Monthly Markets Memo - July 2015
Equity Markets Perspective
The global equity investor fared well for the first half of the year but recent developments have caused the markets to become more volatile. Initially, markets became unsettled due to the news that came out of Europe when Greece demanded a change in debt structure with its creditors. We then watched as the local Chinese equity markets took a tumble, dropping over a third of its market value from June 12th to July 8th. As I am writing this, the urgency around Greece’s debt issue has been addressed though it doesn’t appear that this will be a long term solution.
As we examine what has been happening in Greece, it has at times seemed frustrating that such a small country has consumed so much attention and that it has had such an effect on global markets. It is times like these that we are reminded that while our financial markets may in name may be regional (i.e. U.S., Europe, Emerging etc.) they are affected by things going on around the globe. In this case, every time it is reported that Greece may not be able or willing to pay back its creditors the possibility that the country will exit the EU (European Union) grows. This then opens up the possibility that the Euro area as a monetary union may not work over the long term in the absence of a much closer political and fiscal union. It is times like these that I am appreciative that I live in the U.S. which has not only a monetary union but is a united nation with a common identity and purpose as well. However, since we are global investors we must work with these and other types of issues as we invest outside of the U.S. Since these issues usually provide additional risks to our portfolios we look for opportunities to invest in ways that may reduce some of the volatility that comes along with those risks. We use strategies such as structured notes, global convertible bond funds and other ‘less than equity market beta’ strategies as part of our overall investment plan for many of our clients’ accounts where feasible.
Readers of last month’s ‘Markets Memo’ may remember that I spoke about the fact that the Chinese equity markets had some divergent valuation characteristics as a result of the huge local equity market gains. I stated that many of the smaller (less established) companies were trading in ‘bubble territory’ while the larger and more profitable companies were trading cheaply. The markets have since gone through some significant pull back. In fact the markets draw down was so significant that the Chinese government has intervened and many of the high valuation equities were stopped from even trading.
It is certainly disconcerting to see the amount of volatility that occurred not only in these areas but across the globe due to the amount of uncertainty in these markets. However, it is always important to step back and take a look at the bigger picture when the financial headlines make you want to ‘head for the hills’. It should be noted that companies within these markets are not widely held among investors outside of their countries. Another factor to consider is that only about 7% of the Chinese population own equities in these companies so while China represents a large portion of the global economy, the average investors will be little affected.
The next major event that could cause volatility in both the bond and equity markets is the potential change in interest rates. We have been told by the head of the U.S. central bank, Janet Yellen, that she expects that they will raise interest rates this year. If it seems like a long time since the Federal Reserve began a rate-tightening cycle that’s because it has been. The last time was actually back on 6/30/04. It is interesting to note that in the 1st month following that hike, the S&P 500 fell 3.3%, though in the 6 months following the index gained 7.2%. It is of course impossible to know for sure how the markets will respond once the ‘hiking process’ begins. A case could be made that the equity markets may become more volatile since valuations are stretched higher than they normally are when interest rates begin climbing. In addition the S&P 500 has gone almost 1,400 calendar days (i.e., from 10/03/11 through June, 2015) without a 10% or greater drop in the index which is the 3rd longest stretch without a double-digit pullback in the last 50 years. A case can be made though that things may go fairly smooth since the economy is moving along, corporate profits are still good and the consumer’s balance sheet and debt to income are in good shape. At this point we are not changing our stance that maintaining an overweight to the equity markets is still the best plan. If we do have to experience some volatility due to interest rate changes we believe it will be relatively short term in nature given the above mentioned positive dynamics.
We are not constructive on many areas of the bond market though, especially bonds that have high interest rate sensitivity such as government bonds. Interestingly, it appears that many investors may have not picked the right investments during the years since the crisis. The bond mutual funds have received net inflows every year except one (2013) since 2008 while the U.S. equity mutual funds have seen inflows for only one year (2013) since the crisis (2008). During this time, the major equity market indexes produced double digit returns while a conservative bond index (AGG) produced low single digit returns.
“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” John Maynard Keynes
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies are revealed, this post is not intended nor does it reflect transactions within any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from accurate sources but is not warranted to be correct, complete or accurate. Statistical data has been obtained from sources including www.bea.gov,www.bls.gov and www.morningstar.com.