The year started with uncertainty and heightened volatility across most asset classes. For the quarter, the stock market volatility subsided a bit and returns remained mostly positive. Volatility did pick at the end of second quarter, which was punctuated by the “Brexit” vote, where the UK elected to leave the EU. Polls were mixed throughout the quarter, generally leaning in the direction of the “remain” vote. The decision to leave the EU was marked by skepticism about Europe-wide policy making and regulatory intervention, along with a surge in immigration and the resulting nationalism. The UK Prime Minister, David Cameron favored continued membership in the EU, and quickly resigned when the vote went against his position. The resignation, along with the uncertainty created by the Brexit vote, created heightened volatility at the end of June. The UK exit from the EU will likely be a long and uncertain process, but the impact on the US economy should be negligible. The other factor that continues to contribute to uncertainty is the Federal Reserve’s timing around interest rate hikes.
In our last letter, we highlighted how we were cautiously optimistic about the markets, with our indicators leaning more bullish than bearish. This contrarian view was and continues to be counter to most other advisors and asset managers, who are much more bearish and susceptible to being influenced by headline risk. Although news and big developments are of concern, we try to stay above the noise and focus on the data and the prices of the assets we own and monitor. Again, going into Q3 2016, we see a more bullish outlook than most. We are continuing to use this volatility to add good stocks that exhibit the qualities we favor.
Stock Market Review. For the quarter, the S&P 500 was up 2.5%, the Dow up 2.1%, and NASDAQ was down -0.2%. We saw stocks, bonds and commodities led by gold and oil rally this quarter. Energy was the best performing sector, up 11.6% for the quarter, followed by telecom up 7.1% and utilities up 6.8%. Technology and consumer discretionary were the worst performing sectors, down -2.8% and -0.9%, respectively. This defensive sector outperformance is not surprising given their sensitivity to interest rates. Interest rates as measured by the 10 year Treasury fell from 1.94% to 1.46%, the lowest level on record. This quarter saw funds flowing from higher growth assets like technology stocks to more stable defensive assets like Treasuries and defensive dividend paying stocks, which can be interpreted as somewhat ominous. For the quarter, capital flowed from risk assets to safer assets, including gold.
For the S&P 500, valuations remain somewhat elevated, yet within long term averages. The forward 12 month P/E ratio remains at 16.6x, which is just above the 25 year average of 15.9x. Quarterly earnings are for the S&P 500 are projected to growth from $23.97/share in Q1 2016 to over $31/share by Q4 2016, suggesting more room for upside. One of my favorite valuation measures, price/free cash flow is at 23x vs. its long term average of 28.1x. For the first half of 2016, the S&P 500 gained 3.8%, while the NASDAQ lost -0.2%.
Bonds & Interest Rates. Interest rates as measured by the bellwether 10 year Treasury remained range bound for most of the quarter up to the Brexit vote. After the vote, yields tumbled in the US, with interest rates for the 10 year Treasury hitting all-time lows at just below 1.5%. Uncertainty around the Brexit vote combined with overly accommodative monetary policies has had the flight to quality effect, pushing yields down. This volatility is likely to remain as long as uncertainty prevails. With interest rates on foreign bonds so low and in some cases negative, the rest of the world is seeking anything with a positive yield, further driving up prices and pushing yields down. Interest rate spreads as measured by the 2 year Treasury and the 10 year Treasury are tightening as the yield curve falls and flattens. This is something to watch closely as this tightening spread and falling yield curve suggests economic malaise could be around the corner. For the first half of 2016, bonds have been one of the best performing asset classes, with 30 year Treasuries among the best performing at 16.38% YTD.
All this uncertainty has made it increasingly difficult for the Federal Reserve to raise rates again this year. Some recent softness in the economy, along with below trend inflation suggests the Fed does not see inflation as an imminent threat to the economy. This could warrant keeping interest rates at historic lows. The Fed meets monthly to determine interest policy with each meeting keeping the market on pins and needles. There is no question the Fed would like to raise rates again, but they are being especially cautious given all the uncertainty around the globe and here in the US. Another rate hike is likely to occur within the next year to 18 months, which could lead to more uncertainty and volatility across asset classes. As long as the economy is on sound footing, with a solid growth trajectory, the rate hike will likely be a positive. If rates are hiked into a weak recovery like we have now, we could see the Fed inducing a recession. In my opinion, if the Fed were to raise rates before more robust GDP growth, especially given our below trend inflation, they will send the economy into recession and I will start raising cash.
Economic Growth & GDP. The economy continues to send mixed signals, yet plods along. GDP growth has seen several revisions, finally coming in at 0.9% for Q1 2016, on pace for real GDP growth of 2.3% for 2016. For the second quarter of 2016, unemployment remains near all-time lows, coming in at an annualized rate of 4.8%. Inflation remains low at around 1% and the Federal Reserve expects as gradual increase back to their 2% target. Consumer spending, which makes up 69% of GDP, has been supported by job growth and should continue to do as so as the job market tightens and wage growth improves. Housing continues gradual recovery, but first time buyers still face hurdles and are mostly staying away. The US dollar’s ascent continues to slowly reverse course as the Fed rate hikes become less likely for the foreseeable future. The global economic outlook remains relatively soft by historical standards, with a number of downside risks. The Brexit vote add to this uncertainty as the UK will spend the next 2 years negotiating its exit from the EU.
In my last letter, I highlighted the correlation between the the 10 year treasury yield and GDP growth. I suggested the bond market is forecasting much less GDP growth than most economic forecasters, which has been true. Now with yields falling even further, we could see more downside revisions to GDP for the next few years. The change in real GDP for the next few years remains just above 2%. This could be reduced given how much yields have declined.
In my last letter, I also highlighted that with this tepid growth and little, if any inflation, the Fed is likely to reduce the number of interest rate hikes this year. This was my view prior to the Brexit vote and still remains my view today. Forecasters were calling for 3-4 hikes this year, yet the data and the market seem to be suggesting far fewer. This has been true so far and given the recent increase in global uncertainty is not likely to change. During recent testimony, Janet Yellen mentioned concern around Brexit, indicating that these events still pose risks to the U.S. economy. The Federal Reserve recently stated that this is an economy that is not running hot.
Commodities: Oil & Gold. During the quarter oil prices have nearly doubled to $50 per barrel from February’s low. Similarly, gold prices also rallied during the quarter, moving from $1200 an ounce to nearly $1400 an ounce. With the US dollar weakening during the quarter as the Federal Reserve is less likely to raise interest rates, commodities, led by oil and gold were able to benefit. Commodity centric economies such as Canada and Brazil will likely continue to see headwinds as the commodity prices remain volatile.
Outlook for the Quarter. As mentioned in my previous updates, uncertainty remains a worry, given the recent developments with the EU, combined with the timing of the US rate hike. Internationally, there are many factors at play that could also increase uncertainty including the issues with the EU, a cooling Chinese economy and global deflation to name a few. Our outlook for 2016 remains cautiously optimistic and we continue to look for great stocks to add. We continue to look for opportunities in healthcare and information technology, which are positioned to benefit from an aging population and growing middle class. Bearish sentiment and short interest remains quite high, which could lead to more upside surprises for the market. The technical condition of the market remains mixed to slightly positive. Earnings season for the second quarter improved and this improvement is projected to continue through the remainder of this year. Monitoring data releases will be crucial as the second half of 2016 progresses and we enter the US Presidential elections. Monetary policy continues to loom large, as every month the market awaits the Federal Reserve’s decision on interest rates. We will continue to monitor the markets closely and adjust our portfolios accordingly.