The second quarter of 2017 marked the tenth anniversary of the beginning of the Financial Crisis, and ended with risk assets advancing to record levels. It’s hard to believe it was that long ago, June 2007, which marked the beginning of events that led to what is now known as the Great Recession, an event that triggered great economic chaos and led to unprecedented central bank intervention. The collapse of two Bear Stearns hedge funds (exposed to sub-prime credit derivatives) in June 2007 marked thestart of trouble. By August 2007, the Fed reversed its tightening course as contagion led to disarray in the money-markets and equity markets. By March 2008, Bear Stearns was forced to merge with JP Morgan, and Lehman Brothers was bankrupt by September 2008. Equity markets reached their low point in March 2009 as central-banks engaged in unprecedented monetary policy which included not only cutting interest rates (in some cases to negative levels), but also the buying of financial assets (better known as quantitative easing or QE). Certainly this a time period we all wish we could forget.
Yet, here we are…ten years later, and most investors who stayed the course and maintained their investment convictions are most likely happily counting their regained fortunes as central banks now weigh options on how to withdraw the “morphine drip” from the financial markets - which have seemingly become addicted to easy central bank policies (low interest rates, along with unprecedented asset purchases by the central banks). Make no mistake, many of these policies likely prevented a complete collapse of the economic system and a depression-like scenario from occurring. Meanwhile, as investors are feeling no pain, the economy continues to limp along with modest growth (first quarter GDP +1.4%) and high optimism as asset values continue to stretch. Perhaps, nowhere has this optimism been more apparent than in the Technology sector, with the “Fab Five” (Facebook, Amazon, Apple, Microsoft and Google parent, Alphabet) contributing an outsized portion of the S&P 500 Index’s return during the first half of 2017.
On the economic front, the most positive economic news seems to be “soft” data – sentiment, consumer confidence and other surveys which ask about future intention to spend. Actual “hard” economic data – measurable data based upon actions - has been harder to come by and, in-fact, has been below expectations. Similar to the past eight years, the data hasn’t been extremely weak, it’s just been weak relative to expectations and presumably what’s priced in the equity market. Although the equity market has been signaling optimism, the bond market has been pricing a very different scenario. Despite the Fed raising short-term interest rates in March and June, the 10-year Treasury yield reached a low of 2.13% in June, its lowest level since November 10, 2016. This near-term flattening of the yield curve (the declining difference between short and long-term interest rates) traditionally implies that economic expansion is slowing, however there is nothing traditional about what appears to be driving the shape of the curve - buyers fleeing negative interest rates in Europe and Japan. In the last couple of weeks however, we have seen the relationship of 10yr. Bunds to U.S. Treasuries indicate an “unwind” of those trades as central banks around the globe signal transitions to less accommodative or emergency monetary policy. With “noneconomic” buyers (buyers willing to pay any price) out of the equation to backstop prices, yields should gradually normalize higher. Those caught hanging out on the longer end of the yield curve will feel the most pain as a result.
The conundrum between the bond and stock market (and between “soft” and “hard” economic data) leads us to believe that the low levels of volatility in the market may not persist. Elevated stock valuations and weakening economic data along with high expectations and high optimism create a recipe for higher volatility in the future. Although lofty valuations may continue longer than justified, we believe investors should prepare for more modest returns. With this backdrop we believe stocks of lower-risk, higher-quality companies along with shorter-duration, higher-quality bonds will allow investors to continue to plod along in the near term, however they should take note of impending market volatility and significant market shifts longer term - positioning portfolios accordingly.
For the 2nd quarter 2017, the S&P 500® gained +3.1%, the Russell Midcap® rose +2.7% and the MSCI EAFE® advanced +6.1%. Although the Federal Reserve (Fed) again voted to raise short-term interest rates, bond indices advanced as longer-term interest rates fell and, coupled with interest income, produced strong returns. The Barclays Intermediate Gov./Credit Index advanced +0.94% and the Barclays Aggregate Index gained +1.45% for the quarter. Year-to-date equity market returns have been very impressive as the S&P 500® Index returned +9.3% and the Russell Midcap® Index advanced +8.0%, while the Barclays Intermediate Gov./Credit Index gained +1.73% and the Barclays Aggregate Index advanced +2.27% for the six-month-period.
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Although the information in this report has been obtained from sources that the Firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
Past performance is not a guarantee of future results. Madison Scottsdale is the insurance asset management division of Madison Investment Advisors, LLC. © July 14, 2017.