Quarterly Market Update
Market Conditions Best Addressed with Active Management
Although still negative, earnings growth in recent quarters has improved sequentially, indicating that the trend may be moving in the right direction.
The U.K.’s vote to leave the EU reverberated throughout global markets even before the polls closed on June 23. In anticipation of a “stay” vote, equities had rallied for the previous two weeks. But in the wake of the Brexit, the British vote to exit the EU, stocks around the globe sold off sharply, currencies experienced one of the most volatile days in history, and the yield on the bellwether 10-year Treasury fell to the lowest level since July 2012. Once the dust had settled, most markets, with the exception of the U.S. Treasury market, quickly snapped back to pre-Brexit levels. Indeed, stocks in Europe and the U.S. posted their largest two-day gain since February in the final week of June. The S&P 500 Index ended the tumultuous first half of the year up roughly 3.8%.
Much of the U.S. stock gains came from investors piling into telecommunication and utility stocks. Investor thirst for yield combined with the defensive characteristics of both sectors has attracted strong flows. The S&P 500 utilities sector is up over 20% for the year. In comparison, riskier sectors including healthcare, information technology, and financials are in negative territory for the same period.
Earnings from the first quarter were better than expected, although the pace of earnings growth remained negative. As estimates currently stand, earnings growth for the second quarter is projected to be down 5.2%, the fifth quarter of negative earnings growth.
We believe that earnings will be the critical variable for the success of U.S. companies versus the political and economic uncertainty emanating from the Brexit.
The risk to investors is that global growth will disappoint due to uncertainty surrounding trade. A lengthy UK exit could lead to a prolonged period of political and economic uncertainty in the Eurozone, dampening already anemic economic growth. Indeed, we expect to see a spike in speculation around the viability and survivability of the EU as a result of the Brexit vote.
Certainly the U.S. will feel the pain to some extent, particularly if a strengthening dollar further pressures earnings of multinational companies. U.S. stocks are still fully valued according to historical measures, and there is not a great deal of margin for error for earnings, equity prices, or the economy to move. These constraints are what initially sent the market into a tailspin after the Brexit as there is limited capacity for the economy and financial markets to absorb unforeseen shocks.
Brexit, A Manufactured Crisis
Much like the U.S. fiscal cliff of late 2012, the Brexit vote was a manufactured rather than fundamentally-based crisis. The fiscal cliff debacle would have raised individual tax rates and cut federal spending at a time when the U.S. economy was still recovering from the financial crisis of 2008. The topic was the subject of widespread public concern and intense media debate. Legislatures argued across party lines, threatening to shut down the government. A 12th-hour legislative compromise was reached, but not before the protracted debate created a negative environment for businesses in terms of planning and budgeting and sapped both consumer confidence and overall confidence in the government. As a result of the fiscal cliff and the prolonged political wrangling surrounding it, U.S. sovereign debt lost its AAA-rating.
In a similar fashion, Prime Minister David Cameron called the referendum a couple of years ago in order to solidify his leadership based on the false presumption that the vote to stay would be an easy win. In the wake of the Brexit, UK sovereign debt also lost its AAA-rating. The similarities between the two nations affords some perspective in that the U.S. experienced something similar and survived. Subsequently, it is not a foregone conclusion that the Brexit is as large an economic disaster as the initial market reaction would lead investors to believe.
Previous Significant Drags on Earnings Showing Signs of Easing
We believe that earnings will be the critical variable for the success of U.S. companies versus the political and economic uncertainty emanating from the Brexit. Analysts project third-quarter earnings to increase by 1.2% and fourth-quarter earnings to increase by 7.5%. Such projections may not be too difficult to achieve as the numbers are coming off a much lower base than in earlier years. But a great deal can happen between now and then what with the Brexit and the U.S. presidential election, and estimates will invariably change.
We are optimistic that two significant drags on earnings of the past 12 months – the strong U.S. dollar and low oil prices – are reversing and may put some wind in corporate sails, helping to keep equity prices moving in the right direction. Even with the bounce that the U.S. dollar initially had following the Brexit vote, year-over-year, the greenback is up only .2%, compared to a 20% gain a year ago. Thus U.S. companies are less impacted now from the earlier extremely painful repatriating of earnings. Oil has bounced back from a low of $26, and although the price declined following the Brexit vote, it ended the quarter at $48.33.
And finally, we would be remiss not to mention the stabilizing force of easy monetary policy across the globe. In the U.S., the equity market continues to reap the benefits of an accommodative Fed. And whether appropriate or not, the Fed has almost been held captive to the market, keeping a backstop on equity prices.
The initial market reaction to the Brexit in the U.S. was to give back in a single day the previous two weeks’ gains. Yet the crisis surrounding the Brexit was nowhere near the magnitude of the Lehman event where systemic risks to financial markets were uncovered. Nonetheless, we do not anticipate that volatility will ease significantly but will rather increase leading up to the presidential election. Volatility is always the outcome when stocks are bumping up against fully valued levels. However, most broad indexes, with the exception of the EAFE, are still in positive territory for the year, and there is encouragement to be found in that measure.
U.S. equity valuations are not cheap, but the economic outlook is superior to that of international economies, and we are comfortable adding to our U.S. stock positions. International market valuations are cheaper but not to an extent sufficient to offset the unknown economic environment. The Brexit vote likely lengthens the timeframe for international large caps to outperform those of the U.S., and within this context, we are evaluating our overweight to developed international stocks.
Based on fundamentals, U.S. large caps should continue to outperform. However, between 30% and 40% of the revenues of the companies in the S&P 500 Index come from overseas, so it is important for foreign subsidiaries to do well. The UK makes up only 4% of the world economy, but as a U.S. trading partner, the country is not insignificant. Some pundits are still calling for a fairly significant currency impact on multinationals earnings because the stronger dollar continues to be a drag on earnings.
Active Management, Stock Selection Critical Going Forward
These market conditions speak to active management. Parts of the market will continue to be challenged, especially financials with no spread income for the foreseeable future. The sheer level of outperformance in dividend paying stocks would presage a dividend trade unwind. During the Brexit, international stocks dropped indiscriminately, but there will be winners which were not initially readily apparent. Some overseas companies, excluding European financials, may very well benefit from the Brexit. After all, financial markets are legendary for taking new information and figuring out how to make money from it.
Our philosophy of investing in high quality companies is designed to safely navigate the challenges that invariably present themselves to the investing landscape. Competitive advantages, prudent financial risk management, and shareholder corporate governance drive the value of companies. Individual corporate earnings and outlooks within the context of Brexit and other economic events will be much more meaningful over the remainder of the year than the Brexit viewed in isolation.
BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.
This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).