“We are not going to opine upon the future of Connecticut, but we feel compelled to mention Greece, even though the two economies are roughly the same size.” – A current Massey Quick Long/Short Credit manager.
Macro-driven volatility remained high in the second quarter with both debt and equity markets feeling the effects. Several stories dominated the headlines. After kicking the can down the road in the first quarter, Greece was once again a major market mover in Q2. Global growth and the commodity universe also remained front-and-center news items. The Federal Reserve’s much-anticipated June FOMC meeting provided another barometer for future rate policy. Additionally, China’s equity market tear experienced a significant step backward to add to a growing list of potential worries.
As was largely anticipated, the US economy experienced a slump in the first quarter. According to data revisions released in Q2, real domestic GDP contracted -0.7% in the first quarter after an initially reported increase of +0.2%. While this negative print marked a disappointing near-term reversal of the economy’s positive trajectory, the revision was largely anticipated with most market participants and economists ascribing the result to transitory factors such as the harsh winter and a port strike on the West Coast. Second quarter economic data points have largely supported the temporary nature of the growth hiccup in Q1. In particular, May’s employment report showed an above-consensus increase in non-farm payrolls (280K vs 226K exp.), a strong headline that helped to alleviate some concerns about the US economy. Perhaps more importantly, wages continue to see modest (but encouraging) upward pressure.
The Federal Reserve was once again front and center as market participants anxiously awaited guidance as to the level of future interest rates. June brought with it another much-anticipated FOMC statement. The Fed’s tone was largely more optimistic in nature leading to a consensus feeling that a September rate hike is still very much on the table. Specifically, the oft-cited Fed dot plot suggests at least two rate increases in 2015. The Fed’s economic projections seem to indicate a degree of optimism in the trajectory of the US economy in support of future policy tightening this year.
On the micro front, first quarter earnings represented a mixed bag. According to data from JP Morgan, approximately 71% of S&P 500 companies beat EPS; however, only 46% of the same cohort beat sales estimates. Most believe that company revenues were negatively impacted by the slowdown in the economy and the continued strength of the US dollar. While the dollar gave up some gains in Q2, the currency is still up +4.4% year to date and over +10.3% since the start of the fourth quarter of last year (all data via Bloomberg).
Oil markets stabilized in the second quarter with WTI prices rising from March 31st levels of $47/barrel to close June 30th at $59/barrel. Volatility of oil prices fell in kind as many oil producers adjusted / continue to adjust to new, lower price levels.
The second quarter saw no slowdown in the mergers and acquisition trend that has come to dominate markets. According to data from Thomson Reuters, the second quarter of 2015 (wherein over $1.3 trillion of deals were announced) fell just shy of matching the all-time deal volume record set in 2007.1 As the above link highlights, of note was the sheer size of some transactions announced in the second quarter including Charter’s nearly $80B acquisition of Time Warner Cable and Shell’s $70B acquisition of BG Group. As noted in last quarter’s commentary, we expect continued merger activity and bidding wars as larger companies take advantage of low rates and seek ways to augment growth.
Chances of a “Grexit” reached an all-time high in the second quarter, particularly in the month of June. After staving off its creditors in the first quarter with a last minute extension, the peripheral European nation once again faced looming payments and negotiations with its core Euro-area counterparts and supra-national debt holders. Tensions ran high as it became clear that Greece’s left-wing prime minister, Alex Tsipras, was committed to taking a hardline stance in negotiations while major European economies (e.g. Germany) and the ECB appeared equally unwilling to budge without concessions involving Greek reform. These tensions came to a head in the final days of June when Tsipiras, faced with an impending July 1 payment to the IMF, called for a referendum that would likely decide his own political future as well as Greece’s membership as part of the Eurozone. The standstill in negotiations also led to the ECB withdrawing its emergency funding for Greek banks and a local bank holiday in an effort to stem a potential run on a fragile banking sector. The beleaguered nation subsequently failed to make the aforementioned IMF payment and became the first “developed” nation to be considered “in arrears.” As of this writing, Greece voted “no” to further austerity in the aforementioned referendum and a full resolution has yet to be attained. While Greece does not represent a substantive part of the European economy, markets may rightly be concerned about the precedent that may be set by a member nation leaving the EU.
While Greece was far and away the most discussed topic in international markets in Q2, familiar geopolitical stories also remained among the headlines. Russian military tensions and ISIL hostilities / Middle East terrorist activity remained in focus. Despite the stabilization in oil prices, the uncertainty surrounding future production by OPEC members and potential wildcards (such as Iran nuclear sanctions) also worked to supplement heightened levels of volatility and uncertainty abroad.
Against this backdrop, the S&P 500 managed to eke out a small gain of +0.3% in the second quarter (+1.2% YTD), continuing a streak wherein the index as a whole has not posted a down quarter in approximately two years. However, as shown in the following chart (via Bloomberg), volatility, as measured by the VIX index, ramped up substantially towards the end of the quarter in tandem with heightened Greek exit concerns:
For reference, the S&P 500 shed in excess of -2% on June 29th, a setback that wiped out a substantial portion of the index’s year to date gains.
As was the case in the first quarter, there was a high degree of dispersion among individual sectors. In contrast to the index’s modest gain, the healthcare sector advanced over +2.8% on the back of industry consolidation and continued profitability. The financials sector was another top performing sector, gaining +1.7% as many market participants expect banks to benefit from higher rates. The utilities sector stands in direct contrast as the rate-sensitive sector slumped nearly -6% in the second quarter. Despite the rebound in oil prices, more cyclical energy (-1.9%), industrials (-2.2%) and materials (-0.5%) companies continued to lag the broader markets.
