Monthly Market and Economic Outlook: August 2014

Amy MagnottaAmy Magnotta, CFASenior Investment Manager, Brinker Capital

After pushing higher for most of July, the U.S. equity markets fell -2% on the last day to end the month in the red. Continued geopolitical concerns, a debt default in Argentina and a higher than expected reading on the Employment Cost Index could have provided a catalyst for the sell-off. Investor sentiment levels were elevated in July, so it is not surprising to have any bad news lead to a short-term pull-back in the equity markets. However, we believe equity markets are biased upward over the next six to twelve months and further weakness could be a buying opportunity.

U.S. small cap stocks have significantly lagged large caps so far this year. In July the small cap Russell 2000 Index declined -6.1%. The Russell 2000 is down -3.1% for the year-to-date period, compared to the +5.5% gain for the Russell 1000 Index. From a style perspective, value lagged growth in July but remains solidly ahead for the year-to-date period.

Developed Europe significantly lagged the U.S. equity markets in July, but Japan was able to deliver a positive return. Emerging markets continued their rally in July, gaining +2.0% for the month. Emerging markets have gained +8.5% through the first seven months of the year, well ahead of developed markets. Countries that struggled in 2013 due to the Fed’s taper talk, like India and Indonesia, have been very strong performers, while negative performance in Russia has weighed on the complex. The U.S. dollar has shown recent strength versus both developed and emerging market currencies.

New York Stock ExchangeU.S. Treasury yields edged slightly higher in July. The 10-year yield has fallen 56 basis points from where it began the year (as of 8/7/14), while the 2-year part of the yield curve has moved up eight basis points. As a result, the yield curve has flattened between the 10-year and 2-year tenors; however, it remains steep relative to history. While sluggish economic growth and geopolitical risks could be keeping a ceiling on U.S. rates, relative value could also be a factor. A 2.4% yield on a 10-year U.S. Treasury looks attractive relative to a 0.5% yield on 10-year Japanese government bonds, a 1.1% yield on 10-year German bonds, and a 2.6% yield on Spanish 10-year sovereign debt.

All taxable fixed income sectors were flat to slightly negative on the month. High yield fared the worst, declining -1.3% as spreads widened 50 basis points. Municipal bonds were slightly positive for the month and continue to benefit from a positive technical backdrop with strong demand for tax-free income being met with a lack of new issuance.

We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds, with a number of factors supporting the economy and markets over the intermediate term.

  • Global monetary policy remains accommodative: Even with quantitative easing slated to end in the fall, U.S. short-term interest rates should remain near-zero until 2015 if inflation remains contained. The ECB and the Bank of Japan are continuing their monetary easing programs.
  • Global growth stable: U.S. growth rebounded in the second quarter. Outside of the U.S., growth has not been very robust, but it is still positive.
  • Labor market progress: The recovery in the labor market has been slow but steady. The unemployment rate has fallen to 6.2% and jobless claims have fallen to new lows.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash. M&A deal activity has picked up this year. Corporate profits remain at high levels and margins have been resilient.
  • Less drag from Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year. Fiscal drag will not have a major impact on growth in 2014, and the budget deficit has also declined significantly.

Risks facing the economy and markets remain, including:

  • Fed Tapering/Tightening: If the Fed continues at the current pace, quantitative easing will end in the fall. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, this withdrawal is more gradual and the economy appears to be on more solid footing this time. Should inflation pick up, market participants will shift quickly to concern over the timing of the Fed’s first interest rate hike. Despite the recent uptick in the CPI, the core Personal Consumption Expenditure Price (PCE) Index, the Fed’s preferred inflation measure, is up only +1.5% over the last 12 months.
  • Election Year/Seasonality: While we noted there has been some progress in Washington, we could see market volatility pick up later this year in response to the mid-term elections. In addition, August and September tend to be weaker months for the equity markets.
  • Geopolitical Risks: The events in the Middle East and Russia could have a transitory impact on markets.

Risk assets should continue to perform over the intermediate term as we expect continued economic growth; however, we could see increased volatility and a shallow correction as markets digest the end of the Federal Reserve’s quantitative easing program. Economic data, especially inflation data, will be watched closely for signs that could lead the Fed to tighten monetary policy earlier than expected. Equity market valuations look elevated, but not overly rich relative to history, and maybe even reasonable when considering the level of interest rates and inflation. Investor sentiment, while down from excessive optimism territory, is still elevated, but the market trend remains positive. In addition, credit conditions still provide a positive backdrop for the markets.

