It has been quite a quarter. The U.S Federal Reserve is now on hold, the U.K. has voted to withdraw from the European Union, Puerto Rico has just defaulted on almost $800 million in municipal bond payments, and we are in the midst of the most controversial Presidential election cycle in generations. All of these developments increase uncertainty. Yet after a volatile start to the year, this past quarter’s shockers have left the markets curiously complacent. While these developments do not change our current investment strategy, we think it best to be mindful of the increased uncertainty that surrounds us.
The Federal Reserve is Now on Hold
After months of teasing by Janet Yellen and our Federal Open Markets Committee (FOMC), the Federal Reserve chose to leave interest rates unchanged at their latest meeting and announced that economic and global uncertainties support leaving interest rate policy as is for an extended time. With this latest pass, Janet Yellen, in particular, and the Federal Reserve as a whole has lost credibility with institutional bond traders. These traders will now manage fixed income markets and all longer term interest rates based on their own conclusions. Currently, futures markets suggest the Federal Reserve is unlikely to raise interest rates again until 2018 at the earliest. It would be dangerous to take a bet on this conclusion, but it does suggest interest rates will now stay low for an extended period of time benefiting home buyers and debtors.
The U.S. economy is over seven years into this cycle and our investment strategy for now is driven by the cyclical trend. Recent indicators confirm that once again winter’s weakness was partly a result of seasonal data adjustments. The latest consumer sentiment reading was 93.5, down from a cycle high of 98 in January 2015, but still on a very positive trend. The most recent Purchasing Manager’s Index (PMI) rebounded to 51.3, again down from this cycle’s high, but still in positive territory above 50. And capacity utilization has slid to just under 75, down from a cycle high of 78, but not so far down from the pre-crisis levels of the low 80s. Finally, existing home sales and even housing starts remain at very healthy levels. All these indicators simply confirm the U.S. economy appears past its cyclical peak, but still on a positive, slow growth trajectory into the foreseeable future.
The U.K.’s Surprise Vote for “Brexit”
It is possible that no one was more stunned than the British people themselves when the voting ended with 52% of the United Kingdom’s voters announcing they would like to withdraw from the European Union. What happens next may not be known for months. Officially, the referendum is not binding on Parliament. To initiate the withdrawal process, Britain must invoke Article 50 of the Lisbon Treaty, and it is implied that Parliament must vote for this move. David Cameron has said he will not invoke Article 50 and will step down in October, delaying a move forward or allowing for a cooling off period, depending on your point of view. There is currently a potential power struggle in Britain as no clear new leader is emerging. There is also the risk that other countries consider similar referendums and that European banks become strained trying to keep credit flowing under an uncertain union.
What is clear is that nothing is likely to happen quickly. European countries, and the E.U. in particular, have a history of moving slowly with measured responses. In contrast, U.S. investors see a problem and look for a timely response. U.S. markets seemed to have quickly bounced back from the Brexit shock, but the real impact of this surprise may take months to fully understand.
The immediate response to Brexit was a quick flight to safety from global investors. Selling in the pound, the Euro and particularly European stock exchanges, flooded the world with liquidity. Most of this cash found its way to U.S. Treasury bonds, considered the safest investment in the world today. The cash inflow pushed the U.S. dollar higher and the yield on our 10 yr. Treasury bond below 1.4%. If the dollar’s strength continues, it may hurt U.S. exporters just as they were breathing a sigh of relief when the Fed announced rates would stay put. Emerging markets were also enjoying a small relief rally from our Federal Reserve’s inaction, as their currencies are generally tied to the dollar. As most emerging markets are primarily export economies, they too, will be hurt if the dollar remains strong.
Puerto Rico’s Historic Default
On June 30, the U.S. Congress reached a last minute agreement on a plan to aid Puerto Rico in managing its debilitating debt load. Despite the final agreement, Puerto Rico defaulted on almost $800 million in interest and principal payments that came due on July 1. Much of this debt was supposed to be constitutionally guaranteed by Puerto Rico to be paid before local services. The agreement reached by Congress gives Puerto Rico a stay against litigation by creditors and puts a committee in place to take over the finances of the island to manage out of the debt crisis.
Puerto Rico was long a favored manufacturing location for U.S. companies when the country had preferential tax status to help encourage growth of its industrial base. The tax preference was phased out starting in 1996 and eliminated fully in 2006. Puerto Rico was never able to grow its economic foundation beyond the U.S. companies benefiting from low taxes, and when these companies began pulling out, massive unemployment followed. As the country struggled to recover from the tax changes and then the global financial crisis, Wall Street stepped in offering unending bond financings to meet the appetite of U.S. investors for “triple-tax-free” bonds- bonds with interest that is free from local, state and federal taxes. U.S. Investors benefited for the past 10 years, but again, the country was unable to recharge its economy with the funds. Today Oppenheimer Funds, Franklin Templeton funds and a number of hedge funds are the largest holders of Puerto Rico’s debt. These financial firms have had little incentive to negotiate repayment of their holdings, fueling the current crisis situation.
Like Brexit, we will not know for many months the effects of Puerto Rico’s challenges. Insured bonds are likely to be paid in time and current bond holders may receive delayed payments, alternative bonds or partial losses on their holdings. The default is having a limited effect on bond markets so far and is unlikely to influence municipal market opportunities going forward.
A U.S. Presidential Election
Historically, the stock market moves sideways or down at the start of a Presidential election year. As the leading candidates emerge, markets calm and even improve after the conventions. Once the election is complete, the uncertainty is gone and markets tend to rally no matter what the outcome. The leading candidates are clear at this point and the conventions will introduce the candidates’ running mates. One candidate is considered completely predictable and the other a policy black-hole. Markets may not like either candidate at this point, but the “Brexit” vote has reminded us that it would be unwise to conclude that our next president is clear. Therefore, expect continued uncertainty and potential volatility in the markets from the conventions and the eventual election.
Everything is Different Now
Everything is different but nothing has really changed. As the song suggests, “maybe only slightly rearranged.” All these developments fuel uncertainty for investors, yet both the stock market and bond markets ended the quarter on a high note. The S&P 500 ended the quarter within 10 points of its high. Despite the quarter-end hiccup from the Brexit vote, both markets rallied primarily on the expectation of continued low interest rates in the U.S. and abroad. While mutual fund and hedge fund flows report that some investors have been leaving the markets, many have stayed, flocking to traditionally safe investments in healthcare, consumer staples and sectors with dividends that far exceed bond market yields. In other parts of the world, central banks are not only on hold with regard to interest rates, global traders have pushed their bonds markets so high, that interest rates are negative.