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2nd Quarter 2017 Market Commentary

Stocks around the world edged higher during the second quarter. International and emerging market stocks continued to outperform U.S. stocks, while growth stocks outperformed value stocks. In the U.S., large cap stocks performed better the small cap stocks, but the reverse was true in international developed markets. Domestic bonds had small positive returns year to date, as short term interest rates ticked higher. International bonds, particularly in emerging markets, performed better than domestic bonds as the dollar experienced some weakness against global currencies. Volatility remained conspicuously absent, with the VIX index (a key measure of near-term volatility conveyed by S&P 500 stock index option prices) trading near all-time lows. Oil pulled back into the mid $40s as the OPEC production cuts encouraged a boost in U.S. shale production.

US Stocks are represented by the S&P500 Index. International Stocks are represented by the MSCI EAFE NR Index. Emerging Markets are represented by the MSCI Emerging Markets Index.

Interest Rate Movements

On June 14th, the Federal Reserve increased interest rates for the second time this year. Now the Fed Funds rate stands at 1.00% – 1.25%. While short term interest rates have risen, longer-term rates declined year to date. This caused a flattening of the yield curve. Historically, a yield curve inversion (which occurs when short-term rates are higher than long-term rates) has been associated with economic recession. Investors should keep a close eye on the interest rate curve. The good news for bond investors, however, is that the reduction in long-term rates caused bond prices to rise, while the increase in short-term rates provides better yield opportunities for reinvestment. The Bloomberg Barclays US Aggregate Bond Index is up 2.27% year to date.

There’s a misperception that stock prices always fall when interest rates rise. After all, the purpose of tightening monetary policy is the slow economic activity, right? A look at historic data shows no correlation between changes in the Federal Funds rate and stock returns. Below is a graph of the historic data. If there were a correlation between Fed Fund changes and US stock returns, we would see the dots form an upward sloping line to the left. Instead, we see no pattern.

 

Source: Dimensional Fund Advisors Q2 Quarterly Market Review; Second Quarter 2017

Federal Reserve Balance Sheet

While the Federal Funds rate receives all the media attention, the upcoming reduction in the Fed’s balance sheet will be a pivotal moment for financial markets. In the minutes from their most recent meeting, the Open Markets Committee outlined their plan to begin reducing the size of their balance sheet in a methodical way; starting with $10 Billion per month and increasing to $50 Billion per month over 12 months. [i]

After the 2008-2009 financial crisis, the Fed embarked on three rounds of bond purchases called Quantitative Easing (QE 1, 2, and 3).  These purchases increased the Fed’s balance sheet from about $1.5 Trillion to $4.5 Trillion. In 2014, the Fed began “tapering” bond purchases but continued to reinvest interest and maturing bonds, keeping the balance sheet level around $4.5 Trillion. This fall (consensus expectation is September) the Fed will stop reinvesting all proceeds and will allow balance sheet assets to roll off, starting at $10 Billion per month.

This will be a crucial time for financial markets because other buyers will need to purchase bonds in place of the central bank. The most likely outcome will be a rise in long-term interest rates. The central banks of Japan and Europe will watch closely, as they embarked on similar quantitative easing policies years after the Fed. After all the criticism thrown at the Fed’s unprecedented policies after 2008-2009, we may be about to find out if the exit will be successful.

ESG, Not the Old SRI

In late June, I participated in a panel at the IMN Global Indexing and ETF Conference in Dana Point, CA. The panel topic was ESG (Environmental, Social, and Governmental) investing. The other panelists and the moderator all represented institutional investors, and it occurred to me that individual investors are behind the curve in this topic area. Fifteen years ago, this type of investing was called Socially Responsible Investing (SRI). It consisted of negative screens for the so-called “sin” stocks and bad apples; think tobacco, firearms, and fossil fuels. SRI investors were willing to sacrifice return in order to align their investments with their values. ESG investing is different. ESG focuses on risk management and potential alpha from investing in companies who are leaders in a variety of Environmental, Social, and Governance factors. Environmental is not a blanket rejection of oil producers but a screen to identify those with the best practices for sustainability. Social includes screens for proper use of human capital such as fair compensation, sick leave, paid family leave, and the avoidance of child labor in emerging markets. Governance refers to board structure, composition, and independence. There’s a growing body of research that suggests ESG factors might even be sources of outperformance for investors and at least are not performance detractors. I think investors will see a lot more attention paid to this topic over the next decade, and I am excited to see new developments in the ESG space.

Win by Not Losing

Jason Zweig, author and personal finance columnist for the Wall Street Journal, famously said; “My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.” This is how I feel about the conclusion of each quarterly letter. I try to end each letter with common sense investing principles explained in a new way.

Now that I’ve given away some of my secret sauce, on to this quarter’s conclusion …

We spend a lot of time talking about risk with clients. There are many ways to define risk in investing. One technical term is volatility, or standard deviation. I think that max drawdown, or downside risk, is a more applicable definition of risk for investors. The reason downside risk is important is the lopsided nature of the return required to recover from large losses. For example, you need an 11% gain to recover from a 10% loss, but you need a 43% gain to recover from a 30% loss. The math goes off the charts with a 50% drop, which requires a 100% return to recover to breakeven. This is the reason we spend so much time thinking about risk in addition to returns. Our goal is to create a smoother “rollercoaster ride” for client portfolios by limiting downside risk. In real life; however, I enjoy the rollercoasters with the biggest drops.

 

 

Blair duQuesnay, CFA, CFP®

July 2017

 

 

 

 

Disclosures:
•    All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. It should not be regarded as a complete analysis of the subjects discussed.

  •  Information presented does not involve the rendering of personalized investment advice and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Tax information is general in nature and should not be viewed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
  •  Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio. All investment strategies have the potential for profit or loss. There are no guarantees that an investor’s portfolio will match or outperform any particular benchmark. Index returns do not represent the performance of ThirtyNorth Investments, LLC, or its advisory clients.
  •  ThirtyNorth Investments, LLC, is registered as an investment advisor with the SEC and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.

[i] Minutes of the Federal Reserve Open Market Committee; June 13-14, page 3.