Asset Class Outlook

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Source: Brinker Capital

Brinker Capital, Inc., a Registered Investment Advisor. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index

An End to Complacency

Joe PreisserJoe Preisser, Portfolio Specialist, Brinker Capital

Volatility abruptly made an entrance onto the global stage, shoving aside the complacency that has reigned over the world’s equity markets this year as they have marched steadily from record high to record high. Asset prices were driven sharply lower last week, as gathering concerns that the Federal Reserve Bank of the United States may be closer than anticipated to raising interest rates, combined with increasing worries about the possibility of deflation in the Eurozone, and a default by the nation of Argentina, to weigh heavily on investor sentiment. The selling seen across equity markets last Thursday was particularly emphatic, with declining stocks listed on the NYSE outpacing those advancing by a ratio of 10:1, and the Chicago Board Options Exchange Volatility Index (VIX), which measures expected market volatility, climbing 25% to its highest point in four months, all combining to erase the entirety of the gains in the Dow Jones Industrial Average for the year.

Preisser_Complacency_8.4.14The looming specter of the termination of the Federal Reserve’s bond-buying program, which is scheduled for October, is beginning to cast its shadow over the marketplace as this impending reality, coupled with fears that the Central Bank will be forced to raise interest rates earlier than expected, has served to raise concerns. Evidence of this could be found last Wednesday, where, on a day that saw a report of Gross Domestic Product in the United States that far exceeded expectations, growing last quarter at an annualized pace of 4%, vs. the 2.1% contraction seen during the first three months of the year, and a policy statement from the Federal Reserve which relayed that, “short-term rates will stay low for a considerable time after the asset purchase program ends” (Wall Street Journal) equity markets could only muster a tepid response. It was the dissenting voice of Philadelphia Fed President, Charles Plosser who opined that, “the guidance on interest rates wasn’t appropriate given the considerable economic progress officials had already witnessed” (Wall Street Journal), which seemed to resonate the loudest among investors, giving them pause that this may be a signal of deeper differences beginning to emerge within the Federal Open Market Committee. Concern was further heightened on Thursday morning of last week, when a report of the Employment Cost Index revealed an unexpected increase to 0.7% for the second quarter vs. a 0.3% rise for the first quarter (New York Times), which stoked nascent fears of inflation, bolstering the case for the possibility of a more rapid increase in rates.

Negative sentiment weighed heavily on equity markets outside of the U.S. as well last week, as the possibility of deflationary pressures taking hold across the nations of Europe’s Monetary Union, combined with ongoing concerns over the situation in Ukraine and the second default in thirteen years by Argentina on its debt to unsettle market participants. According to the Wall Street Journal, “Euro-zone inflation increased at an annual rate of just 0.4% in July, having risen by 0.5% the month before. In July 2013 the rate was 1.6%” While a fall in prices certainly can be beneficial to consumers, it is when a negative spiral occurs, as a result of a steep decline, to the point where consumption is constrained, that it becomes problematic. Once these forces begin to take hold, it can be quite difficult to reverse them, which explains the concern it is currently generating among investors. The continued uncertainty around the fallout from the latest round of sanctions imposed on Russia, as a result of the ongoing conflict in Ukraine, further undermined confidence in stocks listed across the Continent and contributed to the selling pressure.

ArgentinaInto this myriad of challenges facing the global marketplace came news of a default by Argentina, after the country missed a $539 interest payment, marking the second time in thirteen years they have failed to honor portions of their sovereign debt obligations. The head of research at Banctrust & Co. was quoted by Bloomberg News, “the full consequences of default are not predictable, but they certainly are not positive. The economy, already headed for its first annual contraction since 2002 with inflation estimated at 40 percent, will suffer in a default scenario as Argentines scrambling for dollars cause the peso to weaken and activity to slump.”

With all of the uncertainty currently swirling in these, “dog days of summer,” it is possible that the declines we have seen of late may be emblematic of an increase in volatility in the weeks to come as we move ever closer to the fall, and the terminus of the Fed’s asset purchases.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Holdings are subject to change.

Update on Impact of Russia/Ukraine Conflict on Financial Markets

QuintStuart P. Quint, CFA, Senior Investment Manager and International Strategist

A past blog in March had commented on several scenarios of how the unrest in Ukraine could play out and the potential implications of those scenarios on financial assets.  Given the crash of the Malaysian airliner over Ukraine, an update seems appropriate.

