ECONOMIC LANDSCAPE The risk-on rotation that took hold in early February continued through the end of the first quarter and has spilled over to the month of April. What has changed? Global recession fears have eased, inflation expectations are rising, business sentiment is improving, manufacturing is showing signs of life, commodity prices have seemed to bottom, emerging market currencies have strengthened, the US Dollar has weakened and most other risky assets have continued to edge higher. The irony of this recovery is that each of these variables mentioned above were the variables that sent the market lower in January. The momentum just so happened to be pointing in the exact opposite direction. In January, we spoke about how the markets and economists were obsessed with the slowdown in China, the strength of the US Dollar and the continued commodity price route that began in late 2014. Many investors sold off risky assets as they believed the slowdown in China and the drop in commodity prices would hinder global growth. Some investment banks were actually predicting oil would drop below $20/barrel (As of April 25 th, the price of crude oil was above $42/barrel). 1 We studied research from many well respected economists discussing the benefits of low oil on our domestic economy, only to be presented with a more detailed and seemingly more legitimate study proving the exact opposite. Yes, we save money at the pump, but how many regional economies and individuals have to suffer for you to benefit from the lower price of the commodity itself? In February, we mentioned the surprising announcement that Japan was venturing into a new frontier of negative interest rates. It seemed by many that the United States economy was overheated and a new recession was right around the corner. We find that sometimes the exact opposite is true when there is a widely accepted obsession for the world economy to move in one direction or another. During the month, our team also brought to light the divergence in market participant sentiment between individual and institutional investors. This was depicted by the Block vs. Non-Block Trades on page 2 of our team s February Insight Letter (let me know if you would like to receive a copy if you missed it). It is truly astounding when you look at the investing behavior between individuals and institutions during periods of market stress. Sadly, many individual investors base their decisions on emotions which inevitably forces them to sell at the worst possible times. As portrayed in the graphs, individual investors were selling and institutional investors were buying. Global stocks, as measured by the MSCI All Country World Index, rallied 5.4% off their lows in the month of February. 2 In March, the equity rally was in full force and global stocks gained an additional 7.39% forcing many indeces back into positive territory for the year. 3 The final report for 2015 Q4 GDP growth showed real (inflation adjusted) growth of 1.4%. The growth in real GDP, although low by historical measures, came in higher than many analysts anticipated. Also, much of the broader economic data that was reported during the month showed continued strength. 1 Thomson Reuters DataStream, April 2016 2 Thomson Reuters DataStream, April 2016 3 Thomson Reuters DataStream, MSCI All Country World Index, February 2016 Page 1
Overall personal income rose higher than expected, residential investment picked up and the overall outlook for the economy seemed much clearer. Today, our team is remaining constructive on the overall economy, however we do feel the road may remain bumpy in the coming months. We believe there are still many risks that deserve everyone s attention. The United States is still in a corporate profit recession. This takes place when there are two consequtive quarters of negative profit growth by corporations. Please refer to the chart below which shows the last five years of corporate profit growth in the United States. You can see that the last two reported quarters were far from great. 2015 s Q4 corporate profits were down -7.8% from the previous quarter and down -11.5% from the previous year. 4 One reason why corporate profits are suffering is from the massive decline in earnings from the energy sector. If you were to remove petroleum and coal company profits from the equation, corporate profits only declined -1.7% in Q4 and actually increased +4% from the previous year. The other major variable that has been holding down profits has been the strength of the US Dollar. As the foreign exchange rate on the dollar appreciates versus other currencies, American products become more expensive to global consumers. We live in a world of global trade and many large American corporations generate enormous profits from international countries. As their products become more expensive, these global consumers purchase less. 5 However, this function of currency exchange works both ways. Please refer to the chart below which depicts the relationship between the US Dollar and US stock prices over the last six months as of April 25 th, 2016. The red line shows the movement of the US Dollar Index versus a basket of other major currencies. The green line shows the movement of the S&P 500 ETF which tracks the largest 500 companies in America. The white arrow shows the point at which the US dollar started dropping significantly. As the dollar exchange rate dropped in value, US goods and services became more affordable overseas. This ultimately helped push stock prices higher in March and April. 4 Thomson Reuters DataStream, April 2016 5 BlackRock Investment Management, April 2016 Page 2
However, this is where one of our concerns lie. In our eyes, not much has changed in terms of potential risks that remain in the global economy. It is hard for our team to imagine the US Dollar continuing to fall in a world of negative interest rates and continued geopolitical risks. The chart below shows the yields of governement bonds in the world s most advance economies as of April 25 th, 2016. Surprisingly, a 10YR US government bond yield of 1.90% leads the pack. Government bond investors in Japan are guaranteed to lose money each year for ten years by purchasing a 10YR JGB at a -0.071% interest rate. That s going to continue to be a tough sell for these investors. Negative interest rates are causing much uncertainty in the global foreign exchange and interest rate markets. There is an extreme shortage of case studies on the repercussions of negative rates as they were never anticipated. Nevertheless, it is our team s belief that these global interest rate differentials will cause additional flows of international funds into the United States to purchase US government bonds at higher rates. This could prove to be another headwind for US corporations. If this scenario was to play out, these international investors would need to convert their currency into US Dollars before they were able to purchase the US bonds. This potential increase in Page 3
demand would put upward pressure on the dollar and create another period of US Dollar strength. 6 scenario would create another disadvantage for the United States in regards to global trade. Ultimately, this PORTFOLIO MANAGEMENT UPDATE PORTFOLIO FOCUS BALANCED GROWTH GLOBAL GROWTH HIGH YIELD INCOME EQUITY TARGET 45% 70% 90% 30% US LARGE CAP 27% 42% 54% 17.5% US MID CAP 2.5% 4% 5% 4% US SMALL CAP 1.5% 2% 3% 0% INTL EQUITY 14% 22% 28% 8.5% FIXED INCOME TARGET 45% 20% 0% 63% ALTERNATIVES TARGET 10% 10% 10% 7% Target % s As of 4.29.2016 Overall, our team remains both constructive and cautious on the overall market outlook. We remain constructive due to the continued improvement of many major economic indicators that we track. The employment reports continue to show strength and the US money supply is continuing to show solid growth. The money supply, as measured by M2, has increased by 6.19% in the last year. An increase in this number signifies that money is moving throughout the economy at higher velocity, which is typically indicative of economic growth. Also, commercial and industrial loans have increased 10.41% in the last 12 months. 7 This displays a clear symbol of confidence in overall business expansion. Our team is also cautious on our overall view of current market sentiment. We are realistic that the market has recovered tremendous ground in a very short amount of time. As of April 25 th, Global stocks have rebounded more than 14% from their February lows. 8 Many economists and strategists are forcasting that first quarter profits will continue to fall. Political risks will continue to loom over markets throughout the summer and we are still dealing with never ending story of the Federal Reserve s next potential rate hike. Due to these views and potential concerns, our team made the following changes to the portfolio management strategies. These adjustments were designed to be more defensive in the near term: Matthew David Sheridan, CFP CPM Portfolio Manager Financial Advisor Durso Wealth Management Group at Morgan Stanley www.fa.morganstanley.com/dursowmg 6 Morgan Stanley, The GIC Weekly, Lisa Shalett, Head of Investment & Portfolio Strategies, April 2016 7 Thomson Reuters DataStream, April 2016 8 Thomson Reuters DataStream, MSCI All Country World Index, April 2016 Page 4
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