Monthly Markets Memo - June 2015
Equity Markets Perspective
The S&P 500 index has moved forward a little over 3% while the international markets have fared better with many international markets moving up over 5% so far for the year. We think this may be just the beginning of international markets outperforming the U.S. markets for the next few years.
The U.S. equity performance has been largely much better than the international markets over the last five years at least partly due to the aggressive monetary policies by the U.S. central bank. Given that the FED is taking a less aggressive stance moving forward while many of the other major central banks such as Japan, Europe and China are becoming more accommodative, is one reason why we think the international markets will fare better in the years to come.
To add further support that it seems reasonable to think that the international equity markets will fare better is that investors are paying a relatively high price for the earnings that the companies in the U.S. are producing. While we are still comfortable holding U.S. equities due to corporate and U.S. consumer balance sheets as well as a solid (though far from spectacular) economy, there is less room for error priced into these equities. Another reason though that U.S. Corporations may be hindered to grow their earnings is that they are already at (or near) record profit margins while many companies outside the U.S. have more room to improve. For instance, operating margins in Europe were lower in 2014 than they have been on average over the last 10 years. As the European economy improves though, these companies have opportunity to grow their margins since they will be able to benefit from economies of scale (allowing costs to grow minimally while revenues grow at a faster pace.) In addition, many of these companies are trading at lower valuations than their U.S. counterparts.
Stocks listed on the Chinese A share markets, which previously offered limited availability to foreign investors, have been ‘on a tear’ gaining over 50% through May. Given the high returns in the market from last year and this year, many of the valuations appear to be in ‘bubble territory’. Seventeen hundred of the approximately twenty-three hundred companies in the A share markets have valuations of over 50 times earnings, with many in excess of over 100 times. However, these companies mainly represent the less established (smaller) corporations while many of the large mega-cap companies such as the banks trade for more reasonable if not at cheap valuations (i.e. some banks at 6 times earnings). One reason for the significant divergence of valuations is that the Chinese government has shifted emphasis from a capital investment economy to one that is focused on getting the Chinese consumer to play a much bigger part of the economy. These smaller companies are more apt to serve the Chinese consumer and many Chinese investors have shown that they are willing to take increased risk in these companies for more speculative gains.
Interest Rates Perspective
Volatility has picked up from historically low levels in the bond market as bond investors appear to be preparing for a FED liftoff later this year. Spokesmen from both the Federal Reserve and the IMF (International Monetary Fund) have warned of the potential for more volatility to come. Given the impaired liquidity (primarily caused by the Central Bank’s QE program) and the still extremely low interest rates, fixed income investors could get nervous fast. Given this dynamic we continue to believe that many of the bond funds offer mediocre to poor risk/reward opportunities.
U.S. Economy Perspective
The economy for the first four months of the year appears to be ‘spotty’ at best, but May has given us some improving activity including the real estate market. It seems likely that the activity could continue to pick up since commercial and industrial loans rose 8.5% in the first quarter. Construction employment continued to trend up over the month (+17,000) and has increased by 273,000 over the past year. Overall, total nonfarm payroll employment rose by 280,000 in May, compared with an average monthly gain of 251,000 over the prior 12 months. Also over the past 12 months, the number of long-term unemployed is down by 849,000.
We anticipate that greater opportunity will lie in the international equity markets than in the U.S. however, we do not anticipate that the ‘ride’ will be as smooth. There are simply more challenges that Europe, Japan and China have to overcome than U.S. markets have had to deal with. Europe has the difficulty of getting a group of countries to agree on certain issues including governmental and corporate reform. In addition, there are plenty of headline and other risk around the potential of Greece defaulting and/or exiting the Euro as a currency. In Japan, they have their own need for significant reform among many companies in order to grow in their competitiveness in the world economy. China’s attempt to transition from a capital investment economy to one that is reliant on the consumer has made progress but it is doubtful that it will be fully accomplished without mistakes and difficulties along the way.
"What monetary policy can do is create the basis for growth. But for growth to pick up, you need investment; for investment, you need confidence; and for confidence, you need structural reform.” - Mario Draghi, European Central Bank President
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.