We remain of the view that the conflict in Ukraine should have a limited impact but likely a longer timeframe to play out, potentially with risks to the downside.  Downside risks would materialize in the event of an overt Russian invasion or further separatist activity in other parts of Ukraine.

We mentioned 3 areas of potential impact: (1) fixed income, (2) commodity prices (particularly energy), and (3) emerging markets.  European equities could also be affected if tensions were to spiral and/or more serious economic sanctions were taken.

Fixed income (as measured by the Barclay’s Aggregate Total Return Index) has rallied nearly 2% since that time.  One factor in the continued rally might stem from risk aversion driven by geopolitical tensions.  However, fixed income has lagged the rally in riskier asset classes such as domestic and international equities.

Energy has staged a modest gain from March to July in spite of ongoing tensions between Russia and Ukraine.  This modest impact comes in spite of not only Russian tension, but also ethnic tensions in Israel and Iraq, also a major oil producer.  Energy markets have been complacent about rising supply sources from elsewhere, including the United States, along with muted demand from many emerging markets and Europe.  Any increase in political tensions along with improved economic growth in the US and more energy-intensive emerging markets could presage an increase in energy prices.

Gold, another traditional safe harbor asset, has actually declined over -2% over this time period.

Emerging market equities have rallied strongly (over +12% during this time period), though Russian equities lagged this gain.  Select continental European equity markets such as Germany and France have been flat and lagged performance of other equity markets, suggesting a slight negative impact from uncertainty in Ukraine.

Barring a major spiraling in tensions, we would expect economic and market fundamentals to be the overwhelming drivers of asset performance rather than geopolitical tensions out of Ukraine.

 

Monthly Market and Economic Outlook: April 2014

Amy MagnottaAmy Magnotta, CFA, Senior Investment Manager, Brinker Capital

The full quarter returns masked the volatility risk assets experienced during the first three months of the year. Markets were able to shrug off geopolitical risks stemming from Russia and the Ukraine, fears of slowing economic growth in the U.S. and China, and a transition in Federal Reserve leadership. In a reversal of what we experienced in 2013, fixed income, commodities and REITs led global equities.

The U.S. equity market recovered from the mild drawdown in January to end the quarter with a modest gain. S&P sector performance was all over the map, with utilities (+10.1%) and healthcare (+5.8%) outperforming and consumer discretionary (-2.9%) and industrials (+0.1%) lagging. U.S. equity market leadership shifted in March. The higher growth-Magnotta_Market_Update_4.10.14momentum stocks that were top performers in 2013, particularly biotech and internet companies, sold off meaningfully while value-oriented and dividend-paying companies posted gains. Leadership by market capitalization also shifted as small caps fell behind large caps.

International developed equities lagged the U.S. markets for the quarter; however, emerging market equities were also the beneficiary of a shift in investor sentiment in March. The asset class gained more than 5% in the final week to end the quarter relatively flat (-0.4%). Performance has been very mixed, with a strong rebound in Latin America, but with Russia and China still weak. This variation in performance and fundamentals argues for active management in the asset class. Valuations in emerging markets have become more attractive relative to developed markets, but risks remain which call into question the sustainability of the rally.

After posting a negative return in 2013, fixed income rallied in the first quarter. The yield on the 10-year U.S. Treasury note fell 35 basis points to end the quarter at 2.69% as fears of higher growth and inflation did not materialize. After the initial decline from the 3% level in January, the 10-year note spent the remainder of the quarter within a tight range. All fixed income sectors were positive for the quarter, with credit leading. Both investment-grade and high-yield credit spreads continued to grind tighter throughout the quarter. Within the U.S. credit sector, fundamentals are solid and the supply/demand dynamic is favorable, but valuations are elevated, especially in the investment grade space. We favor an actively managed best ideas strategy in high yield today, rather than broad market exposure.

While we believe that the long-term bias is for interest rates to move higher, the move will be protracted. Fixed income still plays an important role in portfolios as protection against equity market volatility. Our fixed income positioning in portfolios—which includes an emphasis on yield-advantaged, shorter-duration and low-volatility absolute return strategies—is designed to successfully navigate a rising or stable interest rate environment.

Magnotta_Market_Update_4.10.14_2We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we begin the second quarter, with a number of factors supporting the economy and markets over the intermediate term.

