We hope your summer is progressing nicely. Several quarters ago we began separating our letter into two sections, a brief overview of market returns and key news items, followed by a “Deeper Dive”, a more detailed view regarding one theme we find of particular interest. We hope you enjoy both.
The second quarter of 2016 has been relatively calm compared to the rollercoaster ride for the first quarter. The broad equity indexes had mixed results. For the quarter, the S&P 500 and Dow Jones Industrials increased 2.5% and 2.1%, respectively, while the NASDAQ Composite declined 0.2%
Interest rates fell for the quarter. The yield on 10-year Treasuries ended at 1.49% compared to 1.78% at end of last quarter.
IN THE NEWS
This quarter we would like to highlight a few news items that we believe are noteworthy.
Brexit: what’s old is new again. On June 23, the British people voted on a referendum for Britain to exit the European Union (EU). The referendum is commonly referred to as “Brexit”. The majority of pundits, commentators, and experts did not expect the measure to pass. When the votes were counted, the Leave camp won against the Remain camp by a total of 52% to 48% bringing economic uncertainty to Europe and Britain along with enormous volatility to the capital markets. The British Prime Minister, David Cameron, supported the Remain position and announced he would step down from his post as a result of the vote. Currently, the election of the new Prime Minister is not expected for three more months which extends the time before a negotiation can begin with the European Union regarding the country’s exit. Such negotiations would probably not include a long term trading agreement. Trade negotiations are expected to begin after the exit terms are complete. The British pound has fallen 10% as of the writing of this letter adding volatility to the global currency, equity, and bond markets. In such an environment, it is widely expected that the Federal Reserve will not raise interest rates again anytime soon. Furthermore, there is concern among countries in the EU that others may attempt to leave as well which would further add to uncertainty. Britain is a unique case, however, as it was part of the EU but maintained its own currency rather than using the Euro which makes its exit somewhat easier. The investment implications are still unclear. In the short term, the economies of Europe and the UK will likely slow as a result of a pause in spending by businesses and consumers due to the uncertainty. In the US, the stronger dollar will hinder many companies with large export businesses, while many domestic businesses that purchase raw materials outside the US should benefit. Banks that would have benefitted from an increase in rates by the Federal Reserve have weakened as this catalyst for earnings growth has been significantly delayed.
We would like to elect to avoid discussing the upcoming presidential election, but it seems unavoidable. We will refrain from shaking our Magic 8-ball and guessing on the outcome but we know many clients are interested in “what-if” scenarios, how either candidate might impact the stock market. The positions on various issues of each candidate, if enacted into law, could have notable impacts on sectors of the economy. Hillary Clinton is expected to further expand Medicare/Medicaid, support more government backing of renewable energy, increase infrastructure spending, extend the holding period required to achieve long-term capital gains status, and possibly limit retirement contributions for individuals with retirement accounts holding high balances. These positions should help solar and alternative energy stocks, industrial companies, as well as building materials companies. Her expansion of Medicare/Medicaid may appear to be positive for some healthcare stocks but ultimately negative as the government seeks to control costs by lowering reimbursement rates for services. Traditional energy companies may be negatively impacted as her plans focus on alternative energy at the expense of traditional energy.
Donald Trump plans to expand spending on defense and security, lower corporate tax rates, support infrastructure spending, and lower the capital gains tax rate. His plans would be positive for building materials companies, energy companies, and possibly consumer discretionary stocks buoyed by lower taxes. Any limitations on immigration that affects H-1B visas used often by technology companies could negatively impact that sector.
Each candidate has expressed support for negotiating drug prices for Medicare, a step that would be a significant negative for pharmaceutical companies. Restrictions on free trade and an end to the Trans-Pacific Partnership (TPP) trade deal could also occur under both candidates.
OUR VIEW OF THE MARKETS
As noted previously, our expectations for returns of the US equity market are driven by the earnings expected of companies in 2016 and the amount that investors are paying for these earnings. However, financial markets are complex systems with many variables impacting their behavior. We continue to believe that the low interest rate environment, even negative for some countries, is lending support to the US equity market and may continue to do so for the rest of year.
The P/E ratio of the S&P 500, an indicator of valuation, is still high and tempers the enthusiasm we have for some of the attractive stocks which we have found in the past quarter. As of the end of the second quarter, the trailing P/E of the S&P 500 is 24, up from 22 at the end of 2015. Earnings results for the first quarter were disappointing and declined about 8% from the same quarter in 2015. Poor results from the energy sector weighed on those results but energy has begun to stabilize somewhat so the sector’s impact on future quarters should be less negative.
The S&P 500 Index declined as much as 6% over the two days immediately after the unexpected outcome of the Brexit vote. However, it recovered almost all of those losses within three days. This resilience is a near term positive for the market, in our opinion.
Data in the last few quarters suggest that profit margins have probably peaked which leaves sales growth to drive earnings improvements for most companies. This weaker backdrop has led to sizable declines in certain industries. Within these beaten down industries, we are beginning to find some interesting companies at attractive valuations and are excited about their prospects.
At the June meeting, Chairwoman Yellen of the Federal Reserve changed earlier remarks suggesting a rate hike could occur in July. The subsequent policy statement indicated a more “wait and see” approach for the remainder of the year. One contributor to the apparent pause is a very poor employment report for May. In the report, the data showed that only 38,000 jobs were created in May. A labor strike at Verizon is estimated to have impacted the number negatively by around 35,000 jobs. Even if the result is adjusted for that short term issue, the corrected number of 73,000 is weak. Some market observers believe a single quarter point hike could occur by the end of 2016. We do not believe a single increase in interest rates will result in doom for US equities but the constant uncertainty could produce additional volatility ahead.
We welcome your thoughts and comments and are honored that you have chosen MONTAG to manage your investments. We hope the additional material, focusing on the power of crowds, is useful to you.
