July 2016

2016 Second Quarter and One-Year Trailing Returns Across Asset Classes

July Newsletter Chart

Equities

Looking back, the aftershock of the Brexit vote by the U.K. became top of mind for investors as the unexpected became reality. Central banks around the world were quick to position themselves as a liquidity backstop to the markets, should they have needed them. Investors lowered their risk exposures with an orderly sell-off on the news of Brexit despite the initial shock. The S&P 500 tumbled 5% over two days; however, a sharp rebound ensued that led the index back to its pre-Brexit levels, giving it a solid gain for the second quarter.

U.S. markets fared better than global markets. Safe-haven assets were bid up in response with the 10-year Treasury hitting a new all-time low yield as the thirst for yield remained a strong dynamic, distorting valuations across asset classes. Volatility remains a persistent theme so far this year in the investment landscape.

Looking forward, one could find the multitude of negative headlines across the news spectrum to be overwhelming, even paralyzing, in regard to the current state of the world. These emotions continue to draw attention away from reality. The reality is that the U.S. economy continues to chug along and contagion, or a U.S. recession, appears unlikely at this point. As the dust settles, the market will move on to the next “data point,” and investors might just find that it is a positive one. The S&P 500 could see earnings tick higher on the back of better foreign exchange comparisons and some improvement in the Energy sector from higher crude prices. Further, the U.S. consumer remains a bright spot and parallels solid housing and automotive outlooks. Many of the indicators will be closely watched here for changes on the margin as a result of the U.K. vote; however, the real impact to the domestic economy would likely come as a result of increased caution regarding capital allocation and a rapidly rising dollar, which haven’t been seen so far. Increased global macroeconomic risks will likely lead to a longer run for lower interest rates. There continue to be opportunities for bottom-up fundamental investors to identify attractive valuations with asymmetric, or uncorrelated, return profiles. Sector performance within the S&P 500 was led by Energy, Utilities and Health Care. The worst-performing sectors were Technology and Consumer Discretionary.

 Emerging Markets

Emerging Markets ended the second quarter with relatively neutral performance, as earlier losses in May were offset by a strong recovery in June. Returns were driven in part by a sharp reversal among domestic currencies as the USD stabilized, following the unexpected results from the Brexit vote that raised the possibility of a delay in monetary tightening among central banks, particularly the Federal Reserve (the Fed). Latin America was the best-performing region as equities climbed back from lows in May, led by Peru and Brazil. Mexico lagged as the government announced a US$1.7B reduction in spending for 2016, while the Bank of Mexico surprised economists by hiking its key interest rate by 50 basis points (bps) to 4.25% to support the depreciating peso. Asia was slightly negative overall as China and South Korea declined. Investor concerns regarding the economic slowdown in China persisted as fixed asset investments and retail sales growth missed estimates. The Bank of Korea cut its policy rate to a record low, while the Ministry of Finance announced US$17B in stimulus to spur domestic growth. Positive returns were led by the Philippines, India and Indonesia. The central bank of the Philippines maintained its key policy rates and confirmed that inflation was manageable, while risks to economic outlook remained tilted to the downside due to slower global economic activity and lower international oil prices.

The Europe, Middle East and Africa (EMEA) region declined as countries with exposure to both the European Union (EU) and the U.K., such as Poland, Czech Republic, Turkey and Hungary, fell. South African equities benefited from a resurgence in the rand in June following one of its largest declines since May 2013, when news of a possible arrest of the Finance Minister over alleged irregularities at the nation’s revenue service, and the probability of a sovereign rating downgrade to junk status, were announced. Greece fell as banks tumbled 37% following the Brexit result, while the country secured a

new US$11B debt deal with the IMF. Russia outperformed with a gain of 3%, as the ruble recovered from higher oil prices even as the economy improved from -3.8% to -1.2% in the first quarter. On a sector basis, Consumer Staples, Information Technology and Energy posted positive returns, while Industrials, Consumer Discretionary and Financials lagged.

Fixed Income

Investment Grade Bonds soared this quarter, building on first quarter gains. Treasury prices rallied after a weaker than expected May jobs report, the Fed pushing out expectations on future rate hikes at their June meeting and the U.K.’s unexpected vote to leave the EU. With growing concerns over economic growth, investors have bid up safe habor assets such as Treasuries since the start of the year.

The Barclays U.S. Aggregate Bond Index gained 2.21% in the quarter with the benchmark now up 5.31% year-to-date (YTD). The yield on the 10-year Treasury fell from 1.77% to 1.47% during the quarter, providing holders approximately a 3% return. Investment Grade Credit Spreads tightened by roughly 15 bps, which resulted in stronger performance of Investment Grade Corporate Bonds over duration-matched Treasuries. The U.S. Treasury Yield Curve continued to flatten as the yield differential between the 10-year and 2-year Treasury fell to its lowest level since 2007. Inflation expectations fell, causing nominal Treasuries to outperform Treasury Inflation Protected Securities (TIPS). All else being equal, investors in higher duration, or more interest rate sensitive, fixed income outperformed during the quarter. Within Investment Grade Corporate Bonds, Utility sector bonds were the strongest performer, while Financial sector bonds posted smaller gains. The Barclays Municipal Bond Index posted a 2.61% gain for the quarter bringing their YTD gain up to 4.33%.

The High-Yield market also posted solid gains for the quarter. The Bank of America Merrill Lynch High-Yield Master II Index rose 5.88% and is up 9.33% YTD. High-Yield Credit Spreads tightened by roughly 100 bps. Energy, along with Metals and Mining, were the top-performing sectors within High-Yield as bond prices benefited from higher commodity prices, particularly crude oil, iron ore and coal. Retail and Financial sector bonds underper­formed with smaller gains during the quarter. During the quarter, weaker credit quality substantially outperformed stronger credit quality. This was in part due to the High-Yield market’s significant Energy sector exposure, which benefited from a roughly 10-point rally in crude oil. High-Yield Bond Issuance also picked up in the quarter after a light start to the year.

MLPs

MLPs ended six straight quarters of negative returns by posting one of the strongest quarters in asset class history. After the Alerian fell 24% in the first six weeks of 2016, the asset class began a steady march upward, posting gains of 51% from that point forward. The positive momentum was spurred by an improvement in both crude oil and natural gas prices and a swift reduction in high-yield energy credit spreads. Both commodities responded to a less robust supply outlook, sparking a rally in their respective prices. Investor flows into the asset class remained positive as investors gained incremental confidence that the worst is behind us.

REITs

The NAREIT Equity index posted solid performance for the second quarter of 2016 outperforming the broader market by a wide margin. The relative outperformance of REITs was mainly driven by declines in rates as the yield on the 10-Year Treasury declined from 1.77% to 1.47% by the end of the second quarter.

Within the asset class, Free Standing Retail Net Lease, Data Center, Industrial and Health Care Sectors all performed admirably during the quarter.

The Free Standing Retail sector and Health Care sectors generally comprise REITs with defensive business models and very long lease terms. These REITs are typically viewed as fixed income proxies and performance tends to be strong during periods of declining rates. Data Center REITs were strong performers as companies within the sector posted strong leasing results driven by demand from Cloud providers. Industrial REITs fundamentals were strong as well, driven by demand from ecommerce for warehouse space, which pushed rents higher and occupancy levels to all-time highs, while high land and construction costs kept new supply in check.