It is certainly no secret that the summer months tend to be among the quietest for markets. Yet this year’s lull was quite pronounced, as the lack of any major headlines led to a steep falloff in market activity, especially by the time we reached the “dog days” of summer in August. Few expected it to be such a quiet summer, given the number of worries weighing upon investors early on. Though the Brexit vote in the UK plunged global markets into chaos in June, risk assets seemed to recover almost as quickly as they had fallen. As some raised concerns that the US economy was showing signs of weakness, the economic data coming out this summer proved sufficient to assuage such fears. This same data was referenced by Fed Chair Janet Yellen in her statements at Jackson Hole in August, leading many to surmise a rate hike was imminent. However, such expectations quickly dissipated, and the Fed indeed stood pat at its September meeting.
Given this set of circumstances, it is unsurprising that markets around the world performed as well as they did this quarter. The S&P 500 saw new highs, and equity markets both developed and emerging posted healthy returns. On the fixed income side, riskier assets like corporate credit and emerging sovereigns fared best, as uncertainty over the path of US rates did little to counter what remains to be generally easy global monetary policy. Both the Bank of Japan and the European Central Bank held policy steady this quarter, with the latter reiterating its commitment to further stimulus if necessary. Undoubtedly, this also helped to keep a lid on volatility, and allowed markets to further recover from the lows encountered in the early part of this year.
While this backdrop has proven favorable for investors, we feel that this has created a greater level of complacency in the markets. We increasingly see a global economy facing risks that are not only increasing in number, but also in magnitude. On the geopolitical front, a number of major emerging markets have moved towards populist authoritarianism as their economies have wilted in recent years. Flagging growth in Turkey has led President Erdogan to consolidate power, culminating with the purges that occurred in the wake of the coup attempt this summer.
Meanwhile, to Turkey’s south, the ongoing war in Syria marks yet another front for Russian military adventurism, seen by some as the Kremlin’s attempt to distract Russians from economic woes at home. The US and Russia are increasingly at odds over how to ultimately handle the situation in Syria, in spite of the continuing consequences. The threat of the Islamic State continues to loom over the West, and the humanitarian tragedy that is the refugee crisis continues to worsen. This unprecedented surge of migration has created its own set of problems, not the least of which is the rise of right-wing populism in Europe. With Brexit now seen by some as the first of many victories for Eurosceptics, there is the fear that the EU and its associated institutions may be weakened at a time when Europe needs them the most.
Unfortunately, the political situation on the other side of the Atlantic is not much better as the election draws closer. Whether it is calls for increased taxation, protectionist policies or new regulations on business or migration, both candidates seem to be appealing to increasingly populist sentiments here in the US. Yet regardless of what happens on November 8th, we believe the US economy faces a number of risks. On the surface, headline economic data is fairly positive, especially when one looks at metrics like job creation or consumer confidence. However, this does not change the fact that this economic expansion is now over seven years old and showing signs of age as profit margins decline and returns on invested capital fall. These factors, combined with increasingly rich equity valuations, have given us some pause as of late.
Looking beyond the US, we generally feel increasingly uncertain about the global growth environment. While absent from the headlines recently, we believe that fears over a slowing Chinese economy could easily roil markets yet again. The Eurozone, despite the best efforts of the ECB, remains trapped in economic doldrums, and worries over the German banking system could cause the situation to deteriorate further. While the US remains in comparatively good shape, further rate hikes by the Federal Reserve could prove to be a strain on markets, especially given what seems to us to be a lack of compelling new investment opportunities globally.
With all of these factors considered, we have taken on a more defensive positioning in client portfolios over the past few months. While we remain confident in the long term performance of the companies we choose to own, we have felt it prudent to reduce our equity exposure recently in favor of cash and low-duration fixed income securities. Though we certainly do not wish to be perceived as alarmist, given the uncertainty that persists throughout global markets we feel that such a positioning makes sense in the interest of risk management. As we watch how the balance of the year unfolds, we also feel that these recent moves afford us ample resources to take advantage of anything that might be on the horizon.
If you have any questions about our views or how they relate to your portfolio we encourage you to reach out to us. We greatly appreciate your business and thank you again for your support and trust.
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