Small cap equities continued to fare better than their larger cap counterparts with the Russell 2000 gaining +0.4% in the second quarter. On a year to date basis, the Russell 2000 has outpaced the S&P 500 by over 250 basis points. Many pundits have espoused that the relative outperformance of smaller capitalization companies can be attributed to the fact that their businesses are more exclusively focused on domestic markets and, therefore, aren’t as exposed to the currency headwinds from the stronger US dollar and the volatility caused by international markets.
International markets were buffeted by the quarter-end European Union drama. As might be expected, European markets struggled in the final days of June. However, the region still remains firmly in the black for the year as measured by the MSCI AC Europe Index. While negative in the short-term, the risk of a Greek exit could not fully offset recent optimism surrounding the launch of the ECB’s aggressive quantitative easing measures in the first quarter. Developed Asian markets were similarly hit hard in the final weeks of June but still posted gains in Q2. Japan was once again a regional leader, gaining +2.9% in the second quarter (according to the MSCI Japan, in USD) as growth and inflation have appeared to have finally picked up in the region.
Emerging markets yielded gains in the quarter though China proved to be a major news story once again. After starting the year on a tear, Chinese equities experienced significant declines in the final weeks of June as investors and traders openly questioned the sustainability of the substantial increase in these markets. The MSCI China index lost over -7% in June alone with some regional sub-markets losing in excess of -20% in short order. Given China’s importance within the overall emerging market complex, volatility in the region is worth monitoring closely.
The following chart highlights second quarter performance for various equity markets:2
Bottom Line: We believe equities remain an attractive source of long term growth for client portfolios. Additionally, we continue to emphasize active management in less efficient arenas such as smaller capitalization equities and emerging markets as we believe higher return dispersion will likely engender fruitful hunting ground for active management. We expect recent levels of higher volatility to persist throughout 2015.
Fixed income markets saw volatility alongside their equity market counterparts as divergent monetary policy, market liquidity concerns and macroecnomic risk led to a whipsawing in certain debt instruments. The German 10 Year bond became a poster child for this volatility. After yielding a mere 10 basis points in April, bond yields ramped up substantially to close the quarter at 76 basis points. This spike in rates included a brief stop at the 1% yield level in mid June. While the moves were not as severe as their German counterparts, US Treasuries also saw yield volatility in the second quarter.
As shown in the table below the broader universe for fixed income, as measured by the Barclays Global Agg, posted negative results in the second quarter.3 Riskier high yield bonds managed to post modest gains as the rebound in energy worked to boost a meaningful portion of the high yield bond market.
Nevertheless, the yield volatility discussed above had a stark impact on sentiment as measured by mutual fund flows. Based on Lipper reporting (via JP Morgan), high yield ETFs have seen outflows in excess of $5.5B since late April after seeing inflows in the early months of the year. Clearly, investors became more wary given market volatility and the observed backup in yields during the second quarter. While the standalone magnitude of these outflows is noteworthy, we would once again reiterate that extreme shifts in flows of funds are merely part of a larger problem in the lower-liquidity world of today. These types of sentiment driven outflows can lead to substantial, non-fundamental market movements in the absence of parties willing to take the other side of the trade.
Bottom Line: We continue to approach credit markets with caution. While we favor credit risk over duration risk across the board, we realize that even shorter duration assets could experience principal volatility as the Fed increases short term rates. We remain concerned about continued yield and spread movements in a lower liquidity world and continue to be cognizant of the risks posed by the inherent asset-liability mismatches found within daily liquidity products.
Hedge funds continued to benefit from volatility in the second quarter though results did vary among strategies. As shown in the table below, equity-oriented strategies saw profits driven by reduced correlations and higher levels of return dispersion among individual equities. Event driven strategies also continued to yield positive results as mergers and corporate actions (e.g. share buybacks) remain in the news. In contrast, macro strategies struggled during the second quarter as several popular trades, such as the stronger dollar and European reflation, experienced higher levels of volatility and some near-term trend reversals in the second quarter. Commodity price volatility also impacted these strategies. More directional distressed strategies also yielded modestly negative performance as a result of the broader market volatility.
The following chart summarizes quarterly performance for select hedge fund strategies:4
Bottom Line: After a multi-year, significant bull market rally, alternative strategies have been able to deliver attractive returns to start a more volatile 2015. We continued to believe that these strategies represent an important risk-managed portion of client portfolios.
Conclusion and Outlook
Our focus remains grounded in a dedicated, disciplined asset allocation framework for each client portfolio. We continue to believe that portfolio diversification across asset classes facilitates a broad opportunity set for delivering returns in an environment of increasing uncertainty.
1 Source: Reuters.com (http://www.reuters.com/article/2015/06/29/us-deals-m-a-idUSKCN0P92WN20150629)
2 Sources: S&P, Bloomberg, Russell, MSCI
3 Source: Barclays
4 Source: HFN
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Massey, Quick & Co., LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Massey, Quick & Co., LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Massey, Quick & Co., LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a Massey, Quick & Co., LLC client, please remember to contact Massey, Quick & Co., LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the Massey, Quick & Co., LLC’s current written disclosure statement discussing our advisory services and fees is available upon request.
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