Fasten Your Seatbelts...
For quite some time now, market pundits have discussed an impending return of volatility to global markets. While we encountered two bouts of market instability late last year, they were short lived and seemingly somewhat unfounded. Yet as the year has progressed, particularly in this second quarter, it seems that volatility has been more persistent. It is manifesting itself not only in equity markets, but in fixed income as well. What’s more, the events that are driving it, unlike in the recent past, feel somewhat more tangible. While many saw this return of volatility as part of the “base case” for 2015, it does not make navigating such markets any less challenging, nor does it make investors any less fearful of these market gyrations. Admittedly, many of the headlines driving this volatility are rather disturbing. However, in times like these, it is important to remember that volatility does necessarily signal a shift in the business cycle. Looking at economic data, especially domestically, one has plenty of reasons to believe this economic expansion still has some room to run. Yet if there is anything we should take away from this quarter, it is that the ride in these later stages is likely to be markedly bumpier.
The U.S. economy ground to a halt at the beginning of this year with GDP contracting slightly due to a stronger dollar, strikes at West Coast ports and yet another frigid winter. However, as the weather improved, we received plenty of signs the economy was improving. The jobs market looked stronger, with the unemployment rate hitting 5.3% in June, and consumer confidence and housing numbers making impressive strides as well. With such a stark contrast between the first and second quarters of the year, many speculated on the reaction from the Federal Reserve. In June, the U.S. central bank confirmed that a raise in rates was almost certain to occur by year’s end, but the pace of subsequent hikes was likely to be more gradual than originally anticipated. Nevertheless, this statement pushed Treasury yields, which rose throughout the quarter, even higher. Interestingly, equity markets reacted quite well to this situation. After the Fed’s June meeting, the S&P 500 came coming close to returning to the new all-time highs it had hit in May, ultimately recording a 0.3% gain for the quarter. Though a seemingly meagre return in absolute terms, this placed U.S. equities among the better performers globally, especially as the debt crisis in Greece worsened over the quarter.
Crisis: Greek origins, global impacts
While Greece dominating global headlines or moving markets is far from something new, this most recent spate of bad news was particularly pronounced. Naturally, European assets were particularly hit hard, experiencing a great deal of volatility this quarter. This came in spite of improving economic data in much of the Eurozone, as well as the European Central Bank’s continuing €60 billion per month quantitative easing campaign, a testament to the gravity of the situation. However, few markets around the world were immune to the gyrations, with investors reacting vigorously to seemingly every new headline coming from Athens, Brussels or Berlin.
While this story dominated the quarter, concerns truly amplified in June as Greece approached the deadline to make a €1.55 billion loan payment to the IMF. As expected, Greece failed to make the payment, and then suggested a bailout plan that would restructure its debt and extend its payment schedule. Its creditors, mainly the European Commission, the ECB and the IMF (known collectively as the “Troika”) rejected such a proposal, especially in the absence of any of the reforms they had originally demanded of Greece. Greek Prime Minister Alexis Tsipras called a referendum on the Troika’s bailout proposal, which the majority of Greeks voted against. While many saw this referendum as an “in-out” decision with regard to Greece’s continued membership in the Eurozone, it quickly became clear that the European Union was not willing to let a Grexit occur so easily. An emergency summit was called in Brussels, in a last ditch attempt to resolve the situation.
At this summit, after many an impasse, Greece finally came to an agreement with its creditors, securing a new round of aid in exchange for implementing new economic reforms and austerity measures. With this tentative deal, Greece will be able to stay in the Eurozone and a crisis has (yet again) been averted. However, after five years of watching Greece haggle with the Troika, it would be naïve to think we are immune to another relapse. Tsipras must still sell this deal to the Greek people, in spite of the fact that it runs rather contrary to the anti-austerity platform that put him and the Syriza party in power at the beginning of this year. Undoubtedly, the ultimate outcome of the Greek situation remains to be seen, and markets are likely to continue to be impacted.
As we move into the second half of this year, we believe it is a good time to take inventory of how expectations for this year have matched with reality. The base case of “divergence”, both in terms of global growth and in central bank policy, has largely played in these past six months. Though the Federal Reserve has not yet actually raised rates, they remain on track to do so, barring any extremely negative U.S. economic data in the coming months. When exactly this will occur is really anyone’s guess, but we feel that a liftoff in rates is unlikely to be the earth shattering event so many have made it out to be, especially given the pace at which the Fed is expected to move. The fact of the matter is, the U.S. economy has continued to expand, albeit slowly, and there is little evidence of this trend reversing yet.
However, as we have stated, we do expect more volatility going forward. While the Fed will certainly have a hand in this, especially in the near term, we also believe that a number of situations have the potential to weigh on global markets. Naturally, much of the focus over the past few months has been on the Greek crisis, and the impact on Europe’s fledgling recovery. While we believe the outcome of this situation to be extremely important, we do feel that attention to it has come at the expense of other issues looming elsewhere. In particular, China continues to be of great concern to us. While the rapid rise and precipitous fall of Chinese markets has garnered some attention to the situation, we feel this goes far beyond speculation in China’s equity markets. A number of data points seem to indicate a continued slowdown in the Chinese economy, which given the country’s increased role in global growth in the past decade, is particularly worrisome. Undoubtedly, it is a situation we will continue to monitor.
That being said, as a long term investor, it is always important to keep crises (or specters of crises) in perspective. With macroeconomic risks dominating headlines, and investor risk appetites swinging considerably, it can be easy to become paralyzed by fear. However, these increasingly volatile markets have made many fundamentally attractive assets cheaper. Currently, we spending a great deal of time assessing opportunities this volatility may be yielding. In the same vein, we are looking to our external managers to do the same, especially those who have more flexible investment mandates. However, we intend to be very calculated in any moves that we make, given the environment. With so many signs pointing to bumpier roads ahead, we feel positioning ourselves against potential risks is ultimately the first priority.
We hope that you enjoy the rest of your summer and, as always, greatly appreciate your support and trust.
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