After a tumultuous first quarter, the second quarter brought some relief as most assets were able to rebound to varying degrees. From a big picture perspective, U.S. stocks have been oscillating in a wide range that dates back to the fourth quarter of 2014. In other words, for the last year and a half, stocks have made almost no upside progress, while being subjected to several brief but vicious selloffs. This type of choppy, sideways action is frustrating for both bulls and bears as long as stocks remain within the current range. Global stocks are in a much more precarious state, with only modest recoveries that left many markets still well below their highs of a year ago (or longer).
Perhaps most notable were signs of a renewed reflation trade in previously beaten down sectors, such as energy and commodities (which saw sizable gains). Indeed, after falling to a low of $26/barrel in mid-February, oil began a rally that lasted throughout the second quarter, briefly surpassing $50/barrel by early June. However, even after the rally, oil prices remained more than 50% below their levels of 2014 when they were more than $100/barrel. Gold prices also climbed by nearly $300/oz since the beginning of the year to more than $1,300/oz currently.
Outside of the action in commodities, moves in other asset classes were more muted. After appearing to be on the verge of a larger breakdown at the beginning of the year, stocks continued the recovery that began towards the end of the first quarter, albeit modestly with the S&P 500 gaining about 2%. Interest rates broadly moved lower, with the U.S. 10-year Treasury back down to previous lows near 1.5%, and into increasingly negative territory globally.
Reasons to Remain Cautious
In recent quarterly reviews, we’ve made the case that this is a time for investors to exercise caution because the long running bull market may be transitioning to a bear market. Despite the bounce in risk assets over the past few months, this remains our fundamental view as it is based on our weight of the evidence assessment of a host of factors.
At the top of the list of our concerns is the fact that growth around the world remains lackluster. U.S. GDP growth was just 1.1% in the first quarter, and while there may have been a slight pickup in the second quarter, growth is still mired in a below trend trajectory. The backdrop has been mixed recently, with certain parts of the economy (like consumer spending and housing) holding up fairly well, and other parts (like manufacturing and business investment) exhibiting weakness. One of the more positive areas of the economy has been the labor market due to steady job growth. However, the May payroll report badly missed expectations with job growth of only 38,000, and also indicated downward revisions to previous months. While only one report, if May was a precursor to a weaker job market going forward, it could renew the fears of a possible recession that were prevalent earlier this year.
In addition to ongoing worries about economic growth, we have not seen sufficient improvement in other areas such as technical conditions, valuation, and quantitative evidence to warrant a change in our view. At best, some indicators have clawed back to a more neutral state from previously bearish readings, but we would need to see further gains to consider upgrading them to bullish.
Considering Our Next Steps
While our view has not changed, part of our disciplined process is to constantly monitor key data points and question if our strategy should change, given the most current information. As we navigate the choppy waters, we continue to be cautious and accept the possibility that stocks may grind to new highs.
As a result, we are considering changes to our portfolios that would increase underweight equity positions and move back towards neutral levels of risk if the market were to carry meaningfully above its previous high. If that were to occur, it wouldn’t necessarily feel good from the standpoint of buying at what would be new all-time high prices in what we believe is an already overvalued market, but it would serve to protect against the possibility of missing out on another major bull market leg. After all, there is nothing necessarily preventing stocks from moving to even more overvalued levels, and possibly even developing into an equity bubble similar to that of the late 1990s. While that may seem far-fetched, an important part of our process requires us to keep an open mind and consider a variety of scenarios.
We would like to see how the market eventually resolves the wide trading range it is currently in before making any major portfolio adjustments. As a result, we think that sacrificing a few percentage points of upside from current prices to ensure that the market has convincingly broken above its current trading range is an acceptable tradeoff compared to buying now near the top of the range, only to have the market potentially roll over again.
Investing in a Post-Brexit World
The big event in the second quarter came on June 23rd with the British referendum on whether or not to leave the European Union. The outcome was a surprising vote in favor of “Brexit,” despite all of the conjecture in the run up to the referendum in which expert opinion, conventional wisdom, and even betting odds suggested the result would be to “Bremain.” It sent shockwaves through markets in the following days—the British pound sank, equities came under heavy selling pressure, and global interest rates plunged.
After a scary two-day reaction, most (though not all) assets recovered as markets realized it wasn’t another 2008 Lehman-like event. However, instead of providing clarity, the outcome seemed to create a new set of questions as to what the ultimate ramifications would be.
The short answer is that it creates a lot of uncertainty, particularly within Britain. The aftermath saw Prime Minister David Cameron resign, replaced by Home Secretary Theresa May. Economically, there is already evidence that business confidence is going to take a major hit, as corporate executives don’t know what type of environment to plan for. For the time being, Britain remains in the EU. At some point, they will have to formally begin the process of withdrawing from the EU, and current thinking is that it may take several years to complete that process. In the meantime, British growth is likely to slow, possibly abruptly, and growth may also decelerate in the EU.
There are also concerns that other European countries with growing populist political movements will feel emboldened by this outcome, and will make their own pushes to hold referendums to leave, putting the whole European project at risk.
The implications for the U.S. are seemingly less dire, mainly because our economy is fairly insulated from potential U.K. economic strains due to relatively small trade ties. However, there could be spillover from tighter financial conditions depending on how markets react in the coming weeks.
We expect global central banks to seek to mitigate the negative impact of Brexit. Already, the Bank of England has hinted at possible rate cuts this summer, and there are rumblings that the European Central Bank may need to consider expanding its quantitative easing program again. The Bank of Japan has been eerily quiet even as the Japanese yen has rallied strongly this year, which runs counter to their plan to boost inflation expectations through a weaker currency.
Here in the U.S., the Federal Reserve has refrained from any additional rate hikes, and has pushed the time frame for the normalization of interest rates farther into the future. Given that we are in era of very active central banks whose actions can have significant effects on markets, we also have to brace for the possibility of a significant policy response.
From our perspective, we view the outcome of the vote as another headwind for an already challenging global backdrop, reinforcing a cautious approach at the moment. No one knows exactly how things will play out since no country has never exited the EU before. It will be important to pay close attention to the data this summer to see how much of an impact Brexit is actually having on global trade and business activity. While we think it’s likely to weigh on growth and lead to additional market volatility as the difficult separation negotiations get underway, stocks have shown the ability to overcome many other scary events in the past, including the European debt crisis, the U.S. debt downgrade, China’s currency devaluation, Greece, Ebola, etc., and we have to be on guard to face a similar challenge.
Staying Patient, but Remaining Flexible
Last quarter, we discussed the importance of being patient, but remaining flexible. We still believe this is the prudent course as we enter the second half of the year, especially as the market is again testing important levels near the top of its recent trading range. The resolution of the current range, as well as the evolution of global economic data following the Brexit vote, will help guide our next steps.
For now, we remain defensively positioned, with exposure to various assets that have performed well this year, such as counter cyclical equity sectors, long-term U.S. Treasury bonds, and gold. If volatility picks up again this quarter and stocks stumble, owning those types of positions should continue to provide positive diversification benefits. Conversely, if stocks manage to scale the proverbial wall of worry once again, the contingency plan we have in place will help to ensure that portfolios are repositioned to capture future potential gains.
Overall, we continue to believe that adhering to the disciplined process that we’ve worked hard to develop is the key to achieving healthy risk-adjusted returns over the long term.
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