STC Market Review: Q2

MARKET OUTLOOK

The harsh winter weather and port delays that dampened growth at the start of the year have given way to increases in consumer spending and housing, bolstering Federal Reserve projections that the setback was temporary. The June jobs report provides another critical piece of information to monetary policy makers sounding increasingly determined to lift the fed funds rate off the zero bound in the second half of 2015. While residential construction and consumer expectations support the more positive outlook, industrial production and new orders in manufacturing are painting a somewhat more mixed picture. Both are related to the strong U.S. Dollar and low energy prices. The strong Dollar is making investment at home appear less attractive and is weakening foreign demand for U.S. goods from abroad, while lower energy prices cause both the companies that build pipelines, pumps, and drilling rigs to curb investment, but they also affect areas such as steel, cement, and other fields that supply the oil industry. However, we expect the consumer and housing to drive GDP by a moderate 2.5 - 3.0% in 2015, with similar growth to follow in 2016.

Given our outlook and despite the fact that we are in our 73rd month of a bull market, we think that some runway remains for the equity market given low inflation and low rates, while the promise of higher short term rates late in the year should lead to softening in fixed income prices. This is more of a stock picker’s market, where in the last several years, it has been more of a “rising tide lifts all boats,” which favored more of an indexing strategy. We see value in potential core equity diversifiers such as small caps, dividend growth stocks, and international exposure, particularly in more developed markets such as Europe.

Although we will continue to invest for the long term in both equity and income producing assets, we also think it is a great time to diversify portfolios with alternative investment strategies. The concept of loss aversion—developed by psychologists Amos Tversky and Daniel Kahneman—demonstrates that the average investor prefers avoiding losses about three times as much as accumulating gains. As equities trade at elevated valuations, interest rates appear poised for normalization, and currency markets reflect policy differentials, we believe the differentiated returns found in alternatives address a high desire for loss avoidance on the part of investors.

ECONOMIC SUMMARY

• JOBS : The unemployment rate hit a 7-year low at 5.5% in May, driven by jobs created in the business services sector and construction. Payrolls also climbed in May by the most they've been in 5 months, and hourly pay increased 2.3% year-over-year, at the peak of the narrow range that it’s tracked since the end of 2009. So far in June, initial and continuing jobless claims continue recent trends that are supportive of a tightening labor market, which should help propel growth in the second half.
  
• RATES : The FOMC will also likely begin increasing short term rates late this year (Sept.) to keep the economy from overheating as the labor market continues to tighten. Persistently low inflation is keeping the Fed very cautious about raising short term rates.
  
• INFLATION : The cost of living in the U.S. excluding food and fuel rose less than forecast in May, a sign that inflation may take time to meet the Federal Reserve’s goal. The so-called core measure increased 0.1%, the smallest gain this year, after climbing 0.3% in April.
  
• INDUSTRIAL PRODUCTION : The factory sector continues to suffer from the effects of a strong dollar and low energy prices. Factory production unexpectedly declined in May (-0.2% vs. +0.1% in April) as the slump in energy output deepened. Total industrial production, which also includes mines and utilities, also dropped 0.2% despite gains among automakers.
  
• USD & EXPORTS : The U.S. dollar continues to strengthen versus most major currencies, resulting in less demand for US goods from abroad. This is a net positive for the world (negative for the US) as it should boost exports from some weaker economies. However, the stronger dollar has led to a decline in corporate profits for 2 quarters in a row.
• CONSUMER SPENDING : Personal income and household spending climbed in May by the most in almost 6 years, buoyed by gains in incomes as the U.S. job market strengthened. Consumers may finally be putting savings from lower gas prices to work after holding back earlier this year. Higher stock and home prices are lifting household wealth, and the average household balance sheet is also in much better shape after paying down debt in the wake of the Great Recession.
  
• CONFIDENCE : Consumer confidence rebounded in May, surpassing expectations, and the University of Michigan’s index of sentiment increased to 96.1 in June, exceeding estimates, from a 90.7 May reading. The gain capped the most optimistic first half of any year for households since 2004 and is due to an improving economy from the consumer’s perspective, but it also may reflect the acceptance of weaker economic prospects in the years ahead, primarily because consumers believe low inflation is here to stay.
  
