Gill Capital Partners: Q2 2014 Market Commentary
Market Overview The 2nd quarter of 2014 continued to show signs of strength across many different facets of the economy. While U.S. equities continued to perform well, we were pleased to see strong performance from a variety of asset classes including emerging market equities, real estate, MLPs and international bonds. The themes that are top of mind at our weekly investment committee meetings at Gill Capital Partners are valuation and the potential impact of changing policy at the Federal Reserve. We will address both of these topics below.
The global economy continues to grow and while the U.S. has been in the spotlight in recent years, the Eurozone is now showing signs of life with four consecutive quarters of positive real GDP growth. New stimulus by the European Central Bank, including negative interest rates, will continue this trend and add confidence that the growth is real and sustainable.
Equities have continued their move higher on the back of improving corporate earnings and an ever-accommodative Federal Reserve policy. Looking more closely at valuation, equities would not be considered cheap at these levels, but also not overvalued. Given the lack of opportunity in fixed income, investors are less concerned with valuation and are willing to continue the rotation into equities. We would argue that given the current environment of low interest rates and inflation, the equity market has room to move higher, but at a more measured pace. We would expect more normalized annual stock returns in the 7-8% range.
Two other areas that could create issues for the equity markets are geopolitical concerns and the coming midterm election. Midterm election years, such as 2014, have historically seen short-term pullbacks as investors digest changes in our national leadership. Those pullbacks have also been followed by substantial rallies over the following year, ranging from 12% to 58%. While there is a possibility of volatility, we would view this as a buying opportunity.
Fixed Income Rally
Bond markets have surprised investors with the continuing rally both in the U.S. and overseas. With the removal of quantitative easing and the potential for the Fed to begin raising short-term interest rates in 2015, this move higher has proven almost every fund analyst incorrect about the direction of rates year to date. In our view, there are a few key reasons:
- Thinking back to the basics of economics and supply and demand, the U.S. Treasury issuance is in decline and is anticipated to have a smaller issuance by as much as 20%+ in 2014.
- Many institutional investors must follow the mandates in their investment policies to maintain adequate holdings of U.S. Treasuries and this demand helps to maintain low yields.
- Also, even though the Fed is in the process of decreasing the monthly amount of securities that they purchase… they are still purchasing, just not to the extent that they previously were.
We anticipate the Fed will be done with their purchasing program during early Q4 of this year and we will likely see a tick up in yields at that point. The ten-year Treasury continues to hover around the 2.5% level, but don’t be surprised to see a move closer to 3% by year-end.
One of our favorite graphs to show clients is the change in the Federal Reserve balance sheet over the last six years. To understand the size of the stimulus program, it is helpful to see a graphical timeline of the efforts of the Fed and the staggering change in the balance sheet from approximately $800 billion to over $4 trillion. Don’t forget, this stimulus is on top of a Fed Funds rate of 0%-0.25% that has been in place since December of 2008.
Source: Federal Reserve Bank of Cleveland and the Schwab Center for Financial Research
The main question to answer when looking at this stimulus is, has it worked? With ever improving economic conditions, a long bull run in the equity markets and an unemployment rate that has decreased from 10% in October of 2009 to 6.1% in June, the Fed would likely consider this a resounding success.
The end of quantitative easing is upon us and we are watching closely to see how the economy will react to less government intervention. Inflation is one possible outcome, as newly created money flows back into the economy. Another possibility is higher interest rates. If the Fed decides to sell large quantities of bonds, it will create more supply and in turn lower bond prices and higher yields. We don’t consider all of these possible scenarios to be negative. A more normalized rate environment would move bond yields higher and provide the opportunity for investors to create more income from their bond holdings. It is also important to note that higher rates don’t directly equate to lower stock returns. When rates do rise, it will be more important to rotate away from rate sensitive sectors such as telecoms and utilities and into more cyclical sectors.
In summary, we anticipate increased volatility, but pullbacks are currently opportunities to buy at more attractive valuations. International equities have increasing potential to add positive performance to the portfolios with decreasing risk. Both domestic and international economies are on an extended growth pattern and that is expected to continue.
This material is for informational purposes only and is not an offer to sell or the solicitation of an offer to buy.The general guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for any particular investor or client. Before investing, investors and clients should consider whether the investment is suitable.