Third quarter highlights
The U.S. stock market once again embarked on a gradual upward climb in the third quarter, despite widespread skepticism by the investing public. Though economic reports continued to improve from earlier in the year, they were initially overshadowed by concerns that Brexit might require a bailout of Italian banks. As a result, sovereign bond yields in Europe, America and Japan dropped to new lows in early July but soon began to recover.
Aiding the yield bounce were positive political developments in Japan, where the ruling coalition did very well in elections, as well as in the UK, where the leadership succession went very smoothly with Theresa May installed as the country’s new Prime Minister. Meanwhile, news from S&P 500 companies was “better than feared”. Though earnings were still down on a year-to-year basis, they were better than analysts had predicted. New highs in advancing over declining stocks in most major indices were corroborated by strong internal market statistics, indicating that small and mid-cap stocks were also participating in the rally.
“If you can’t convince them, confuse them.” — Harry S. Truman
Fed ambiguity and political uncertainty
At least part of the increase in yields was due to private and public pension funds having difficulty in meeting their return requirements because of prolonged low-interest rate policies that hurt investors. Fed officials tried to prepare financial markets by sounding more hawkish at the annual Jackson Hole economic summit in late August, but wound up causing a selloff similar to the “taper tantrum” of mid-2013. After a series of softer economic releases, the Fed wound up leaving rates unchanged at the September meeting. This has led many to wonder what government officials are really trying to communicate to the public. At this point, it appears that a rate hike this year (most likely in December) will occur, but of course, the outcome will be data dependent.
The upcoming Presidential election is also causing investment angst, with surveys indicating that the campaign rhetoric is having a negative effect on consumer and capex spending plans. Besides impacting individual sectors such as Healthcare and Financials, the uncertainty extends to multinational companies and major trading partners, such as Mexico and China. Fortunately, we are now entering the last full month before the November election.
Trends in other countries have been mixed. European bank issues, now focused on Deutsche Bank, will likely weigh on Eurozone bourses. Fortunately, Deutsche Bank is not another “Lehman moment”. With the European Central Bank (ECB) serving as a backstop, Deutsche’s short-term liquidity is not an issue although its lack of profitability is causing longer term capital adequacy problems. Meanwhile, China, whose economy had been slowing for the last two years, is having a growth pickup that should help multinational companies and global economies.
Hawaii’s economy continues to grow, with the unemployment rate lower than the national average and still dropping. Tourism remains strong, with the number of visitors hitting an all-time high for the month of August, while spending per tourist rose 5% from last year. Tourism has now been climbing for 19 straight months. Terrorist attacks abroad, particularly in Europe, may be helping to fuel the numbers. The absence of any major storms hitting the islands so far during this hurricane season may also be contributing.
U.S. economic growth should pick up in the third quarter between 2.5-3.0%, a marked improvement from the first half of the year. We see a continued slow upward grind in equities, with occasional pullbacks, characteristic of the markets earlier this year. We are somewhat more cautious on bonds if prices move higher, as the risk-reward ratio is unfavorable if we re-test the lows in yields reached this summer.
- Better trade statistics and an end to the five-quarter inventory drawdown should bolster growth while weaker consumer spending, especially with regard to auto sales, may temper gains.
- A stable U. S. dollar, a recovering China and oil prices should lead to an earnings upturn soon. For the first time since last year, corporate sales, which preceded the profits drop, are forecast to increase in the third quarter.
- Though equity valuations are not inexpensive, the continued moderate growth in the U. S. economy should limit selloffs and contribute to a “buy the dip” strategy for many money managers holding large amounts of cash.
“History has demonstrated time and again the inherent resilience and recuperative powers of the American economy.” — Ben Bernanke
Second Quarter Highlights
The U. S. equity market rose during the second quarter and managed to shrug off near term effects of Brexit, while most international indices struggled. The economy was a big support to stocks, which bounced back after another weak first quarter. Housing continued its recovery, and employment and consumer spending advanced, albeit in an irregular manner. China and oil prices continued to stabilize after a very weak start to the year.
Bond prices continued to rise, with negative interest rates pulling down yields in the U.S. and countries with relatively higher rates. Additionally, the Federal Reserve seemed to acknowledge the “new normal” in its June meeting, when it revised significantly lower forecasts of GDP growth, inflation and the Federal Funds rate for the next few years. The U. S. dollar has continued to trade within a range which has persisted since early last year, adding to further clarity on the part of investors.
Brexit so far
The longer term impact of Brexit is still unknown, though some details are becoming clearer. Fortunately, the transition of power in the U. K. was quick and relatively uneventful. The new Prime Minister, Theresa May, has stated that the will of the people must be respected and will proceed with an orderly withdrawal from the European Union (E. U.).
