“The result of the referendum is clear. Its full implications for the economy are not.”
- Mark Carney, Governor of the Bank of England, June 30th, 2016
Markets saw significant volatility at the conclusion of the first half of the year. An unexpected Brexit was a meaningful driver of downside risk in June. Additionally, persistent global growth concerns, divergent central bank policies, and tragic terrorist attacks both in the US and abroad all continued to weigh on risk assets.
Economic data yielded mixed signals throughout the second quarter. First quarter GDP was shown to have increased at an annual rate of 1.1% with personal consumption once again representing a key driver of the economy. Additionally, residential investment remained a positive contributor. As discussed in Massey Quick’s 2016 Market Outlook, we maintain our position that the consumer will continue to represent a positive growth driver.
Nevertheless, after demonstrating positive trends for multiple months, labor markets experienced a sharp correction with the release of the May nonfarm payrolls figure. The US created only 38,000 jobs in May (compared to expectations of 162,000). While the unemployment rate fell to 4.7%, markets appeared to be shocked by the derailment in job creation. While one data point may not represent a new trend, the May report raised questions about potential downside risks to the US economy.
The US Federal Reserve’s June meeting saw the central bank once again opting not to increase interest rates. The Fed statement (and Chair Yellen’s press conference) continued to highlight global economic uncertainty and a cautious attitude towards the US economic recovery as the reason behind the measured pace in rate hikes. The oft-cited FOMC “dot plot” was a key point of focus for markets as it highlighted a seemingly more cautious Fed than many may have anticipated. In particular, six Fed policymakers foresaw only one rate hike in 2016 while the longer-term outlook for the Federal Funds rate declined. Market-implied odds for a Fed rate hike in 2016 plunged even further after the unanticipated vote by the UK to leave the EU (see International section below). The aforementioned mixed messages from the US Central bank led to continued volatility in the dollar, though the USD still managed to gain approximately +1.6% in Q2.
On the micro front, earnings results continued to be mixed. According to data from JP Morgan released on May 24th, 74% of S&P 500 companies beat earnings estimates in the first quarter. However, earnings growth continued to paint a worrisome picture with Q1 EPS growth clocking in at -8%. The embattled energy sector continued to represent a meaningful drag on earnings; nevertheless, even if one excludes said sector, EPS growth was still negative. The idea of a prolonged “earnings recession” continues to raise questions about the future return potential of domestic equities following a multi-year rally from the depths of the recession. Additionally, many pundits expressed concerns that lackluster corporate performance could translate into a broader economic recession.
The 2016 Presidential election continued to take shape with Donald Trump and Hillary Clinton emerging as their respective party candidates. Uncertainty remains high as the campaigns for the White House begin in earnest.
It’s possible that no single word dominated second quarter news headlines as much as “Brexit.” Markets seemed to hang on every set of odds and polling data that emerged regarding the June 23rd referendum. When results were released on June 24th, the UK’s decision to leave the EU caught markets off guard and engendered significant risk asset volatility. The pound dropped to thirty-year lows while equities also slumped dramatically. In contrast, perceived safe haven assets (e.g. US Treasuries and gold) received meaningful bids. In the aftermath of the vote, central bankers around the globe rushed to pledge their willingness to promote financial market stability. This accommodative policy rhetoric may have helped to stem further losses in the final days of June.
While the immediate aftermath of the Brexit vote was certainly dramatic, the longer-term impact remains unclear. The logistics surrounding a UK exit could take years to unfold. In the interim, markets are clearly demonstrating angst about the impact Brexit will have on global growth, the global financial system and the precedent it could set for other countries to leave the EU. Please visit Massey Quick’s website for additional commentary and thoughts on Brexit.
Equities demonstrated meaningful volatility in the second quarter with the oft-cited VIX index ramping from 13.95 to 15.63 over the course of the quarter. This increase included a spike to 25.76 on the day of the Brexit announcement. After posting gains in both April (+0.4%) and May (+1.8%), the S&P 500 was whipsawed dramatically by volatility in June as a result of the Brexit announcement. For context, the S&P fell approximately -3.6% on the day the Brexit referendum results were released. Nevertheless, despite this sharp drawdown, a somewhat surprising bounce in the final days of June allowed the index to finish the quarter up +2.5%.
As might be expected, international markets were not immune to the swings in investor sentiment throughout the quarter. As was the case in Q1, results were generally mixed across regions. When measured in dollars, the MSCI AC Asia Index gained +0.8% in Q2 while the AC Europe Index expectedly fared worse to post a loss of -2.3%. Despite continued concerns about China’s slowing growth and potential currency devaluation, emerging markets posted another quarter of gains; the MSCI EM index was up +0.8% in Q2.
