2nd quarter of 2016 was anything but dull. Overall, this year has been very volatile, and we are only halfway through. Although recent events in the United Kingdom have dominated the headlines, it was only a few months ago when the big global concerns were all about Asia and specifically China. Lower oil prices, and those economic issues surrounding them, also seem like distant memories.
For the 2nd quarter of 2016, the change in value of each of the major world market indices was as follows:
Much of the biggest gains this year have come from a rebound in the energy sector as oil price moved higher. Utility and telecom stocks have also been big beneficiaries as bonds yields collapsed and have remained stubbornly low.
In order to end the quarter in positive territory, the Dow finished the month of June with its best 3 days in 4 months. Domestic stocks rallied for a third consecutive day of gains of over 200 points. These gains recouped nearly all of the losses from the prior week's surprising United Kingdom's referendum to leave the European Union ("Brexit").
While a rally in the stock market suggests that anxiety over Britain's departure from the European Union has eased, a surge in U.S. bond prices on June 30th signaled that many investors remain cautious about the possible long-term implications. As bond prices rose, the yield on the 10-year Treasury note fell to 1.46%; that is an 80 basis point drop in yields since December 31, 2015!
The First Half of 2016 was Interesting
The first half of 2016 was an interesting one for investors. Within the U.S. equity markets, the biggest winners were stocks that pay dividends such as utilities, telecoms, and consumer staples. Many experts feel these equities can still provide dividend income, but at their current valuations they may offer little, if any, growth. U.S. equity averages are once again within a few percent of their records and bond yields have fallen to record lows. As a matter of fact, as of the day of this writing (July 11, 2016) the S&P 500 had a record close of 2,137.16.
When the year began, many analysts predicted higher interest rates, and that would have fared poorly for bond investors. Three or four interest rate hikes were anticipated by the Fed, and if that had happened investors with long maturity bonds would have suffered. Instead, both 10 and 30 year U.S. Treasury Securities hit their lowest yields ever. According to Tradeweb data cited by the Wall Street Journal, the benchmark 10-year Treasury note traded at 1.385% in the wee hours of Friday July 1st which is below the 1.404% closing low of July 24th 2012, during the European debt crisis.
Oil prices, foreign currency valuations and corporate earnings are all still major concerns for investors. All of those issues took a back seat in late June as the United Kingdom’s vote to withdraw from the European Union set off a shock wave of uncertainty which eased quickly the following week. Another highly anticipated and uncertain situation that should heat up in the next few months is who will be elected President of the United States on November 8, 2016. While the election cycle still has further to go, investors should also pay careful attention as to which party will control the House and Senate in 2017. All in all, 2016 is only halfway complete and the rest of the year could prove to be dramatic. Hold on tight!
Interest Rates: Lower for Longer?
At the end of the 2nd quarter, central banks appeared ready to keep rates lower for longer. So far in the United States, there has been only one rate hike since the end of the Great Recession. It was December 2015, when the Fed increased rates from near zero to a range of 0.25 to 0.5%.
This year, there have been no rate increases, and Fed Chair Janet Yellen has already signaled a reluctance to raise rates. Yellen, told Congress on Tuesday June 21st that weak economic growth in the United States could force the Fed to hold off on any imminent interest rate increases. “Proceeding cautiously in raising the federal funds rate will allow us to keep the monetary support to economic growth in place while we assess whether growth is returning to a moderate pace,” she said. Despite all of her caution about the economy, Ms. Yellen did not see a recession on the horizon. “The odds of a recession are low,” she said. As always, she and her colleagues will continue to monitor the economy and inflation carefully.
The expectation had been that the Fed could raise rates twice this year, with the first hike occurring in July. However, economists now say a Fed rate hike is off the table, not only for the summer meeting but for the rest of this year. “The Fed is looking at potentially years of uncertainty. This will hurt consumer spending and capital investment in the United States,” said Sung Won Sohn, economics professor at California State University, Channel Islands. “I would put it pretty close to zero probability that we will have a hike in interest rates this year or next year.” Stay tuned!
When investors consider preparing for lower rates for longer, they are targeting the Fed and its likely policy on short-term interest rates. The Fed is expected to keep the cost of borrowing money lower for longer than was previously expected. If rates remain low, then savers will suffer longer with low returns on their accounts. Homebuyers, companies and governments will be able to keep on borrowing cheaply. Fed Vice Chairman Stanley Fischer said on July 1st that it was too soon to tell whether Britain's vote to leave the European Union had changed the U.S. economic outlook. He continued by saying, "It clearly is a huge event for the U.K., and it's an important event for Europe." As for whether the United States would consider guiding interest rates into negative territory, as central banks in Japan, Switzerland and elsewhere have done, Fischer said it was unlikely.
