@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital
The U.S. equity markets experienced a modest pullback in August, with a -2.9% decline in the S&P 500 Index, fueled by concern over the anticipated Fed tapering of asset purchases as well as a U.S.-led military strike on Syria. However, the index is still up +16.2% through August, the best start since 2003.
International equity markets fared better than U.S. markets in August despite the headwind of a stronger U.S. dollar. So far this year, the return of developed international equities has been about half of the S&P 500 return while emerging market equities have declined -8.8%. Both Brazil and India have experienced declines of more than -20.0%, suffering from significantly weaker currencies and slowing growth.
Fixed income outperformed equities in August on a relative basis, but the Barclays Aggregate Index still fell -0.5%. Interest rates continued their move higher, and the yield curve steepened further. The yield on the 10-year U.S. Treasury note has increased 140 basis points from a low of 1.6% in early May, to 3% on September 5, fueled by the Fed’s talk of tapering asset purchases. The technicals in the fixed income market have deteriorated markedly. The rise in rates has not yet lost momentum, and investor sentiment has turned, causing large redemptions in fixed income strategies. Our portfolios remain positioned in defense of rising interest rates, with a shorter duration, emphasis on spread product and a healthy allocation to low volatility absolute return strategies.
Interest rates are normalizing from artificially low levels, but still remain low on a historical basis. Despite slowing or ending asset purchases, the Fed has signaled short-term rates will be on hold for some time. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome. In addition, the fundamentals in certain areas of fixed income strategies, including non-Agency MBS, high-yield credit and emerging-market credit, look attractive.
However, we continue to view a continued rapid rise in interest rates as one of the biggest threats to the U.S. economic recovery. The recovery in the housing market, in both activity and prices, has been a positive contributor to growth this year. Stable, and potentially rising, home prices help to boost consumer confidence and net worth, which impacts consumer spending in other areas of the economy. Should mortgage rates to move high enough to stall the housing market recovery, it would be a negative for economic growth.
Outside of the housing market, the U.S. economy continues to grow at a modest pace. Initial jobless claims, a leading indicator, have continued to decline. Both the manufacturing and service PMIs have moved further into expansion territory. U.S. companies remain in solid shape and valuations do not appear stretched. M&A activity has picked up. Global economic growth is also showing signs of improvement, in Europe, Japan and even China.
However, risks do remain. In addition to the major risk of interest rates that move too high too fast, the markets are anticipating the end of the Fed’s quantitative easing program. Should the Fed follow through in reducing monetary policy accommodation, it will do so in the context of an improving economy. Washington will again provide volatility generating headlines as we approach deadlines for the budget and debt ceiling negotiations. However, unlike in previous years, there is no significant fiscal drag to be addressed. In addition, the nomination of a new Fed Chairman and geopolitical risks (Syria) are of concern. The market may have already priced in some of these risks.
Risk assets should do well if real growth continues to recover despite the higher interest rate environment; however, we expect continued volatility in the near term. As a result, in our strategic portfolios we remain slightly overweight to risk. We continue to seek high conviction opportunities and strategies within asset classes.
Some areas of opportunity currently include:
- Domestic Equity: favor U.S. over international, financial healing (housing, autos), dividend growers
- International Equity: frontier markets, Japan, micro-cap
- Fixed Income: non-Agency mortgage backed securities, short duration, emerging market corporates, global high yield and distressed
- Real Assets: REIT Preferreds
- Absolute Return: relative value, long/short credit, closed-end funds
- Private Equity: company specific opportunities