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Market Commentary
By The Deighan Team

After a long, tough winter and a reluctant, slow spring, it is summer at last! Warm weather pastimes, lush gardens, and barbecues tend to occupy our minds this time of year, but just as gardens need tending, so do portfolios. For those who are more interested in hearing a quick “bottom line”, I will deliver a fast take away as an introduction, with more detail to follow for those who find the financial markets as interesting as we do.

In the second quarter, worldwide financial markets ended largely flat with a few exceptions. First quarter GDP declined by 2% in the U.S. The dollar continues to be strong against other currencies worldwide making foreign travel fun for our citizens, but weighs heavily on large domestic multinationals operating on foreign soil, and more difficult for our manufacturers to sell their goods. The clouds gathering over Greece have given way to rain as they have defaulted on their obligations to the European Union (EU) and may be headed toward a “Grexit” from the Euro as currency. Economic growth in China has slowed and Asian markets have been extremely volatile. The U.S. equity market crept ahead only slightly in the second quarter and many worry about a pullback. Finally, the Fed continued to forecast an increase in short-term rates in September or early 2016. Looking ahead, there is a good deal of hand wringing over the influence of the foregoing issues on U.S. financial markets, but hand wringing usually bodes well for markets, while complacency does not. Digging a bit deeper, overall U.S. market fundamentals still look pretty solid, but equity markets remain vulnerable to market shocks due to worldwide events, which could cause pullbacks over the near term. According to Schwab Chief Investment Strategist, Liz Ann Sonders, a market pull back might be a gift in disguise, as it would lay a foundation for a new leg of growth.

Looking back at the past three months, quarter end results were disappointingly flat. We did see a “musical chairs” effect among the worldwide markets throughout the first six months of 2015 as some of the 2014 winners drifted back while some of the 2014 losers regained footing. For example, the bell weather US large company index, the S&P 500, was up only 1.23% for the first six months of the year after soaring 13.69% in 2014. Meanwhile, despite clouds gathering over Greece, the developed international equity markets have delivered 5.52% for the first six months of the year compared to a sorry -4.90% in 2014. Fixed income, as measured by Barclays US Aggregate Bond Index, slipped into the red at -0.49 for the first six months of the year versus a gain of 5.97% for 2014. Much of this rotation is to be expected. Markets that have done well often take a breather, while those that have lagged move ahead. This is one of the reasons we advocate for maintaining balanced, diversified portfolios.

Asset Class	Representative Index	2014	1Q15	2Q15	YTD
US Large Cap Equity	S&P 500 Index	13.69%	0.95%	0.03%	1.23%
US Small and Mid-cap Equity	Wilshire 4500 Completion	7.94%	5.28%	-0.56%	4.67%
Developed Int’l Equity	MSCI EAFE (Net)	-4.90%	4.88%	0.62%	5.52%
Emerging Int’l Equity	MSCI EM (Net)	-2.19%	2.24%	0.69%	2.95%
Alternative Equity	HFRX EH Eq Mkt Neutral	3.63%	1.69%	-0.86%	0.84%
Hard Assets	Bloomberg Commodities	-17.01%	-5.94%	4.76%	-1.57%
Broad Fixed Income	Barclays US Aggregate	5.97%	1.61%	-2.10%	-0.49%
Cash Equivalents	BOA/Merrill Lynch T-bill 3mo	0.03%	0.00%	0.01%	0.01%

 

While we like to think of the summer as a time when the living is easy, there is currently quite a bit of uneasiness in European financial markets. However, none of the current news is surprising. Greece’s difficulty meeting its obligations as a member of the EU has been brewing for some time. Previously the EU and the International Monetary Fund (IMF) had established an aid program that traded quarterly infusions of capital for progress on budget and structural reforms. The program was set to end in December of 2014 but was extended twice with a June 30 deadline for the second extension. However, Greek economic recovery was not meeting projections. This, coupled with crippling austerity measures, led to a change of government in 2015. The new government, mindful that European institutions hold nearly 80% of Greek debt, demanded further assistance. The EU, IMF, and Greek government entered into negotiations. As the June 30 deadline approached, the Greek government broke off negotiations to call a referendum on whether to keep the terms of the aid program. On July 5, Greek voters elected not to accept the austerity measures. At the time of this writing, the next steps are all but clear. Greek banks are predicted to run out of cash on Monday, July 13. Greek leadership wants to remain in the EU. This is wise since to pull out and reinstate the drachma would cause a stunning financial collapse and certainly political instability within Greece. At the same time, EU leaders face creating a precedent by writing down Greece’s obligations, since Spain and Portugal struggle as well. As we watch this Greek drama play out, we are hoping for a reconciliation with achievable terms; financial collapse and political instability may be a high cost to pay for holding Greece to the original terms of its obligation, which they clearly cannot meet with a stagnant economy.

