Stocks were modestly higher in June, with U.S. small cap equities and emerging markets leading the way. Large cap U.S. equities, measured by the S&P 500 Index, rose 0.62%. The MSCI Emerging Market Index gained 1.01%. Core bond prices were modestly lower as yields rose slightly. The U.S. 10-Year Treasury note ended the month with a yield of just 2.27%.
Global economic activity has continued to grow at a modest pace, with favorable employment data supporting the U.S. and improving manufacturing activity spurring European economic growth higher. During its June meeting, the Federal Reserve raised short-term interest rates 0.25% to a range of 1.00% to 1.25%. Central banks in Europe and Japan continue to hold their benchmark rates in negative territory.
U.S. equities were positive in June, led by the Russell 2000 small cap index, which returned 3.46%. Emerging market equities continue to perform very well in 2017, with a YTD gross return of 18.43% through June.
Core bond prices were slightly negative during the month, with the Barclays U.S. Aggregate Bond Index returning minus 0.10%. High yield bonds were flat during the month, but have performed well YTD, with a return of 4.99%. Emerging market bonds have performed very well with the JP Morgan U.S. dollar-denominated emerging market bond index rising 6.19% and the local currency emerging market bond index rising 10.36%.
As many expected, the Federal Reserve raised short-term interest rates to a range of 1.00% to 1.25% at its June meeting. The move was well-telegraphed by the Fed, and it marks the continued normalization of interest rate policy in the U.S. In its statement from the June meeting, the Fed noted that “the labor market has continued to strengthen and economic activity has been rising moderately so far this year.” While the Fed indicated that it would raise rates again this year, it noted that future rate hikes would continue to be gradual.
The Fed is balancing two primary objectives with its current rate hiking policy. On one hand, unemployment is low, the labor market is healthy, and equity markets are experiencing minimal volatility. With those factors in mind, it is in the economy’s best interest for the Fed to continue raising rates to prevent excessive risk-taking and leverage from building up in the system. The last recession came about due to many contributing factors, with the primary causes being low interest rates and the resultant excessive risk taking by consumers and banks. Although the economy may not feel like it is in euphoria mode right now, the Fed is moving forward with rate hikes in order to keep animal spirits in check.
Nevertheless, the Fed is not moving forward at the same pace of rate hikes as it has in the past. During the current cycle, the Fed hiked rates once per year in 2015 and 2016, and has now hiked rates twice this year, with the committee anticipating that it will hike 1-2 more times this year. By comparison, in previous rate-hiking cycles, the Fed has moved more aggressively, hiking 6-8 times a year. The central bank is moving more slowly this time around due to the fact that inflation has remained subdued and risk-taking appears to be in line (not withstanding major U.S. equity market indices like the S&P 500 at all-time highs).
Although interest rates are still very low compared to historical levels – the average Fed Funds rate from 1954 to present is 4.90% — the increase in the overnight rate from near 0.0% a few years ago to over 1.0% now will help to improve interest income in the U.S. Looking forward, the Fed must continue to balance the fact that higher rates benefit many aspects of the economy (higher interest income for savers, as illustrated in the previous chart), while raising rates too high or fast would hurt lending and disrupt financial markets.
We point out this balance because, in our view, the Fed’s moving too aggressively to hike rates is a potential risk to the equity market as we head into the second half of the year. Stocks have enjoyed the benefits of easy money in the system as well as the idea that the Fed was willing to put tighter policy on hold any time the markets experience a sell-off. The Fed is walking the line between supporting markets and openly dissuading risk-taking through more aggressive interest policy. The further rates rise, the more they teeter towards discouraging risk-taking, and thus U.S. markets may find reason to become more volatile.
This is one of the reasons we have maintained our international and emerging market equity exposure in Sage’s diversified portfolios. Whereas U.S. central bank policy is becoming tighter, central bank policy in Europe and Japan remains very accommodative. JP Morgan notes that Euro area and Japanese data continue to impress, and Mario Draghi, the president of the European Central Bank, has continued to reinforce that they will keep easy policy in place.
The combination of improving economic growth (the Euro area has posted better GDP growth than the U.S. over recent quarters) combined with favorable central bank policy should help boost equity prices. We have already seen these two factors at work in 2017, as the MSCI ACWI Ex US Index has returned 14% YTD compared to a 9% return from the S&P 500. European equities are still undervalued relative to U.S. stocks. At present, the Shiller CAPE ratio, a valuation measure that looks at long-term earnings relative to the current price, shows that Euro equities at a CAPE ratio of 17x versus 30x for the U.S., a discount of 43%. European equities also have higher yields than the U.S. (3.0% vs. 2.0%). These factors, combined with an improving economic environment and the potential for increased domestic spending as they carve out a bigger role in international trade agreements (particularly as the U.S. steps back), could lead to continued outperformance from international markets.
Emerging market equities, with a YTD return of 18%, are one of the strongest performing asset classes this year. Looking forward, we continue to believe the long-term growth story of emerging markets remains intact, as growing populations and increasing middle class consumption will help fuel GDP growth that is in excess of developed markets. Combine future excess growth potential with undervalued assets and the potential for very attractive long-term returns from emerging markets becomes evident. The following chart shows the CAPE ratio premium/discount of emerging market equities relative to U.S. equities. At various points EM equities have traded at a premium to U.S. equities and at other points at a discount.
At present, EM equities trade at a sharp discount to U.S. equities, but could potentially move higher from such low relative valuations, as they did in the early 2000s. That period, from 1999 to 2007, was extremely favorable for emerging market equity performance on both an absolute basis and a relative basis, compared to the S&P 500. Over that time period, emerging market equities returned 420.2%, cumulatively, compared to a 38% cumulative return for the S&P 500.
In the most recent stretch of underperformance for emerging market equities, from 2008 to the end of last year, they have returned minus 9.7% compared to a return of positive 79.1% for the S&P 500. Although it is impossible to predict the degree to which emerging markets will outperform in the future, it is our view that emerging market equities may well be returning to another prolonged stretch of outperformance relative to the S&P 500, as they have in the past.
In summary, we are happy with the strong returns from U.S. and international assets during the first half of the year. We believe the Federal Reserve’s interest rate policy will need to be closely watched going forward, as it must strike a balance of hiking rates to stave off excessive risk taking, but must not hike too quickly and disrupt financial markets. Investors should be aware of the potential for a faster than expected hiking policy to reintroduce volatility into U.S. equity markets. Given the potential for higher interest rate policy in the U.S, contrasted with continued easy money policy in Europe and Japan, we believe investors are likely to experience continued outperformance from their international investments. Improving economic growth and still attractive valuations should also help make the case for holding international investments in a diversified portfolio. As always, we respect the trust you have placed in us, and we welcome any questions you may have about our views on the current economic and market environment.
The information and statistics contained in this report have been obtained from sources we believe to be reliable but cannot be guaranteed. Any projections, market outlooks or estimates in this letter are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of these investments. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. These projections, market outlooks or estimates are subject to change without notice. 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 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. All indexes are unmanaged and you cannot invest directly in an index. Index returns do not include fees or expenses. Actual client portfolio returns may vary due to the timing of portfolio inception and/or client-imposed restrictions or guidelines. Actual client portfolio returns would be reduced by any applicable investment advisory fees and other expenses incurred in the management of an advisory account. 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 Sage Financial Group. 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. Sage Financial Group 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. A copy of the Sage Financial Group’s current written disclosure statement discussing our advisory services and fees is available for review upon request.
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