Investment Team Third Quarter Update
by: R. Samuel Fraundorf & Jason Lioon
With 9 ½ months in the books, 2016 has been a relatively good year for investors. Climbing the proverbial “wall of worry,” global equities have overcome a difficult start to the year (remember that the S&P 500 was down 5% in January) to post solid results. In just the third quarter, global equity markets rose over 5%. The S&P 500 is now up over 7% year-to-date, although small cap (+9% for the quarter and +11.5% YTD) and emerging markets (+9% in Q3 and +16% YTD) continue to lead the way. With low interest rates, slow but steady growth, and generally accommodative central banks, investors remain comfortable embracing risky assets.
Fixed income has also done surprisingly well. Despite a lot of angst over the potential for rising interest rates, the Barclays Aggregate Bond Index is up over 5% so far this year. The yield on 10-Year Treasuries has moved higher in recent weeks on widespread fears of a Federal Reserve rate hike before year end, but bond returns for the year remain strong. Credit markets have also performed extremely well, led by high yield at +16% YTD.
Looking ahead, the minutes from the most recent Fed meeting in late September indicate a majority of officials are leaning towards a rate increase “relatively soon.” Chairwoman Janet Yellen has stated that solid recent economic performance, particularly in the job market, increased the Fed’s outlook for growth and inflation. Higher inflation would give the Fed more room to raise rates, which have remained flat since a rate hike late last year.
With reasonably solid economic data, increasing wages, and job growth (see unemployment chart, opposite), the markets are now pricing in a greater than 60% chance the Fed raises rates by 0.25% at its December meeting. Still, the Fed is continuing to be very deliberate about the pace of these rate increases, so we do not expect there to be a rapid increase in rates. We believe this increase is largely priced into longer-term bonds, although inflation is the largest risk to this outcome. Expectations for inflation remain very low, and an inflation surprise could spur the Fed to act more decisively.
We generally do not like to comment on elections for a variety of reasons: we are not political experts, financial markets are more impacted by monetary policy than fiscal policy (though the real economy is more driven by the latter), and the connection between Washington and financial markets can take years to evolve. However, this presidential election is unlike any we have ever seen, leading to a number of questions from investors.
While the media and the nation has been transfixed on the presidential race (looking at the TV ratings of the two debates), the real issue we believe is the potential for change in leadership in the Congress. The reason the Congress is so important is a split between the White House and Capitol Hill leads to slower change and financial markets tend to react negatively to change. Democrats would need to gain four seats in the Senate (and hold the White House, giving the tie-breaker to the Vice President) to gain control. As we write this, there is slightly better than a 50% chance that will occur. In the House, Republicans hold a 30 seat advantage and most polls and predictions show them losing some number of those seats, but retaining an overall majority. Looking at stock prices, trading indicates financial markets are not pricing in a fully Democratic Congress.
Both major party platforms have outlined material changes in taxes, foreign trade, energy policy, and domestic safety net programs (Food Stamps, health care, etc.) and their proposals are very different from each other. The two similarities in objectives between the parties is increased infrastructure and defense spending. The uncertainty of the outcomes for everything else leads directly to current market volatility. The S&P 500 has tended to exhibit positive results with more status quo in Washington following the election and negative returns in the event of a more significant reshuffling. Given the impact on things such as oil and gas exploration and production, individual and corporation income tax policy, minimum wages and budget deficit focus, there is the potential for a great deal of uncertainty and change. Markets do not like uncertainty, which has been reflected in equity market volatility over recent weeks. This is inline with past presidential election cycles; once the winner has been decided, the uncertainty overhang is removed and the market generally is free to move higher.
This uncertainty is the direct result of a wild and wholly unconventional presidential election. The nation faces the prospect of electing the most disliked president in modern history, regardless of which party is the victor. It does appear women may hold the key to the final tally; while the Republican candidate is holding a similar spread to his Democratic rival among men as did the candidates in the 2012 election (+7% in 2012 vs. +5% in 2016), he is trailing his opponent by almost double the spread among women (-8% in 2012 vs. -15% in 2016). A recent analysis by Nate Silver of fivethirtyeight.com showed if only women voted for the president today, former Secretary of State Clinton would take 458 of the 538 electoral votes. And this analysis was conducted prior to all polls being able to fully adjust for any impact from recent video tapes and the last debate. However, there have been many turns so far in this election, and no one should be ready to declare a winner. Financial markets seem to indicate the outcome will still lead to a split Congress. We will know in a few weeks.
From a portfolio standpoint, we continue to believe risks to both stocks and bonds are generally balanced, so we are making little adjustment to our allocation recommendations. That said, within equities we are fearful of the valuations associated with some dividend-oriented stocks. In an effort to generate income, we are concerned investors have forgotten dividend payers are still stocks and are subject to many of the same risks associated with the rest of the market. Many of these companies are trading based on their yield alone; as an example General Mills and Google both have a PE of 20, but Google is growing far more rapidly and has no debt! The one thing General Mills has going for it? A 3% dividend yield.