Market Insights: Second Quarter wrap-up

Second Quarter wrap-up

After enduring a difficult correction period that lasted over three quarters, North American equity markets have taken off since February.  With the TSX Composite here in Canada down over 10% year-to-date at one point in late January, it finished the second quarter up 8.1% on the year.  We have seen the relative strength of the Canadian market versus the U.S. market really pick up for the first time in years.  Although it is unclear if this can continue, it is a positive sign to finally see some strength in our local market.  If the current business cycle is moving into the latter stages, as some speculate, then cyclical industries should continue to outperform the broader market which would be a boost for TSX.

The U.S. stock market performance, however, has been a bit more divided this year.  The S&P 500 is up 2.7% at mid-year, while the NASDAQ is down 3.3%.  We have a seen a reversal of the strength in big tech names that we witnessed last year which had held up their indices against a weaker broad market.  The main story from a Canadian investor perspective is that we have seen the Loonie roar back this year, moving up 7.1% against the U.S. dollar.  Unfortunately, this can be a strong headwind for globally balanced portfolios, as illustrated by the S&P 500 which was actually down 4.1% in Canadian dollar terms at mid-year.  

Internationally, markets have been mostly negative, and look even worse when taking into account our rising currency.  Developed equity markets outside of North America (MSCI EAFE) are down 12.4% this year in Canadian dollar terms.  In addition, we have witnessed a large dispersion of returns across the globe.  For example, the FTSE 100 (United Kingdom) is up 4.2% this year and the Nikkei (Japan) is down 18.2%, both in local currency terms.

Of course, the big news as the quarter ended was the result of the UK referendum known as Brexit.  This day had been anticipated for some time, but it really wasn't until a few weeks preceding the event when a victory for the 'Leave' vote started to become a potential reality.  That being said, markets had rallied fairly strongly the week preceding the vote, and so the result definitely surprised many people.  The result of this fairly unexpected outcome was very volatile markets over the next few days as the month of June wrapped up.  At the end of the day, however, markets shrugged off this volatility for the most part, especially in North America, and ended the quarter not far off from where they were prior to the vote.  It is evident that the marketplace is not overly concerned with the fallout of the Brexit vote, at least for the moment.  One reason for this is that markets may be viewing it as a very long-term process, and not really shaping the next six to nine months, which equities tend to focus on as a forward-looking discount mechanism.  What remains to be seen is if this will result in contagion to other countries, especially those that use the Euro as their currency.  Could France be next?  If that potential were to come into view for the consensus, it could certainly put further pressures on markets.  That being said, we believe the Union will do everything in their power to avoid this.  We provided some perspective on Brexit a couple weeks ago; please click on the link to review these earlier comments.

Our main focus remains on Canada and the U.S.  We have discussed our Milestone Recession Risk composite in the past; it is a composite of ten leading indicators from some of the most reliable sources in our industry.  Our gauge is still in a favorable area, meaning that we view recession risk for the U.S. in the next six to twelve months as being relatively low.  Although this indicator did start to move into caution territory earlier this year, it was still ultimately a ways off from 'flashing red'.  From a strategic asset allocation perspective, this is a very important tool for us in managing portfolios and staying focused on the long-term and determining where we are positioned in the business cycle.  If you look back to late January, at the depths of the recent equity bear market, you will see the emphasis we put on focusing on longer-term factors.  We maintained that "while we are seeing some calls to sell into rallies similar to 2011, we currently view it as a better strategy to hold/buy into further testing of recent lows during this bottoming process, particularly based on the history of similar market environments which we have discussed in past posts."  To see the entirety of that post, please click here.  We will provide updates on our composite as time progresses.

We maintain an overall constructive view on equity markets, particularly North America, based on the fundamental drivers for the U.S. that we wrote about almost a year ago here, and more recently here with some comments from Canaccord's U.S. Equity Strategist Tony Dwyer.  We have also recently discussed some positive technical attributes to the current environment here and here.  Globally, we are also seeing some improved economic data of late, with the G10 economic surprise index rising to its higest level in 18 months.

With the recent push higher for the S&P 500, it is worth noting that breadth of the market appears to be much stronger than at the May 2015 peak.  The index has seen an 18-month period of consolidation, and is now pushing to new highs.  We want to emphasize that we have recently experienced two back-to-back 90% upside volume days on the NYSE.  As it sounds, a 90% upside volume day is one where 90% of the volume of shares traded is up. We were also very close to having two back-to-back true Upside Days, but the advancing/declining issues were a bit under 90%, however, still extremely strong breadth.  This 'back-to-back' is a rare occurrence, especially near a 52-week high, and is almost always followed by continued strength over the following six to twelve months, as history has shown.  The last time this happened was back in December 2011 and again in January 2012, right before the S&P 500 gained ~24%.  

Our last point we would like to pass on is the current state of bond yields in North America hitting new all-time lows, and we specifically want to point out the current dividend-bond yield spread.  In the U.S., we have seen the Moody's Baa yields (low investment grade corporate bonds) hit 4.2% which is the lowest since 1952.  More importantly, the dividend yield on S&P 500 recently moved above the U.S. Treasury 30-year bond yield for the first time since the 2008-09 global financial crisis.  With sentiment levels far from bullish (in fact, until recently, very pessimistic) and many under-invested managers, we could see a rotation out of fixed income and into equity, pushing the S&P 500 to new highs.  From our lens, Credit seems to be indicating 'yes' to a new S&P 500 high.  Although equities in North America are trading well above average historical valuations, they are not yet extreme.  One could argue this over-valuation is justified by the low yield and low inflation environment we are in, which is positive for equity markets in general. History has shown that equities can stay overvalued for lengthy periods of time, and we maintain that will likely be the case for a considerable time period going forward.         

We continue to monitor our leading indicators and will make adjustments as the year progresses if we see any heightened risk on the horizon.  

Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through June 30th, 2016: