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Investment Overview: 3rd Quarter 2015

Frank W. Savage, CFA,

October 05, 2015

Growing Your Wealth

Articles

The Economy

The U.S. economy picked up steam in the second quarter after a weak first quarter in which harsh winter weather, west-coast port strikes and a strong dollar negatively affected output.  Real GDP growth was revised up from 3.7% to 3.9% as U.S. consumer spending posted one of its best performances of this recovery.  In addition, the vast majority of the construction-related categories were also revised higher.

American households appear to be brushing off the turbulence of financial markets, helping the U.S. navigate through slowing global growth.  Personal spending increased 0.4% in August from a month earlier and follows similarly strong readings in June and July.  Persistent spending is being supported by steady hiring, falling unemployment and reasonable near-term wage growth.  Solid and sustainable personal spending is particularly important as personal consumption accounts for approximately two-thirds of GDP.

Oil prices remain pressured, hitting a six-year low in August, despite lower U.S. production and relatively stable demand.  Government data confirmed in late August that the nation’s oil output peaked in April and has fallen steadily since.  Offsetting the decline in U.S. production, and effectively putting a lid on prices, are output increases from Saudi Arabia, Iraq, Russia and Brazil.  Many prognosticators are expecting oil to trade between $40 and $50 per barrel for the remainder of 2015.    

Fears of a Chinese-lead worldwide growth slowdown were at least temporarily abated by the upwardly revised second-quarter GDP report along with Federal Reserve comments suggesting that the U.S. economy isn’t on the edge of an economic precipice.  Nevertheless, the strength of the Chinese economy and its effect on the rest of the world will remain on the forefront of investor’s minds throughout the remainder of 2015.  On a positive note, the Eurozone continues to show hopeful signs of a gradual recovery from its current state of stagnant growth as accommodative European Central Bank monetary policy takes hold.

Third quarter economic growth looks promising given the continuing strength of the housing sector and the robustness of recent retail and automobile sales reports.  New home sales are at recovery highs while existing home sales remain strong.  Manufacturing activity is likely to remain a headwind as the energy and materials sectors cut spending in the face of declining commodity prices.  Also contributing negatively is the potential for a widening trade gap to persist as U.S. businesses fight a strong dollar that causes their goods to be more expensive to overseas buyers.  After factoring in a weak first quarter and a stronger second quarter, most economists expect Real GDP growth in the range of 2.0% to 2.5% for the year.

Interest Rates

Yields on longer-term Treasury issues fell over the quarter as investors, concerned about global growth, shed riskier assets and flocked to the safety of U.S. government debt.  The yield on the 10-year U.S. Treasury finished the quarter at 2.04%, after beginning July with a yield of 2.35%.  The fall in bond yields pushed broad bond market indices into positive territory for the quarter, reversing negative second quarter returns.  Inflation appears well contained for the time being, however the stronger jobs market may be beginning to push wage levels higher, a harbinger for future inflation concerns.

Investment-grade corporate bond spreads are on track to increase for the second year in a row for the first time since the financial crisis in 2007 and 2008.  Although debt spreads have increased, corporate debt issuance remains strong, up 15% in 2015 after setting records in each of the past three years.  Investors are somewhat perplexed by the widening of credit spreads, which can portend a weakening economy, given an improving employment picture, robust consumer spending and strong corporate balance sheets.  

High-yield bond spreads have also widened in recent months, largely due to firms with significant exposure to China’s economic slowdown.  According to Standard and Poor’s Rating Service, 53.4% of non-investment grade borrowers from the metals, mining and steel industries are trading at distressed levels.  By contrast, companies in the health care industry had a distress ratio of just 3.6%.  As of mid-September, nearly 16% of bonds rated below investment grade traded at distressed levels, the biggest share since 2011.

A consensus appears to be building within the Federal Reserve that an increase in the Federal Funds Target Rate is in order by the end of the year.  Both Mr. Dudley and Mr. Williams, presidents of the Federal Reserve Banks of New York and San Francisco, respectively, echoed Chairwomen Yellen’s sentiment that a strong case presents itself for raising interest rates if the economy continues on its current growth trajectory.  Nevertheless, debate remains.  While the U.S. economy appears solid, some Fed officials are also worried that inflation is running too low to warrant a rate increase.  Officials are also weighing how a rate increase might affect our global economic interests in the face of financial and economic turmoil abroad.   

We continue to anticipate longer-term bond yields will eventually rise from today’s paltry levels given the likelihood of rate hikes coupled with the expectation of continued economic growth and the potential for inflation to begin to surface.  However, geopolitical uncertainties and a lack of confidence in global economic conditions may continue to keep rates lower than normal in the near-term.

Treasury yields of selected maturities for recent time periods are displayed below.

 
  Treasury Bill Treasury Notes & Bonds
  3 mo. 2 yr. 5 yr. 10 yr. 30 yr.
09/30/15 -0.02% 0.63% 1.36% 2.04% 2.85%
06/31/15 0.01% 0.65% 1.65% 2.35% 3.12%
3/31/14 0.02% 0.56% 1.37% 1.92% 2.54%

 

The total return numbers for various fixed income indices over the last twelve months are displayed below (data from Bloomberg).

52 Week Returns (a of 9/30/15)
Barclay Capital US Aggregate 2.94% Merrill Lunch US High-Yield -3.57%
Merrill Lynch US Treasury Int-Term 3.19% Merrill Lynch US Municipal Index 3.16%
Dow Jones Corporate -0.92% JP Morgan Embi Global -1.96%

 

Stocks

Major market averages fell across the board in the third quarter on concerns over a slowdown in China coupled with the potential market impact of the Federal Reserve’s plans to normalize monetary policy.  Stock market volatility remained high as equity prices again fell in the waning days of September after battling back from a late August rout.  