As far as the U.S. is concerned, initial earnings reports from money center banks indicate that the Brexit problem is manageable, though British and European companies will be impacted more. Of greater concern is whether Brexit causes other E. U. members to leave. Right wing populists, particularly in France and Austria, have seized the opportunity to say that their countries should also leave. Unfortunately, the latest terrorist tragedy in Nice will also inflame anti-immigration advocates.
As we stated in our special Brexit report last month, any further departures from the E. U. would be greatly complicated because the remaining countries all use the Euro as their currency, a fact that kept Greece from leaving. The current situation does, however, put Germany, the chief E. U. member, in a quandary. Can it afford major concessions to other E. U. members to induce them to stay, or will the cost of further diluted economic growth eventually outweigh the benefits?
Yen headaches and a proposed remedy
As the negative interest rate policy instituted earlier this year backfired, Japan has struggled with the rising yen putting pressure on Japanese exports. The most recent elections, however, has strengthened Prime Minister Abe’s hand and a vigorous policy response is likely. Earlier this week, former Fed Chairman Bernanke travelled to Tokyo to discuss policy options with Japanese government officials. One option (originally conceptualized by economist Milton Friedman) concerns “helicopter money”, either a direct or indirect form of currency printing. The end result is that money ends up in the hands of consumers, who could then freely spend it without having to repay it. With all other policies falling short, this controversial proposal could be the remedy to stoke Japanese inflation, weaken the yen, and thus boost the economy. In Japan’s case, it is important that the consumers see the advantage of the non-taxable money and thus be more willing to spend it. Overall, the concept of helicopter money is gaining traction and has been predicted by such financial luminaries as Ray Dalio of Bridgewater Associates, Jeff Gundlach of DoubleLine Capital and Bill Gross of Janus to be eventually implemented by governments to increase inflation and economic activity.
The Rice Partnership’s investment outlook continues to focus on the American economy, which is likely to maintain its average growth pace between 2.0-2.2%.
- U. S. equities should do well, especially those with limited European exposure. In particular, small and midcap stocks should perform, as they have done since the February lows.
- Earnings headwinds such as oil and China are fading.
- Bonds may be overbought at this point. Much of the recent rally in yields was due to a convergence in global yields and not because of a significant slowdown in the U. S. economy. This global yield convergence has its limits, however, as volatility caused by exchange rates begins to outweigh the returns from this strategy. Also, negative interest rate policies may be frozen or abandoned if investors begin to hold cash instead of paying interest to borrowers.
Late yesterday, the United Kingdom voted to leave the European Union. Global financial markets had rallied earlier in the week on hopes that the British would vote “Remain” and thus provide more certainty to the future of the EU. As a result of the vote, global markets are sharply lower today. We offer the following observations and recommendations:
- Overall economic growth will likely be somewhat lower, with early estimates showing a 0.5% impact to global real Gross Domestic Product (GDP), as the disruptions from Brexit impact businesses, especially in the UK and in the Eurozone. The US economy will be less affected, as it conducts less trade with both entities.
- Fears of a global recession are likely overstated, similar to the January growth scare, which was prompted by the volatility of China and oil at the time. Both stabilized, eventually leading to a rally in equity markets.
- Major central banks are vigilant, and have already signaled willingness to provide adequate liquidity to lenders and other companies. Also, central banks have not run out of policy tools, as pessimists have contended. This last point will be expanded upon in our next market commentary, coming out early next month.
- The Brexit will likely take time to fully execute, with most economists estimating at least two years. While introducing uncertainty, the protracted timeframe will likely reduce any massive dislocations, both in the UK and in the EU.
- Brexit does introduce the possibility that more EU members may leave; however, the remaining European nations use the Euro as their currency, causing great complications if they would want to leave. The UK, on the other hand, has always used the Pound as their currency, making a divorce with the EU much easier to accomplish.
- The financial industry, especially in the US, is in much better condition that it was in 2008. Preliminary results from the latest “stress tests” show that the major banks have more than adequate capital in case of a major economic downturn or event, such as Lehman Brothers. A repeat of a financial crisis similar to that period is extremely unlikely.
- The longer term issue is really more of a political, rather than a financial nature. The major reason for the “Leave” vote was a concern over unbridled immigration and a loss in sovereignty. This message reverberates both on the Continent and in the US as well.
- The latest developments further postpone any Fed tightening, which should help stabilize the markets. There is now a significant chance of no Fed rate hikes this year.
- The trading range for the S&P 500 is still in place. As on numerous occasions over the past two years, selloffs have provided buying, rather than selling opportunities.
- Our portfolios are well diversified with numerous asset classes, including low correlation categories such as gold that offer a cushion against market selloffs. Additionally, the equity portion of portfolios is slanted towards defensive companies with most of their revenues in North America, especially in the US.