Speaking of Negative Interest Rates
Since the global financial crisis of 2008, major central banks have implemented extraordinary monetary policies. This has included reducing interest rates to a near zero rate. Central banks used this strategy to promote growth and provide economic stimulus.
The Fed has maintained an ultra-low interest rate policy, but the European Central Bank (ECB) and the Bank of Japan (BOJ) have implemented negative policy rates. Today, over 30% of the world’s global sovereign debt supply is now in negative territory. A negative interest rate means the central bank and perhaps private banks will charge negative interest; or instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank.
While the strategy of keeping interest rates negative may have helped lenders, it creates unease for savers. Negative interest rates also take away the Central Banks’ ability to use interest rate reductions as a way to ease things during uncertain times.
A jump in purchases of safes has been reported in Japan as people store their money at home instead of in bank accounts. In a recent letter to a congressman, Janet Yellen said that, “Policymakers would need to consider a wide range of issues before employing this tool in the United States, including the potential for unintended consequences.”
In a move that greatly surprised the markets, the citizens of Great Britain voted on a referendum to leave the European Union on June 23rd. Known as “Brexit”, this event dominated the headlines the last few weeks of the quarter. While the long-term repercussions are still far from certain, equity markets around the world were reeling from the news.
U.S stocks suffered a drop of over 3% the day after the vote. The markets quickly recovered almost all of their losses the following week. Because American companies generate 70% of their revenues domestically, they continue to remain insulated from global events. Stocks are still appealing relative to bonds, where more than 60% of stocks in the S&P 500 carry a dividend higher than the 10-year Treasury note, according to Bespoke Investment Group.
During this same time period, the Fed held a stress test of 33 of the largest banks. In a worst-case scenario theorized by the Fed, the banks tested had nearly twice as much capital as required (8.4% versus the prescribed 4.5%). This is more than enough to withstand a potential loss of $385 billion from bad loans. Analysts feel this test should help allay fears that Brexit will not create a repeat of the 2008 crisis that could take down the financial system.
Foreign markets are another story. Following Brexit, the Stoxx Europe 600, which measures large, mid, and small capitalization companies across 18 countries in the European region, suffered its largest one-day decline since the 2008 financial crisis of 7%. The British Pound fell 9% to its lowest level in 3 decades.
The political fallout also continued to play out. Upon the news that Brexit was confirmed, British Prime Minister David Cameron announced that he will resign from his position by October. As a matter of fact, he will actually resign this coming Wednesday, July 13th, and Home Secretary Theresa May will take over the reins as Prime Minister. Markets seem to digest that news well.
The full logistics of how the country will depart from the European Union are still unknown, and no one is sure how trade negotiations will proceed after this historical vote. While markets loathe uncertainty, there may be a silver lining: trade agreements are now a blank slate. Wise policies in London, Brussels, and Washington could potentially repair any damage.
Ultimately, analysts summarized that this event could cause an increase in the likelihood for a British recession. The impact on the United States should remain relatively small due to consumer spending, and the Fed is not likely to raise interest rates the rest of the year.
Oil and Energy Prices
After a miserable start to the year, energy prices turned higher and were the best performing commodity sector during the 2nd quarter of 2016.
The plunge in the price of oil over two years caused it to halve in value from 2014 highs, but this quarter, crude oil posted impressive gains. Energy was the worst performing sector of 2014, and it repeated and took the dubious honor of being the worst performing sector of 2015. This quarter it has become the best-performing commodity sector, and it is also the leader for the first six months of the year.
While this provided some relief, geopolitical and other factors can quickly affect energy prices. The first six months of this year saw huge price recoveries for energy, but analysts feel it is likely that there will be more volatility in the second half of 2016 across all energy markets. There are so many things going on globally that could send the price of oil higher or lower in upcoming months but for the 2nd quarter many energy companies performed well. As stated earlier, equity markets do not like uncertainty, and investors need to still keep a watchful eye on oil prices.
Should I Stay Invested?
Of course, but individual investors always need to consider risks when making decisions. A well-defined investment plan tailored to your goals and financial situation that considers the chance of normal ups and downs of the market can help investors during volatile times.
