Q2 2017 Portfolio Commentary & Outlook – Tug of War
With longer days, wouldn’t you think summer would move along slower? Instead, it always amazes me how quickly the 4th of July comes and goes. It must be the outdoor activities, family time, and easy livin’ that make time fly.
Along those lines, (poof!), we have the first half of 2017 in the books and are now looking forward to how we want to position ourselves for the next six months.
Thinking in terms of stock market themes, the first half can be defined as well-behaved, orderly and strong. Our growth benchmark, the All Country World Index (ACWI), returned a respectable 11.48% year to date through June 30. Once again, our BSW growth portfolios bested this index over the same period attributable to our overweight exposure to foreign developed and emerging market stocks along with some active manager outperformance.
While the theme of the second half won’t be fully baked until we don our 2018 party hats this January, we have a sneaking suspicion that it won’t resemble its easy-on-the-eyes predecessor. This is not to say that we are predicting poor returns. On the contrary, we think this market has more room to run. It’s just that, due to a confluence of events, we see increased volatility in most asset classes and some potentially vulnerable areas of the market.
As we enter the second half of 2017, opposing forces build. On the one hand, global GDP growth is set to notch its highest level in six years. And for the first time in four years, there is coordinated manufacturing momentum across all regions of the world.
This coordinated GDP and manufacturing growth should drive earnings growth, and by extension, stock prices. In addition to this, Europe is now in a sweet spot for growth; with credit readily available, the European consumer is feeling the best she has felt in 10 years.
European Economic Sentiment Indicator (ESI):
On the other hand, we see global central banks taking the opportunity to tighten monetary conditions in the second half of 2017. In anticipation of the next recession, central banks need to create room to ease conditions.
The Federal Reserve has already started raising short-term rates and has announced that it will start shrinking its bloated balance sheet as early as October. Remember, The Fed has been actively buying bonds since 2008. Adding bond purchases to the Fed’s balance sheet effectively injected money (created out of thin air) into the financial system, which helped to coax the economy out of the Great Recession.
The Fed will look to shrink its balance sheet by selling and/or not reinvesting up to $50 billion worth of bonds per month. Yes, that’s $600 billion per year (or about 4.5% of the current money stock) that will essentially be taken OUT of the monetary system. This is an exit strategy that has never been attempted at this level. It remains to be seen how the bond and stock markets will react. The Fed will be very transparent in communicating its intentions, but even so, we anticipate some bumps in the road as market participants absorb ramifications of the tightening measures.
The European Central Bank announced that it may consider tightening monetary conditions; taking their cue from the Fed. This is on the heels of Canada, the Bank of England and China announcing their own intentions of raising rates and making money less plentiful.
The main issue with the latest tightening scheme is that most of the money created globally since 2008 didn’t find its way into the economy (think: capital equipment purchases and productivity upgrades), but was instead used to buy financial assets (think: stocks, bonds, and real estate). We see this illustrated in the below chart of the S&P 500 versus the money supply.
This experiment has not gone full circle yet, so we don’t know with a high degree of certainty how it will work. This is a risk that we will be closely monitoring through 2H 2017.
To be clear, we think this game of tug of war between central banks and global stock markets could go on for quite some time. Central banks do not want to curtail what has been a tepid economic recovery in most regions. We anticipate that they will monitor how their moves affect markets and either pause or reverse course as needed – which brings its own issues, but that’s for another blog post.
BSW will be rebalancing portfolios within the next few weeks. As discussed in previous posts, this is part of our disciplined management. Since stocks have run through the first half of the year, we will be trimming select areas of growth portfolios to realign asset classes to individual client target weights. With stock gains, we will purchase bonds and/or underweight asset classes within client portfolios. Think of this as harvesting fruit in order to plant seeds in other productive areas of the portfolio.
We are maintaining our overweight to foreign developed and emerging market stocks for 2H 2017. Valuations overseas are more reasonable than those in the U.S. and there is evidence that these regions are just beginning their growth cycles. With the U.S. markets having outperformed over the previous four consecutive years, now that their houses are in order, it is time for the rest of the world to catch up.
Enjoy the rest of your summer!
Director Public Investments