All U.S. large-cap indices were down similarly for the quarter with the S&P 500 Index, the Dow Jones Industrial Average and the NASDAQ Composite losing approximately 6% to 7%.  Small capitalization stocks, depicted by the Russell 2000 Index, performed even worse as the risk-off trade intensified during the month.  Large-cap international stocks fared no better than their domestic counterparts with the developed-market MSCI/EAFE Index off 10% and the MSCI Emerging Markets Index off a shocking 18% for the quarter. 

Below is a table which displays various equity index returns for the past quarter.

 
Equity Indices 2nd Qtr. 2015 
S&P 500 -6.44%
Dow Jones Industrial -6.98%
NASDAQ -7.09%
S&P 500 Growth -4.83%
S&P 500 Value -8.25%
Russell 2000 (small-cap) -11.92%
MSCI/EAFE (developed international) -10.16%
MSCI/EM (emerging markets) -17.79%

 

With the third quarter selloff, U.S. equity markets in general appear to be trading near or slightly below fair value versus historical averages, especially after factoring in the low interest rate environment.  Many cyclical stocks have been particularly affected by global growth worries over the last several months and appear to be offering attractive value for the long-term investor.  Although significant uncertainty exists with regard to China’s economy and Fed rate action, we continue to position portfolios for a resumption in global growth. 

While economic headlines abroad have generally been uninspiring, the possibility exists for developed foreign markets, and in particular European equities, to surprise to the upside given reasonable equity valuations and lower expectations.  So far, preliminary third quarter reports indicate that the European economies are weathering the drag from a beleaguered China.  

On an economic sector basis, defensive stocks held up significantly better than their cyclical counterparts.  Equities exposed to pro-cyclical global revenue streams continue to be hampered by economic weakness and a persistently strong dollar.  Worrisome news out of China predictably troubled the Energy and Materials sectors during the quarter as both were off approximately 16% to 17%.  With the exception of Health Care, the defensive sectors of the economy (Consumer Staples and Utilities) held up relatively well with the Utilities sector actually posting a healthy 5% gain.  Health care stocks were thrashed late in the month on condemnation from House Democrats and presidential candidates Bernie Sanders and Hillary Clinton that accused pharmaceutical companies of price gouging.  Implementation of pharmaceutical price controls appears to be the promise de jour as we enter into primary election season.

The following table details S&P 500 sector returns for the quarter (price only).

 
Return by Stock Sector 3rd Qtr. 2015
1. Utilities 4.79%
2. Consumer Staples -1.38%
3. Consumer Discretionary -3.60%
4. Information Technology -4.31%
5. Industrials -7.26%
6. Telecommunications -7.32%
7. Financials -7.94%
8. Health Care -11.45%
9. Energy -16.32%
10. Materials -17.31%

 

 

The U.S. economy picked up steam in the second quarter after a weak first quarter in which harsh winter weather, west-coast port strikes and a strong dollar negatively affected output.  Real GDP growth was revised up from 3.7% to 3.9% as U.S. consumer spending posted one of its best performances of this recovery.  In addition, the vast majority of the construction-related categories were also revised higher.American households appear to be brushing off the turbulence of financial markets, helping the U.S. navigate through slowing global growth.  Personal spending increased 0.4% in August from a month earlier and follows similarly strong readings in June and July.  Persistent spending is being supported by steady hiring, falling unemployment and reasonable near-term wage growth.  Solid and sustainable personal spending is particularly important as personal consumption accounts for approximately two-thirds of GDP.Oil prices remain pressured, hitting a six-year low in August, despite lower U.S. production and relatively stable demand.  Government data confirmed in late August that the nation’s oil output peaked in April and has fallen steadily since.  Offsetting the decline in U.S. production, and effectively putting a lid on prices, are output increases from Saudi Arabia, Iraq, Russia and Brazil.  Many prognosticators are expecting oil to trade between $40 and $50 per barrel for the remainder of 2015.    Fears of a Chinese-lead worldwide growth slowdown were at least temporarily abated by the upwardly revised second-quarter GDP report along with Federal Reserve comments suggesting that the U.S. economy isn’t on the edge of an economic precipice.  Nevertheless, the strength of the Chinese economy and its effect on the rest of the world will remain on the forefront of investor’s minds throughout the remainder of 2015.  On a positive note, the Eurozone continues to show hopeful signs of a gradual recovery from its current state of stagnant growth as accommodative European Central Bank monetary policy takes hold.Third quarter economic growth looks promising given the continuing strength of the housing sector and the robustness of recent retail and automobile sales reports.  New home sales are at recovery highs while existing home sales remain strong.  Manufacturing activity is likely to remain a headwind as the energy and materials sectors cut spending in the face of declining commodity prices.  Also contributing negatively is the potential for a widening trade gap to persist as U.S. businesses fight a strong dollar that causes their goods to be more expensive to overseas buyers.  After factoring in a weak first quarter and a stronger second quarter, most economists expect Real GDP growth in the range of 2.0% to 2.5% for the year. 

 
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The Investment Overview is published quarterly by the Union Investment Management Group of Union Bank & Trust Company. Please address correspondence to: Union Bank & Trust, Attn: UIMG, PO Box 82535, Lincoln, NE 68501-2535.