Continued volatility remained the main theme of the 3rd quarter. Although economic conditions in the U.S. seem to be stabilizing, questions surrounding international economies, interest rate hikes and the presidential election contributed to near daily fluctuations the markets have avoided during most of the current multi-year bull run.
With all the volatility, investors who stuck with higher volatility stocks and lower quality fixed income were rewarded. Growth oriented areas of equities, such as small cap and emerging market stocks outperformed the larger, dividend paying stocks. Ironically, this was a change from the prior quarters where equities in the dividend paying and low volatility sectors outperformed. In fixed income, high yield and emerging market debt outperformed higher quality fixed income vehicles such as treasury bonds. Valuations, and an increased appetite for risk going into the 4th quarter, appear to be the reasoning behind the shift. However, a growing consensus that the U.S. Federal Reserve may continue their accommodative stance and hold off on any rate increases until 2017 could be contributing to the “risk-on” appeal.
Looking forward, there are three areas of concern that could affect domestic markets negatively: interest rate increases, a strong dollar and inflation.
Economic conditions in the U.S. look favorable enough to warrant a rate hike in December or early 2017. However, the Federal Reserve has proven to be transparent through their commentary suggesting they will be careful in their approach to sustained increases. Due to muted growth economically around the world, it is our opinion it will take several years for the Fed to get rates back to what are considered “normal” levels. Their transparency and cautiousness should prevent an interest rate shock scenario that could damage both growth and equity prices.
While economic conditions in the U.S. are slowly improving, developed international countries, mainly Europe, are not seeing the same improvement. While the U.S. is preparing to raise interest rates, the Euro and some Asian monetary policies are still easing. The result is a strengthening dollar vs. most currencies around the world. The overarching concern is the effect it will have on U.S. companies that do business worldwide. A strong dollar typically means declining revenue for international sales as well as the potential for manufacturers to look outside the U.S. for cheaper production. That could lead to a decline in earnings for the companies that do business overseas. Corporate earnings have been declining over the past few quarters. Declining earnings could lead to the possibility of an overvalued equity market, and increase the potential for a short term pullback bringing market valuations to a more reasonable level. However, it is our view that economic conditions domestically are improving with both, gas prices and unemployment low. These types of economic indicators are beneficial to the U.S. consumer which should lend itself to a strong holiday shopping season and the potential for corporate earnings to exceed expectations. Our view is corporate earnings are more likely to beat already decreased expectations and lead to positive equity returns.
With U.S. economic conditions becoming more positive, the Fed will have a difficult time making interest rate decisions. On one hand, they need to make sure they eventually get rates normalized as well as making sure to curb excess inflation. On the other hand, the Fed needs to be careful not to slam the brakes on, based on historical standards, a very weak recovery. In our view, inflation is the major occurrence that could end the multi-year bull market and set the potential for a recession. Eventually, the economic cycle will see itself in a such circumstance, as it always does. However, growth both domestically and worldwide is so low that inflationary conditions are negligible and we believe the potential for positive equity returns remain.
From a portfolio standpoint, we favor domestic equities over international for the near term. We believe there may be greater potential in international equities over the longer term due to the low expectations and valuations in many of the European companies. We continue to believe a strengthening dollar validates a position that allows us to hedge currency exposure internationally.
With the likelihood of increasing domestic interest rates, positioning the fixed income portion for interest rate sensitivity is important. We believe interest rate hikes will be sporadic enough as to not “shock” the system or drastically effect bond prices. Thus, it is prudent being on the shorter side of the yield curve, but still seek opportunities for interest in some areas outside of treasury bonds or with higher yielding debt. We continue to believe that a portion of the portfolio should be in emerging market debt which provides not only diversification outside of the U.S., but also, quality yield.
As always, I stress that in this ever-changing political and economic environment, sensible diversification is the key to weathering any market uncertainties.
Jason M. Vavra, CPA, PFS
The information contained herein is not considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Past performance is no guarantee of future results.