No one can fully predict the future, and past performance is no assurance of any type of financial return. However, we do have historical information to inform us. In fact, what seemed like some of the worst times to invest in the market turned out to be some of the best times. For example, the best five-year return in the U.S. stock market began in May 1932, in the midst of the Great Depression (+367%). The next best five-year period began in July 1982, amid an economy in the midst of one of the worst recessions in the postwar period, featuring double-digit levels of unemployment and interest rates (+267%). The most recent example of a great five-year period includes the one following the market bottom of the 2009 Great Recession (178%).
Today’s low interest rates are not helping investors and retirees who might need current income. Pension funds and insurance companies are also facing difficulties in generating returns that meet their needs. At the midyear roundtable conducted by Barron’s, a panel of stock market experts felt that stocks would rise by less than 5% in the second half of 2016. Although they predict a rise, they cautioned investors to be very selective when choosing investments.
Some analysts are suggesting that with interest rates at or near historic lows we are in an era of “TINA” or There Is No Alternative to stocks. They cite that in a world where cash returns nothing and bond yields are little more, that equities might be the only source of return for investors. I understand this but believe this is dangerous thinking. While cash can be “trash” in today’s market, keep in mind that a bond’s “total return” is comprised of Yield plus Appreciation. In this year’s highly volatile market, bonds have offered solid protection and somewhat of a shock absorber for many portfolios. As of the close of the market on July 8th, the Aggregate US Bond Index’s (AGG) total year-to-date return was slightly over 6%. When yields eventually move higher, investors may also be able to buy some longer term bonds at cheaper prices.
We are carefully monitoring equity and bond markets so we can communicate with clients. The second half of 2016 could include uncertainty especially as the presidential election cycle heats up. We may even see other countries in the Eurozone have their own referendums of “stay or go?” However, market volatility is a part of investing, and it should be a reminder for you to review your investments regularly. So instead of being worried by volatility, try to be prepared.
Equity investors should be prepared to take a long term approach (5+ years and preferably longer) when looking at returns. Your time horizon, goals, and tolerance for risk are key factors we consider in helping to ensure that you have an investment strategy that is created for you.
It’s never bad time to ask:
Don’t focus on the markets so much BUT on your personal financial situation. Your answers to these questions will govern how we recommend investment vehicles for you to consider. We can help you determine which investments to avoid and how long to hold each of your investment categories before making major adjustments. For example, if your cash flow needs have changed for the next few years, you might consider different investments than someone who has limited to no cash flow needs.
Of course, as always, discuss any concerns with us. Our advice is not one-size-fits-all. We will always consider your feelings about risk and the markets and review your unique financial situation when making recommendations.
We offer consistent communication, a schedule of regular client meetings, and continuing education for every member of our team on the issues that affect our clients.
A good financial advisor can help make your financial journey easier. Our goal is to understand our clients’ needs and then try to create a plan to address those needs. We continually monitor client portfolios. While we cannot control financial markets, interest rates or geo-political events, we will always keep a watchful eye on them. No one can predict the future with complete accuracy, so we keep the lines of communication open with our clients. Our primary objective is to take the emotion out of investing. We can discuss your specific situation at your next meeting, or you can call to schedule an appointment. As always, we appreciate the opportunity to assist you in addressing your financial matters.
If it’s been more than a year since your last financial review, please give Jan Berkholtz a call at our office to schedule an appointment so we can make sure everything is in order. If you feel the need to discuss your situation before our next scheduled review, please call our office at (770) 951-9001 or e-mail me at firstname.lastname@example.org.
Alan McKnight, MBA, CFP® is Vice President of Kays Financial Advisory Corporation. He has 20 years of experience working with retirees and pre-retirees. He is also an Adjunct Faculty Member and Professor of Finance and is an Ed Slott Master Elite IRA Advisor. He can be reached at (770) 951-9001 or at email@example.com.
This report and Mr. McKnight’s comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance. Any security mentioned in this report may not be suitable for all investors. No investment mentioned in this newsletter constitutes a recommendation to buy, sell or hold a particular investment. Such recommendations can only be made on an individual basis after an assessment of an individual investor’s risk tolerance and personal circumstances. Past performance of any investment mentioned is not a guarantee of future performance. Statements regarding the investment concerns and merits of any company and fair market value computations are strictly the opinion of Kays Financial Advisory Corporation. Employees of KFAC and KFAC clients may have positions and effect transactions in the securities of the issuers mentioned herein.
Sources: Investing.com, Barron’s, The New York Times, PressHerald.com, CNBC.com, Wall Street Journal, Fidelity.com, Seeking Alpha, Broadleaf Partners, MDP©, Forefield.com, Morningstar.com, CNN.com.