Back in the U.S., we have our own mini Greece with the impending bond default of the territory of Puerto Rico. On June 28, the governor of Puerto Rico, Alejandro Padilla, announced that the island of some 3.6 million people would be unable to pay its debts of roughly $72 billion. As of this writing, the White House was not considering bailing out the territory. Puerto Rico’s inability to pay her debts will certainly hurt some American investors. It may also make it more difficult for Puerto Rico and other unstable states and municipalities to borrow funds to finance infrastructure, but unlike Greece, Puerto Rico remains part of the US, and will not be facing bank closures.

There is a certain amount of concern over the negative GDP number for the first quarter of 2015. Once again, it makes sense to look at the number in a wider context. We must recall that in January, February, and March, the weather outside was unusually frightful. Adverse weather affects our domestic growth rate. Moreover, over the last decade our first quarter GDP growth has averaged out to zero, while the measure has averaged 2.3%, 2.1%, and 1.6% for the second, third and fourth quarters. In fact, the first quarter GDP rate for 2014 was -2.1%. This slower than expected rate of economic recovery from the Great Recession as compared to the pre-1990’s is believed to be due partially to the increased levels of public debt as a percentage of GDP reducing the rate at which the economy recovers.

This underscored the importance of the Fed backing slowly away from intervening and shoring up the U.S. economy with an interest rate hike unless truly necessary. We are relieved that the Fed ceased the quantitative easing program which may have been necessary during the aftermath of the 2008-2009 economic crisis, but served to seriously balloon our debt. The next step is to normalize short term borrowing rates to the extent the economy is healthy enough to sustain the increases. Analysts initially predicted a federal rate hike because of positive moves in numerous U.S. economic indicators. According to the U.S. Department of Commerce, Bureau of Economic Analysis, total non-farm payroll employment increased by 280,000 jobs in May after a weak increase of 30,000 in April. Unemployment recently normalized at around 5.5% and remains unchanged and housing and retail sales strengthened. After the June meeting, officials at the Fed began hinting at a September rate hike. However, the CPI (less food and energy) has seen only very meager increases this year as has personal income and the dollar has appreciated markedly. This, coupled with the market instability resulting from the Greek Debt Crisis, may cause the Fed to hold off on the rate hike until 2016. Whenever the change comes, the current thinking is it may have less of an effect on long-term U.S. interest rates than it did in the 1980’s, or even the mid 1990’s. The Fed has been clear that it will proceed with rate increases on a measured basis. Furthermore, the correlation between national short-term interest rates and long-term interest rates has been dropping while the correlation between long-term interest rates across developing nations has been increasing, which brings our attention back to projected growth trends on the worldwide stage.

Chinese economic growth has been flagging. China routinely saw pre-recession annual GDP growth of over 10%. Chinese GDP growth in the second quarter fell slightly to 7%. The International Monetary Fund projects China’s GDP growth rate to fall to 6.8% in 2015 and 6.3% in 2016. Some analysts believe this is China approaching normal or sustainable growth. Is 6.3% a bad growth rate? By comparison, U.S. GDP grew 2.4% in 2014 and saw negative growth (-2.1%) in the first quarter. In contrast, India is expected to see GDP growth of 7.5% in 2015, and Mexican GDP growth is expected to overtake the United States’ growth rate by 2016. Mexico has a $1.26 trillion dollar economy, making it the 15th largest in the world. This is partially due to ambitious reforms (tax reforms, reductions in government spending, and deregulation) instituted by President Enrique Peña Nieto. As an aside, nothing would do more to resolve our border issues with Mexico than a healthier Mexican economy. Clearly China, India, and Mexico are growth rates to watch.

All is not bleak despite challenging headlines, but due to the large debt burden we must digest, U.S. investors must exercise patience as we progress slowly to increase our economic growth and market returns. All things considered, U.S. fundamentals remain relatively stable. Even the price of oil seems to have settled in at a price of around $60 per barrel. Thus, we advocate buckling your seat belt and riding through any difficulties that may arise. As always, we emphasize investment quality and portfolio durability as we select and monitor securities and rebalance portfolios. As one of our young recruits recently said during an Investment Committee meeting, “Despite some of the hand wringing out there, we don’t have to start living in caves and return to a hunter-gather society…but if things don’t work out with the EU, the Greeks might have to.” That would be a sincere shame.