  • Global monetary policy remains accommodative: Even with the Fed tapering asset purchases, short-term interest rates should remain near zero until 2015. In addition, the ECB stands ready to provide support if necessary, and the Bank of Japan continues its aggressive monetary easing program.
  • Global growth stable: U.S. economic growth has been slow and steady. While the weather appears to have had a negative impact on growth during the first quarter, we still see pent-up demand in cyclical sectors like housing and capital goods. Outside of the U.S. growth has not been very robust, but it is still positive.
  • Labor market progress: The recovery in the labor market has been slow, but we have continued to add jobs. The unemployment rate has fallen to 6.7%.
  • Inflation tame: With the CPI increasing just +1.1% over the last 12 months and core CPI running at +1.6%, inflation is below the Fed’s 2% target. Inflation expectations are also tame, providing the Fed flexibility to remain accommodative.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets with cash that could be reinvested, used for acquisitions, or returned to shareholders. Corporate profits remain at high levels, and margins have been resilient.
  • Less drag from Washington: After serving as a major uncertainty over the last few years, there has been some movement in Washington. Fiscal drag will not have a major impact on growth this year. Congress agreed to both a budget and the extension of the debt ceiling. The deficit has also shown improvement in the short term.
  • Equity fund flows turned positive: Continued inflows would provide further support to the equity markets.

However, risks facing the economy and markets remain, including:

  • Fed tapering/tightening: If the Fed continues at its current pace, quantitative easing should end in the fourth quarter. Historically, risk assets have reacted negatively when monetary stimulus has been withdrawn; however, this withdrawal is more gradual, and the economy appears to be on more solid footing this time. Should economic growth and inflation pick up, market participants may become more concerned about the timing of the Fed’s first interest rate hike.
  • Significantly higher interest rates: Rates moving significantly higher from current levels could stifle the economic recovery. Should mortgage rates move higher, it could jeopardize the recovery in the housing market.
  • Emerging markets: Slower growth and capital outflows could continue to weigh on emerging markets. While growth in China is slowing, there is not yet evidence of a hard landing.
  • Geopolitical Risks: The events surrounding Russia and Ukraine are further evidence that geopolitical risks cannot be ignored.

Risk assets should continue to perform if real growth continues to recover; however, we could see volatility as markets digest the continued withdrawal of stimulus by the Federal Reserve. Economic data will be watched closely for signs that could lead to tighter monetary policy earlier than expected. Valuations have certainly moved higher, but are not overly rich relative to history, and may even be reasonable when considering the level of interest rates and inflation. Credit conditions still provide a positive backdrop for the markets.

Magnotta_Market_Update_4.10.14_3

Source: Brinker Capital

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high-conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Data points above compiled from FactSet, Standard & Poor’s, MSCI, and Barclays. The views expressed are those of Brinker Capital and are for informational purposes only. Holdings subject to change.

Investment Insights Podcast – Unrest in Ukraine and Investment Implications

Stuart Quint, Investment Insights PodcastStuart P. Quint, CFA, Senior Investment Manager and International Strategist

Stuart joins us this week to share some comments on the developing situation in Ukraine and its impact on investors.  Click the play button below to listen in to his podcast, or read a summarized version of his thoughts below.

Podcast recorded March 3, 2014:

Ukraine’s struggles are overwhelming. Political, economic, and now military challenges confront the country. Politically and militarily speaking, the U.S. and the European Union (EU) have few tools at this time and modest willpower to oppose Russian intentions in Ukraine. And given that the ruling government is merely a caretaker for the May elections, it seems unlikely there will be a bailout package offered by the International Money Fund (IMF) any time soon. Default on existing international and local obligations appears likely in the near term.

Russia is not without its own constraints, though, as the Russian economy is directly tied to Europe. Three out of every four dollars of foreign direct investment in Russia come from Europe.[1]  The EU also remains Russia’s most important trading partner with 55% of Russian exports destined for Europe.[2]

Let’s take a look at the potential scenarios: (1) Russian annexation of the Crimea, (2) negotiated settlement with later elections that would most likely bring about a grand coalition government, probably with leanings toward Moscow, and (3) military escalation (civil war, Russian forces occupy eastern Ukraine, either of which results in a smaller Ukraine or outright disintegration as a sovereign state).

So what investment implications might this have? (1) The near term is helpful for fixed income, with commodities benefiting from any disruption of supply (oil, gas) and flight to safety (gold), and (2) negative impact most of all for European (Russia supplies 30% of European gas supply[3]) and emerging markets (mainly Russia, but also other markets with the need to import capital could suffer from currency weakness and higher interest rates demanded by investors).