We recommend resisting the temptation to emotionally sell in this situation. Warren Buffett has commented repeatedly that it has been foolish to vote against the US and the American economy for the last 240 years, and it remains so. We agree, and still believe that the US is still in a long-term bull market in stocks, though the periodic episodes of volatility will continue.
“The stock market has forecast nine out of the last five recessions. “ — Paul Samuelson
Global equity markets opened 2016 with one of the worst starts on record, before rallying sharply in the last several weeks of the first quarter. Sentiment turned very pessimistic in January, with many investors concerned about a possible economic recession spreading from China and other emerging markets to the U. S. Oil and other commodity prices continued to fall.
Fortunately, the market’s worst fears failed to materialize as economic reports, particularly in the U.S., showed continued economic growth. In addition, a significant purchase of JP Morgan stock by CEO Jamie Dimon led to a sharp rally beginning in mid-February, with analysts realizing that bank stocks would not be as impacted as they had thought by bad energy loans. By the end of the quarter, most indices showed either modest gains or losses, similar to the result of last year.
Bond prices continued to confound forecasts, with yields in most countries falling as a result of slow growth and negative interest policies pursued by the European Central Bank and the Bank of Japan. Though the Treasury yield curve flattened slightly, yields past one-year maturities fell, with the 10-year Treasury yield down from 2.27% to 1.77%. The relief rally from the “Dimon Bottom” in equities soon spread to high yield and commodity prices, and then to the beleaguered emerging markets.
U.S. economic growth in the first quarter is seen to be weak, continuing a seasonal pattern experienced since the recovery began in 2009. The weather has again been a factor, though not the major one, with global weakness especially weighing on manufacturing.
Hopefully, the second quarter will play to script and rebound robustly, with continued improvement in the job market and bank lending as major factors. A more accommodating Federal Reserve will help, as Chair Janet Yellen has scaled back the pace of the anticipated increases in the Federal Funds Rate.
FIRST QUARTER TAKEAWAYS
At this point, the main question is whether the rally in financial assets will continue and evolve into a new leg higher for the bull market, or roll over and test the lower end of the trading range that began in mid-2014.
- We believe that the next major move will be on the upside, though that may take some time. Stock valuations are not excessive but also not cheap, and significantly higher equity prices will require earnings and revenue growth. Unfortunately, that is not likely until later in the year. In particular, earnings of energy companies are still under pressure, with oil still impacted from global oversupply.
- Hawaii’s economy should grow faster than the mainland, but it will feel the effects of the global slowdown. According to the University of Hawaii Economic Research Organization (UHERO), the state will grow at 3.2% in 2016 before slowing to 2.1% next year. The job market is tight, with the unemployment rate around 3%, led by a strong construction industry. However, any cooling in the luxury condominium market will moderate future gains in construction.
- Our investment outlook is unchanged. Investors should avoid getting too pessimistic, as we have experienced several sharp rallies over the last two years following steep declines. Negatives such as the global slowdown and a lackluster near term domestic earnings outlook are well known by now and should recede as the year progresses. Stocks are still attractively priced relative to bonds, even if expected returns going forward are 6-8% instead of the 9-10% returned historically.
“Now is the winter of our discontent, made glorious summer by this sun of York.”
— From Richard III, by William Shakespeare
Financial assets of all kinds had a difficult time in 2015. Little seemed to work, with equities, fixed income, and other alternative asset classes either little changed or down in a volatile year. Though some individual stocks did well, most did not, as the overriding themes of a weakening China – and emerging markets, in general – and plunging oil prices plus other commodities, as well – weighed on companies with direct or indirect exposure to either cause. Bond returns were also mixed, with most Treasuries and municipal bonds up slightly while high yield “junk” bonds performed poorly. The fourth quarter did feature a sharp rally in October, but there was no follow through. Though many seemed relieved that the Federal Reserve Bank finally stopped equivocating by raising interest rates in December, concern soon surfaced that the tightening would continue in 2016 amid weakening U. S. and global economies.
The New Year has begun with China and oil continuing to dominate investor psychology. There are things that need to occur before both negatives turn into positives – or at least move to neutral. For one, Chinese leaders need to regain the confidence of global investors by stabilizing their economy and currency. This will take time, and the Bank of China might assist the process by consulting resources such as the World Bank, International Monetary Fund and other central banks for advice. Genuinely pursuing needed reforms and removing subsidies to industries with excess capacity would also help. Since it is obvious now that the Saudis and other major petroleum producers will not cut their output, the oversupply will only go away when enough weak oil companies go out of business. Rather than an event, this will likely be a drawn out process lasting at least several months. The debt of many secondary companies is already trading at distressed levels.
