The U.S. economy is still growing, albeit at a modest pace. Consumer confidence hit the highest level in nine years. The University of Michigan Consumer Sentiment Index also backs this up.
When consumers are confident, they spend more money. In turn, this can act as a virtuous circle until an outside force acts upon it.
The presidential election and how the eventual winner impacts the economy is on investors’ minds. A few are worried about the election being the outside force that hits consumers.
One issue the incoming President will face is the likelihood of a recession at some point. By the time the new President takes office, this expansion will be closing in on eight years. The longest economic expansion ever for the U.S. was from 1991 until 2001. Simple math would tell us we are due within the next four years.
The chart below shows the federal government tax receipts as a percentage of total Gross Domestic Product (GDP). The increase in this rate over the past five years tells us it is a risk for the incoming President.
Taxes drain money out of the system. Today, it is taking money out at one of the highest rates in the last 30 years. With interest rates at the lowest level since the 1950s, we would prefer to see more fiscal stimulus or lower taxes. This would help buoy the economy.
The financial media watches the Federal Reserve with bated breath every time a governor speaks. Still, there is only so much that they can do. Maintaining low interest rates certainly helped the economy. There is dissension within the ranks at the Fed with three members voting to raise interest rates at the last meeting. We will wait to see what happens in the fourth quarter with the possibility of another interest rate hike this cycle, the last one being in December 2015.
Stock markets rallied across regions during the third quarter. Emerging markets were the top performers followed by developed international. The U.S. lagged, with domsetic small caps outpacing mid and large caps.
The chart below shows the sector performance on a year-to-date basis. Energy in the red line is the
top performer in 2016 after being the worst in 2015. The thin blue line for utilities and the thin orange line for telecom peaked in July. Both were down during the quarter despite the broader market being up.
Last quarter we talked about the outperformance of yield-oriented sectors. In a few circles these became known as R.U.S.T. (Real Estate, Utilities, Staples (consumer), and Telecom). Most portfolio managers felt these areas were overvalued. This was due to the flow of cash into these sectors and inexpicable prices paid (hence the not so affectionate label).
The U.S. equity market was the best performer over the last five years, as shown in aqua below. Japan has come back down to earth after the stimulus package from 2014 wore off, as shown in green. Europe’s stocks, in orange, lagged both Japan and the U.S. Political issues from not being fiscally linked produced imbalances between Germany and the periphery countries. The biggest underperformer was emerging markets in violet.
In the past we discussed the cheap value in share prices and currencies for emerging markets. The chart above, however, is much simpler. Over the past five years, emerging markets has been the lowest performing region. Though it still turned in positive returns for investors. If the first rule of investing is “buy low and sell high,” which markets would an astute investor consider adding funds to?
The Aurum Asset Allocation Frameworks have strategic asset class targets for the long-term. Our tactical weights reflect value-based opportunities. This is where our research shows favorable conditions for an asset class. Portfolios maintain a small underweight to developed markets in favor of emerging markets.
Corporate credit spreads relative to comparable Treasuries decreased during the quarter. This allowed bonds to turn in a positive quarter, except for municipals.
Yields on the 10-year Treasury bottomed in the first week of July and rose 0.40% since, shown in orange. This is the third multi-month rise in yields over the past four years. Each period below is highlighted by grey vertical bars. In each case, Japan’s Government Bonds (JGBs in aqua) rose sharply just before U.S. yields perked up.
In 2013, the 10-year Treasury yield rose from 1.63% to 3.00% over seven months. In 2015, Treasury yields rose from 1.64% to 2.49% over five months. The sample size is quite small at only two, however, pressure on yields could continue higher for a few more months. The Federal Reserve’s rhetoric around raising interest rates in the fourth quarter is putting pressure on yields. Policy responses from Japan and Europe is as well.
High yield bonds have done well this year. This followed a poor performance in 2015, driven by the energy sector. Because of this, prices started out at distressed prices for energy. The credit spreads were comparable to the distress in telecom in 2001 and financials in 2008. The graph below shows the spike in yields for each of these sectors at those points in time.
With the price of oil stabilizing and doubling from $26 per barrel to $50 barrel, the price of stocks and bonds for energy came roaring back.
The Aurum Asset Allocation Frameworks maintain fixed income allocations at the strategic targets.
Our preference remains for fixed income securities collateralized by assets. This provides an extra layer of protection on cash flows or yield for our fixed income.
During the third quarter, hedge funds led the way as credit and equity-oriented strategies did well. The reversal in bond yields hurt trend following managers. REITs fell while increasing inflation expectations helped TIPS.
Below is the yield of the Barclay’s TIPS index. TIPS stands for Treasury Inflation Protected Securities. The unique aspect of TIPS is that the principal price of the bond adjusts annually based on the consumer price inflation (CPI) index. With inflation averaging 2.2% over the past two decades, TIPS offered a great value in the early to mid-2000s with a yield well above inflation.
Aurum Asset Allocation Frameworks
Inflation has actually been running below the yield of TIPS lately. This means investors are locking in a negative real yield. So today, this unique asset class does not look attractive.
We increased our underweight to diversified strategies during the quarter as one of our managers retired. REITs and TIPS maintained a zero percent weight.
There are investment opportunities for those willing to look at uncomfortable places. Equity momentum is positive across regions. The back-up in interest rates could offer up compelling value in fixed income as well. The election is weighing on the minds of investors, however, historically the party leading the White House has little correlation to the performance of markets. Marking portfolio decisions based on politics just does not mix. We will stick to a diversified approach across asset classes.
This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.