A negotiated settlement involving recognition of Russian claims in exchange for a roadmap to stabilize the rest of Ukraine would reverse many of these trends.  Indeed, a similar situation occurred when Russia invaded Georgia in August 2008, but the crisis in Ukraine has potentially more serious implications given its proximity to Western Europe and that it carries a large population of over 45 million people.[4]

The views expressed are those of Brinker Capital and are for informational purposes only. Holdings are subject to change.

Quagmire

Joe PreisserJoe Preisser, Portfolio Specialist, Brinker Capital

The drums of war, which resounded so strongly from our nation’s Capital during the past few weeks, have quickly been muffled by the possibility of a relinquishment of the Syrian government’s chemical weapons stockpile to an international force.  The hastily, cobbled-together diplomatic effort led by the Russian government is dangerously scant on detail, but has offered, as German Chancellor Angela Merkel observed on Wednesday, “a small glimmer of hope” that these weapons of mass destruction can be seized peacefully (New York Times). The delay, and possible aversion of a military strike by the United States, brought about by this development has temporarily allayed tensions around the world and added strength to the current rally that has brought equities in the United States back within sight of the historic heights reached earlier this year.

9.13.13_Pressier_Quagmire_2The long march of the United States back toward armed conflict in yet another nation in the Middle East began with Secretary of State, John Kerry’s emphatic denunciation of the heinous chemical weapons attack perpetrated by the Syrian Government on August 21, which killed an estimated 1,429 people including at least 426 children (New York Times).  Mr. Kerry was quoted as saying, “the indiscriminate slaughter of civilians, the killing of women and children and innocent bystanders by chemical weapons is a moral obscenity…And there is a reason why no matter what you believe about Syria, all peoples and all nations who believe in the cause of our common humanity must stand up to assure that there is accountability for the use of chemical weapons so that it never happens again” (Wall Street Journal). The possibility of American intervention sparked a precipitous decline in stocks listed around the world, with those in the emerging markets having been sold particularly aggressively, as fears of a spillover into a broader regional conflict containing the potential to disrupt the price of crude oil, weighed on investors.

The unprecedented vote by the British Parliament on August 29 to decline the government’s request for an authorization of military force (Telegraph U.K.), began a tentative rebound in global equities, which was furthered by President Obama’s decision on August 31 to seek Congressional approval before embarking on an attack, as both decisions led to the ebbing of worries about any immediate action.  The recent emergence of the potential diplomatic solution to the crisis in Syria, brokered by Russia, has provided further fuel to the reversal in indices around the globe, as concerns of the unintended negative consequences which surround any military conflict have, for the time being, abated.

Chart representing MSCI Emerging Markets Index.

Chart representing MSCI Emerging Markets Index.

Though the President has requested that Congress delay any vote related to the authorization of force until this avenue of diplomacy is fully explored, the potential for United States military action lurks in the shadows and may have in fact been strengthened by this development.  Democratic Whip, Steny Hoyer of Maryland commented on the potential failure of Russia’s endeavor to Bloomberg News, “People would say, well, he went the extra mile…He took the diplomatic course that people had been urging him to take—and it didn’t work.  And therefore under those circumstances, the only option available to us to preclude the further use of chemical weapons and to try to deter and degrade Syria’s ability to use them is to act.”

The suffering in Syria, where the United Nations estimates the death toll to be in excess of 100,000 lives, with half of those lost being civilians and an untold number of injured and displaced, is a tragedy of unfathomable depth.  The fact that it has taken the use of some of the most hideous weapons on Earth to spur the international community to action in an effort to stop the slaughter is deeply regrettable, however it has brought with it the promise of an end to the conflict now in its third year.  Although a diplomatic solution is certainly preferable to military action, if the current negotiations fail to bring Bashar al-Assad’s store of chemical weapons, which is the largest active stockpile in the world, (Wall Street Journal), under international control, the use of force will be a necessary recourse, as the killing of innocents must be stopped.

9.13.13_Pressier_Quagmire_3It’s easy … to say that we really have no interests in who lives in this or that valley in Bosnia, or who owns a strip of brushland in the Horn of Africa, or some piece of parched earth by the Jordan River. But the true measure of our interests lies not in how small or distant these places are, or in whether we have trouble pronouncing their names. The question we must ask is, what are the consequences to our security of letting conflicts fester and spread. We cannot, indeed, we should not, do everything or be everywhere. But where our values and our interests are at stake, and where we can make a difference, we must be prepared to do so.” –William Jefferson Clinton

The views expressed above are those of Brinker Capital and are not intended as investment advice.