The upshot to all this is that the first half of 2016 is likely to remain difficult, with relief coming later in the year. Chinese real GDP growth, although not in the 6.5-7% range that the government has predicted, will probably be in the 4-5% range. That will be considerably slower than it has been, but not recessionary. Keep in mind that China is an oil importer, so lower oil prices are a net positive for the economy, especially the consumer. Also, once enough excess supply is wrung out of the oil market, prices should finally stabilize, though few predict a rapid recovery. Even so, the fact that a bottom will have been reached should help repair market sentiment. Crucial to all this is the stance of the Fed, which seems to favor two to four more interest rate hikes this year. However, any additional weakness due to China, oil or the markets could slow U. S. growth to a level that keeps inflation from increasing back to the desired 2% rate, and force the Fed to delay any further rate increases until conditions improve.
We still believe U. S. stocks are in a longer term bull market because, even with growth likely to be moderate, our economy is nowhere near a recession. The economy is still producing jobs, housing is improving, consumers are still spending and the Treasury yield curve is positive. For 2016, U. S. GDP growth may average around 2-2.2%, a little slower but still in the same range that it has grown for the past five years. Though we continue to be cautious regarding energy and other commodities and remain underweighted regarding emerging markets, we also see opportunity in select consumer discretionary, information technology and industrial stocks. Once the negatives mentioned above are resolved, markets could rally substantially. The best market opportunities occur when extreme pessimism ignores positive economic fundamentals. We presently are approaching such an environment.
“I know you think you understand what you thought I said, but I’m not sure you realize that what you heard is not what I meant.”
— Alan Greenspan
In the third quarter, global financial assets endured their worst decline in four years. There were few safe havens, as commodities, stocks, and most currencies and bonds participated in the descent. As mentioned in our special report from September, the catalyst was China and the consequences spread to other emerging markets.
Though it is clear growth in China has slowed, concerns of a recession there are overblown. While most likely not growing at a 7% clip, China’s economy is still growing, led by an expanding service sector which is offsetting much of the softness in the manufacturing sector. This is also apparent in the China sales figures of multinationals, with consumer companies such as Nike seeing rapid growth while manufacturers such as Caterpillar reporting poor revenue results. What may have discomforted observers more, however, was a series of policy missteps by Beijing, including aiding the creation of a stock market bubble, backtracking on economic reforms and a surprise devaluation of the yuan. Even Federal Reserve Chair Janet Yellen sounded some doubt about China when she remarked about the “deftness in which [China’s] policy makers were addressing those [economic] concerns.”
The Fed itself was not without fault, as investors grew frustrated over its equivocation on the timing of the first interest rate increase since 2006. After signaling at the beginning of summer a September increase, Fed officials voted to leave rates unchanged, citing global weakness as a major factor and causing some economists to cynically remark that the Fed now has a triple mandate, i.e. to control employment, inflation and the global markets. However, the markets subsequently have begun to regain confidence with the Fed, as Yellen’s caution is proving correct with the latest two employment reports showing moderation in job growth. Meanwhile, problems at firms such as Glencore, the commodities conglomerate, or Petrobras, the Brazilian controlled oil company, remain but have receded in recent days.
Keys to a turnaround in the markets include signs of stabilization in Chinese manufacturing and in commodities, particularly oil. Though fumbling with its policy responses lately, China is a “command economy,” with its government more able to directly influence its economic performance and steady the situation than in developed countries. U. S. petroleum production has been falling since April and recent Middle East unrest, especially with Russian intervention in Syria, may finally indicate a bottom for oil prices.
U. S. economic gains will be affected somewhat by these events, with an inventory drawdown also contributing to moderate expansion. Current estimates for third quarter GDP growth are settling in the 1.5-2% range, with manufacturing and exports feeling the brunt of the slowdown. The job market is still improving, though at a more tempered pace. Also, markedly lower gasoline prices are helping consumer spending, which equates to approximately 70% of our economy. A pickup in housing is also helping mitigate the effect of foreign economic weakness.
The Hawaii economy continues to expand and now has the third lowest unemployment rate in the country. Conditions may moderate here as well due to the stronger U. S. dollar impacting tourism and trade. Fortunately, the islands have so far avoided any major storms from the strong El Nino weather phenomenon that has occurred this year and which could directly and adversely affect us.
We are constructive on the outlook for U. S. equities, as the recent correction has removed pockets of speculation, especially among the smaller biotechs. The overall valuation of the market is reasonable. Concerns about profit growth are overstated, as the Fed’s report for corporate income is actually improving, with lower oil prices impacting the energy sector and masking improvement elsewhere. Domestically oriented consumer stocks should show good profit gains. Bond yields are likely to trade in a tight range, with the prospects for a 2015 rate hike by the Fed receding with each soft economic report. Developed, rather than emerging countries remain our choice among foreign markets.