Tuesday, June 30, 2015

LJPR Summer Commentary

Summer Commentary

Markets:  Global markets continued to send a mixed message through May and into June with signs of weaker global growth, combined with strong manufacturing numbers, modest acceleration in wage growth and good job numbers.  The major points from our Outlook at the beginning of the year are still on target. Given the dollar/euro and lower energy prices (which help consumers like Europe), we’ve recently increased our allocation to a slightly stronger position in developed international markets including Europe.  The strong dollar is a mixed blessing:  it’s great for imports and bad for exports.  When we buy Saudi oil, we are getting a relative bargain.  When we sell American goods abroad, they’re more expensive.  Given that analysis, we believe the developed international markets are improving in terms of growth potential.  This growth is supported by lower local currencies and easy monetary policies, which should offset the drag of a continued stronger U.S. dollar. 

Greece: While no one can anticipate what the outcome will be regarding the situation in Greece (their debt issues and whether they will remain in the Eurozone), we believe client portfolios are well positioned regardless of the end result.  As of this writing, the Eurozone is working toward a deal before Greece’s bailout program ends at the end of June when they need to pay the International Monetary Fund (IMF) 1.5 billion euros – basically money they don’t have.  The central bank in Europe is trying to strike a balance between safeguarding the country’s central bank and keeping Greek lenders in business, which is providing the aid, while the Greek government veers toward default.  By the time you are reading this, the situation will have likely changed several times.  To put the Greek situation in perspective, their overall debt represents around 175% of their GDP – not a good thing (anything north of 90% is a drag on further growth). As far as the size of their economy in global terms – it is a little bigger than the state of Oregon. 

Should Greece default or exit the union, the initial reaction of the markets will likely be negative with expectations of a quick recovery, barring any meaningful contagion fears. Our recommended allocations are positioned adequately given our outlook for the remainder of the year whether a deal is worked out or not (if it hasn’t by the time you are reading this). We would view any pullback in the markets from a Greek default or exit from the Eurozone as a rebalancing and buying opportunity for the region as a whole and would consider moving to an overweight position in developed international markets as the dust settles from the fallout. The situation there is constantly changing and we are keeping a close eye on developments and will make adjustments as conditions warrant.

Oil:  Energy has moved higher, off its lows when we had moved to increase our dedicated exposure to the sector – this has been a positive for returns.  We continue to closely monitor this area of the market.  Our thesis at the beginning of the year, that lower oil prices would benefit emerging markets, continues to do well on a year-to-date basis. Not surprisingly, when oil prices are low, people use more (drive up I-75 on a weekend if you don’t believe it).  Demand is up, and the curve shows that demand is increasing at a more rapid rate than supply.  We think oil will continue to rise in price, and geopolitical risks in the Middle East or Russia could accelerate the price increase.

Politics and Geopolitical Risk: LJPR’s outlook for domestic politics and geopolitical risks has not changed. We expect continued gridlock in Washington to last at least through 2016. It appears that close to 20 people are now running for president, so investment in television ads and/or earplugs might be useful.  Russia, ISIS and North Korea continue to be the areas of concern and wild cards for potential negative shocks to global markets. Cyber-warfare is starting to really rear its head, and we will be working on a cyber-security seminar again in the future.  Recognize that geopolitical risk is always there and maximizing diversification in portfolios continues to be a key element in helping protect from these risks.

The Fed:  Expectations of the Fed’s interest rate hike this year is still the consensus within the investment community, even in light of the negative growth numbers for the U.S economy that were reported for the first quarter of this year and the commentary from the Fed after their meeting this June. Once the Fed does start to raise rates, there is a strong probability that the pace will be slow and gradual.  While there may be negative market reactions initially, similar to the last “taper tantrum” in 2013, expectations of a rising rate environment are priced into the market and the expected gradual pace should help to minimize downside risk; particularly to those investments with interest rate risk exposure.  Keep in mind, rising interest rates are ultimately a positive for the U.S. economy – meaning the economy is on solid footing and growing along with a return to a more normalized interest rate environment.  We’ve shortened our duration on our bond side, so we can take advantage of a rising rate environment.

Our goal for clients is to make sure the fixed income side of portfolios are adequately protected in an environment of rising rates.  While we have never tried to time rate increases or their magnitude – no one knows with any certainty the direction of these variables (not even the Fed at this point), we do believe some minor adjustments to our target bond allocations were warranted by decreasing the sensitivity of portfolios to rising rates. Should market conditions or indications change, we will adjust the portfolios further.

Next step:  Things are good, but not great.  We have had a 6-year bull market after the Great Recession, without a meaningful correction (10% or bigger drop).  It’s been almost 7 years since the last recession, a recovery period that is historically quite rare.  It seems obvious we will get a correction in some market, probably the US.  It also seems immanent that we will have some form of slowdown.  Here’s a statistic that we should all soak in.  If you had a portfolio that had in it the S&P 500, which all of our portfolios do have, you would have experienced an 8.09% return for the period 1994-2014 (source: Morningstar).  If you missed the 10 best days in that 20 year period, you would have only made 4.41%.  Miss the 30 best days?  -0.12%!  Miss the 60 best days and you had an annual return of -5.36%.  To exacerbate this, mutual fund trades take place at the end of the day, so to dodge a bad day, you have to get out the day before the bad day.  To get one of the best days, you have to get in the day before.  We don’t know how to do this, and as far as we can see, neither does anyone else.  So when the market corrects, we will rebalance.  History tells us to stay diversified and make adjustments to the mix, but also tells us to stay in. 

Happy summer!
Leon and your LJPR team