Second Quarter 2016 Investment Commentary

The June quarter was the latest period where the fundamentals of corporate sales, earnings, margins, and valuation had little impact on prices in the financial markets. Instead, investors watched as traders attempted to position for macro events, perceived as crucial, which have come to dominate daily market action. In 2Q this included an on-again, off-again Federal Reserve, a surprise Brexit outcome in which the UK voted to quit subsidizing its neighbors via a popular vote to exit the European Union, a loud and shaky end to the U.S. presidential primaries, and an increasing amount of overseas and domestic terrorist activity.

The Fed meetings were in late April and mid-June, and the infamous Brexit vote interceded a week before the second quarter ended.  Economic data leading up to the April Fed meeting had been viewed in the context of a forecast recovery in consumer spending and consistent job growth after a dismal Q1 GDP.  Most thought this would finally force the Fed to follow through with 2 or 3 additional interest rate increases in 2016.  However, a surprisingly soft May employment report, released June 3 ^rd , threw cold water on that consensus, completely repricing the interest rate markets for no additional Fed action until at least September.  The Fed, fearful of disappointing the markets, essentially confirmed the revised view at their June meeting.

The dramatic surprise of the Britons voting to leave the EU pushed all sovereign bond yields down further in a capital flight to the perceived safety of government bonds.  US 10 year bond yields, which had already declined sharply in Q1, plunged under 1.5% at quarter-end and dropped to new record lows in the first days of July as the market consensus shifted to no Fed rate hikes in 2016.  With over $10 trillion in global sovereign debt trading at negative yields due to the forced buying of central banks, US 10 year yields at 1.5% still offer the highest yield of any debt in the G-7.

These large moves in both bond yields and perceptions surrounding central bank policy affected stock prices and specific industry groups during the quarter.  Interest sensitive sectors such as utilities, telecoms, and consumer staples turned into leaders due to their higher individual yields and tendencies to trade as bond surrogates.  Those same groups started the quarter as pariahs because traders emphasized more cyclical sectors under the notion that the economy was set to sustain a 3%+ growth path in 2016.  By quarter-end the 2016 GDP forecast had dropped sharply under 2.0% and the tentative rotation toward technology, consumer discretionary, and financials was abandoned.

Financials deserve the most commentary as the yield curve spread and forward inflation expectations both dropped to new lows for the expansion in Q2.  This is an obvious headwind for net interest margins and the financial sector was rerated to lower multiples of book value and forecast earnings.  Earnings estimates for financials also fell the most of any sector aside from technology during the quarter.  Earnings for the S&P fell 6.7% in Q1, the fourth consecutive quarterly decline, and are forecast to drop another 5.3% in Q2.  In spite of the falling earnings and lowered GDP forecast, the S&P produced a modest 1.90% return after waffling between small gains and losses all quarter.

Bonds in significant swaths of the sovereign market are trading at NEGATIVE yields.  Yes, this means that you voluntarily lend $1,000… knowing that you will receive back less than your principal.  We’ve noticed that our phones are not ringing with clients begging to buy these things, so the question is: to whom does this make sense?

The reality is that most institutional investors are attempting to generate percentage returns on portfolios, so they win if they buy bonds with negative interest rates and sell them at interest rates that are more negative .  This is, of course, the definition of the greater fool theory – that it doesn’t matter what you pay for something as long as you think you can sell it to someone who is willing to pay more.  It’s happened with tulip bulbs, it’s happened with dot.com stocks, and it’s happened with collateralized mortgage securities; now it is time for bonds.  This episode seems more obvious than those historical precedents, but, hey, maybe it’s only us who think lending investors’ money at a guaranteed loss makes poor financial sense…

In this case, Central Banks play a big part, as they have convinced large fixed income investors and banks that they will serve as buyer of last resort if things get uglier.  Most households, however, are more interested in absolute returns than relative returns, so buying a negative yielding bond makes no sense.  Sometimes global finance sounds complicated and sexy, and sometimes it just sounds dumb.  We suspect that history will prove this episode to be the latter.

But it affects rates, and valuations, across the globe – the US ten year treasury is currently trading at a 1.6% yield, pushed down, in part, because any yield at all looks attractive to investors investing capital from overseas, who are choosing between 1.6% here and negative rates on other sovereign bonds.

It also affects stocks.  Long term cash flows are usually discounted at some interest rate in order to come to a present value – the lower the interest rate, the higher the present value.  If the value of stocks is the present value of all future cash flows, then extremely low interest rates support higher valuations, at least on paper.  The fly in the ointment is that if you use unnaturally low interest rates in your calculations, what happens when the mania passes and those rates normalize?  The fact that you can find a way to justify valuations does not mean you will make money from them.

It is easy, right now, to find smart people who will say that valuations look fine relative to interest rates , which is to say that valuations look fine relative to negative yielding bonds in parts of the developed world.  But these are two sides of the same coin – if one believes that stocks are fairly priced because of aberrational interest rates, it goes to say that one believes in the idea of buying bonds with a negative yield for the same reason.

You can feel confident that LCM portfolio managers will never buy a bond with a negative interest rate, and, in fact, at this market high the cash position in our portfolios has grown considerably, as you would expect of a manager with an absolute return focus in this environment.   Fortunately, we have generated a reasonable absolute return on a year-to-date basis, with the LCM balanced accounts up mid-single digits YTD through the date of this commentary, despite conservative positioning.

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