• HOUSING : The U.S. housing market is expanding, albeit slowly, and much better able to withstand a rise in long-term rates than it was at the time of the "taper tantrum" in 2013. Recent upticks in existing (+5.1%) and new home sales (strongest since 2/08) could partially be driven by better weather and the prospect of higher mortgage rates ahead accelerating demand. But we think the bigger driver is improvement in the housing market's fundamentals, which will remain in place regardless of the Fed's actions, because they revolve around household incomes and balance sheets, not credit costs.
  
• LEI : The index of U.S. leading economic indicators climbed more than forecast in May, showing growth will pick up in the second half of the year. The 0.7% increase in the Conference Board’s index, a measure of the outlook for the next three to six months, matched the April advance, exceeding expectations of 0.4%.
  

EQUITY MARKET SUMMARY

• News about economic data and Greece have dominated the equity tape; however, US investor interest in the subject of Greece usually doesn’t last beyond 24 hours as none of the main possible outcomes (sustainable deal, muddled détente, ongoing acrimony, new gov’t, or even Grexit) really would change the macro narrative dramatically.
  

• So far this year, stocks haven’t mustered the upward momentum that they achieved in recent years, instead sticking to a tighter trading range.
  
• Growth-oriented stocks have largely outperformed relative to Value, and Small to Medium Cap stocks have outperformed Large Caps. YTD the Russell 2000 (Small Cap Proxy) was +6.90% (the Growth portion +10.6%, Value +3.2%), followed by the Russell Midcap up +4.31% (Growth +6.1%, Value +2.4%), while the S&P; 500 Index (SPX) was up +3.10%.
  
• Healthcare was the strongest performing sector (+10.5%), driven by M&A; as well as increased utilization due to the Affordable Care Act. Demographics also continue to be a driver with the large and ageing Baby Boomer population. Consumer Discretionary stocks have also performed well (+7%) on the back of lower energy prices and wage increases.
  
• Utilities were the weakest sector (-8.3%), lagging mainly because of the threat of higher interest rates. Utilities usually underperform in a rising rate environment. Energy also continues to be weak (-1.7%).
  
• Valuation remains on the high end with the SPX Price to Earnings Ratio (PE) of 20.5 vs. historical average of 17.0
  

US FIXED INCOME

• Market performance of fixed income has been softer since the end of the 1Q, with all eyes on economic data and how quickly and to what extent the Fed will raise the Fed Funds rate.
  
• Investors are starting to recognize that some interest rate and inflation risk should be built back into bond prices and are demanding higher yields both on US Treasuries and spreads for non-government securities.
  
• We do not believe this is the start of a sustained fixed income bear market. Interest rates in the US are still effectively zero and are negative in Europe. Until there are changes to these policy rates, cash is not an alternative for investors. Bonds, even with low yields, are still comparatively alluring.
  
• The Fed: The Street right now is penciling in one rate hike in 2015 (either Sept or Dec but more likely the former) and that assumption should hold barring a big upside jobs number on 7/2 (i.e. <280K). However, we think that two rate increases are more likely than none.
  
• Bond prices moved to close to all time highs between January and April as the economy struggled, but since April, prices have softened slightly with oil prices recovering and they continue to soften as more data shows that economic growth is returning.
  
• Year-to-date the Barclays Global Aggregate is off -3.68%, while the U.S. Aggregate is closer to flat (-0.73%).
  
• U.S. High Yield has outperformed other sectors (+2.94%). Municipal bonds have been flat (-0.12%), and US investment grade corporates have weakened with total returns -1.47% for A-rated bonds and -1.73% for BBB-rated bonds.
  
• The US Treasury yield curve has steepened slightly since year end, with the 10yr 24 bps higher at 2.41% and the 30yr 43 bps higher at 3.18%, indicating an expectation for higher rates longer term.
  

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About the Author

Kristin Bell joined Southeastern Trust in May 2015 as Vice President and Portfolio Manager. Kristin came to STC with more than seventeen years experience in investment related analysis, trading, and portfolio management, including roles at Unum Group, Wachovia Bank, and Fidelity Investments.

Kristin holds a B.A. in Psychology from Wheaton College as well as the Chartered Financial Analyst designation. She has previously served on the board of St. Peter's Episcopal School and as Treasurer for the Thrasher School PTA Executive Board.

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