The constituent sectors of the S&P 500 continued to show a high degree of dispersion. A bounce in the price of WTI oil from $38.34/barrel to $48.33/barrel in the second quarter was a boon to energy stocks (the S&P 500 Energy was up +11.6%). Additionally, as was the case in Q1, utilities (+6.8%) and telecom (+7.1%), two sectors that are commonly perceived as safe havens, continued their strong year. Technology (-2.8%) and consumer discretionary (-0.9%) stocks were the only two sectors to yield negative quarterly returns as many market participants may have sought to rotate capital out of past winners during periods of market volatility.
Bank stocks were once again a front-and-center news item in Q2 as Brexit worries weighed heavily on the sector. Several large domestic European banking institutions posted meaningful declines in the days following the UK referendum results and subsequently lagged their counterparts in the market bounce at the end of June. Perhaps unsurprisingly, the financials sector is the worst-performing group in the S&P 500 through the end of the first half (total return of -3.1%).
Bottom Line: Following the unprecedented events in the UK, we continue to favor domestic equities over their international counterparts. We maintain our view that volatility is likely to persist and anticipate continued use of opportunistic rebalancing to maintain exposure to quality opportunities.
Global bonds posted gains in the second quarter with the Barclays Global Aggregate index advancing +2.9%. Global bond markets made headlines in Q2 when it was reported that the amount of debt around the world offering negative yields exceeded $10 trillion for the first time. Continued accommodative central bank policy and a bid for safe-haven assets have continued to drive yields lower. Although the Federal Reserve is engaged in a tightening cycle, Treasuries were not immune to this phenomenon: following the end of the quarter, US 10 Year and 30 Year bond yields both touched record lows not seen since 2012.
High yield bonds continued to see a significant rally from their February lows for most of the second quarter. However, as was the case with equities, the Brexit vote threw a wrench into the uptrend. Despite this hiccup at quarter end, the Barclays Global High Yield index posted gains in each month of Q2 to return +4.4% for the quarter. As noted in our first quarter update, the riskiest segments of the high yield market continue to dramatically outperform their safer peers. Based on data from JP Morgan, CCC-rated bonds have returned +17.8% YTD through June 30th while their BB-rated counterparts have posted gains of +6.3%.
On a fundamental basis, the second quarter saw default activity slow relative to the first quarter as the rebound in energy prices may have helped to stave off some bankruptcies in the near-term. According to further data from JPM, year to date defaults stand at $43.8B across both bonds and loans. Despite the slowing of defaults in Q2, the overall high yield default rate currently stands at 3.6% (versus 1.9% at this juncture last year). It is clear that many companies are still not out of the woods and, as noted in our 2016 Market Outlook, we would expect further default activity, particularly within the beleaguered energy and mining sectors.
Bottom Line: We continue to approach credit markets with caution given unprecedented central bank policy and structural issuers pertaining to market liquidity. Our emphasis remains on higher quality securities with lower duration risk.
Hedge funds had a relatively positive second quarter as increased volatility may have yielded attractive opportunities. Based on preliminary results, the HFN Hedge Fund Aggregate Index advanced +2.1% in Q2. While this figure trailed broader equity and fixed income markets, it marked a reversal from a difficult first quarter. As was the case in Q1, there was meaningful dispersion among individual strategy types. Distressed strategies (+10%) were among the best performers as several beaten down situations (particularly within lower-rated commodity credits) continued their rally from Q1 lows. Non-arbitrage fixed-income oriented strategies (+2.4%) may have also benefitted from these tailwinds while Macro funds (+1%) benefited from the heightened volatility in June to close the quarter in the black. Equity-oriented strategies continued to post lackluster results with the Long/Short index gaining a more modest +0.8%. In many cases, the whipsawing of markets in the final days of the month proved damaging to both longs and shorts for these strategies. Several high-profile hedge fund managers have continued to receive press for their performance struggles. Additionally, investor frustrations likely came to a head when it was reported that the hedge fund industry saw its most meaningful outflows since 2009.
Bottom Line: We are sympathetic to investor frustration with hedge fund performance. However, we maintain our position that increasing levels of volatility and market inefficiencies in illiquid assets create attractive opportunities.
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.
1Source: Bureau of Economic Analysis
2Source: Bureau of Labor Statistics