Financial markets in May were mixed with modestly positive returns in U.S. equity markets (+1.3% for the S&P 500), modestly negative returns for international equity markets (-1.5% for the MSCI ACWI ex USA), and flat returns in U.S. fixed income markets (-0.2% for the Barclays Aggregate). U.S. economic data was on the weaker side, generally attributed to bad weather; however, the labor market continues to show improvement. The expectation is still for the Fed to commence rate hikes later this year.
In U.S. equity markets all sectors were positive for the month except for Energy and Telecom. The healthcare sector led with gains of more than 4%. Small caps led large caps for the month, and growth led value except in the mid cap segment.
International equity markets delivered a small gain in local terms, but the stronger dollar weighed on returns for U.S. investors. Japan gained more than 5% in local terms amid stronger economic data, while Europe gained less than 1% in local terms. Emerging market equities lagged developed markets in May, declining -4% in US dollar terms. China and Brazil were particularly weak performers. Despite weaker performance in May, both developed international and emerging markets lead U.S. equity markets so far this year by a sizeable margin.
The 10-year U.S. Treasury yield ended the month 10 basis points higher at a level of 2.13% and so far in June 10-year yields have backed up another 25 basis points (through June 5). However, because of the small coupon cushion in U.S. Treasuries today, only a small increase in yields can lead to a negative total return for investors. The credit sector was mixed in May, with investment grade experiencing declines and high yield delivering small gains. Municipal bonds continued to underperform taxable bonds. Year to date high yield leads all fixed income sectors.
Our outlook remains biased in favor of the positives, but recognizing risks remain. We have entered the second half of the business cycle, but remain optimistic regarding the global macro backdrop and risk assets over the intermediate-term. As a result our strategic portfolios are positioned with a modest overweight to overall risk. A number of factors should support the economy and markets over the intermediate term
- Global monetary policy accommodation: Despite the Federal Reserve heading toward monetary policy normalization, the ECB and the Bank of Japan have both executed bold easing measures in an attempt to support their economies.
- U.S. growth stable and inflation tame: Despite a soft patch in the first quarter, U.S. economic growth is expected to turn positive in the second quarter and the labor market has markedly improved. Reported inflation measures and inflation expectations remain below the Fed’s target.
- U.S. companies remain in solid shape: U.S. companies are beginning to put cash to work through capex, hiring and M&A. Earnings growth outside of the energy sector is positive, and margins have been resilient.
- Less uncertainty in Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year; however, Congress will still need to address the debt ceiling before the fall. Government spending has shifted to a contributor to GDP growth in 2015 after years of fiscal drag.
However, risks facing the economy and markets remain, including:
- Timing/impact of Fed tightening: The Fed has set the stage to commence rate hikes later this year. Both the timing of the first rate increase, and the subsequent path of rates is uncertain, which could lead to increased market volatility.
- Slower global growth: Economic growth outside the U.S. is decidedly weaker. It remains to be seen whether central bank policies can spur sustainable growth in Europe and Japan. Growth in emerging economies has slowed as well.
- Geopolitical risks: Could cause short-term volatility.
Despite higher than average valuations and neutral investor sentiment, the trend is still positive and the macro backdrop leans favorable, so we believe there is the potential for additional equity market gains. The quantitative easing programs of the European Central Bank and the Bank of Japan, combined with signs of economic improvement, have us more positive in the short-term regarding international developed equities, but we need to see follow-through with structural reforms. We expect U.S. interest rates to continue to normalize; however, U.S. Treasuries still offer relative value over sovereign bonds in other developed markets, which could keep a ceiling on long-term rates in the short-term.
As we operate without the liquidity provided by the Fed and move through the second half of the business cycle, we expect higher levels of both equity and bond market volatility. This volatility should lead to more attractive opportunities for active management across asset classes. Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.
*This entry was originally posted in Brinker Capital’s blog. Brinker Capital provides this communication as a matter of general information. Portfolio managers at Brinker Capital make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions. Neither Glenn McKinney nor Lincoln Financial Securities are affiliated with Brinker Capital.