Investors were subjected to quite a shock at the end of the 2nd quarter, as US stocks rallied immediately after a precipitous decline due to the UK’s vote to exit from the European Union. The Dow Jones industrial average has already recovered, almost to where it was before the vote, and remains in positive territory, up 2.9% so far in 2016. The technology driven NASDAQ has lost money all year, down 3.3% at the end of the second quarter. Both technology and financial stocks continue to take a beating with biotechnology stocks faring the worst, declining 20.7% during the first 6 months of the year. Overall, small and midsize companies beat out their large capitalization peers as the continued global race to devalue local currencies hurts exporters worldwide.
Stocks in Europe have not fared well since the economic pressures of the potential EU disintegration weigh heavily on the continent. The European stock index was down 9.8% overall but Britain, the perpetrator of the crime, bested the US market by advancing 4.2%. The British pound fell sharply, almost 10% against the dollar, handing US equity investors a net loss after the dollar pound currency translation. Italy’s stock market, down 24% during 2016’s first six months, indicates the structural weakness of its banking system which I wrote about in last quarter’s commentary. Spain, though not in quite as bad shape as Italy, is suffering from its second political crisis of the year and its stock market fell 14.5%.
In Asia, Japan’s benchmark index fell 18% despite continued efforts on the part of the government to stimulate Japan’s economy. The Japanese yen strengthened, which hurt Japanese exporters, and Japan continues to have negative interest rates which shows how fundamentally weak the Japanese economy remains. The Chinese market continued to fall, declining 17.2% while Premier Xi tries to grapple with a collapsing banking sector, falling exports, and the need to further consolidate his authoritarian control over both rural and urban provinces.
The big news on the commodity front is the recovery in US energy prices. Crude oil was up 30.5%, and natural gas increased 25.1% during the first six months on supply disruptions and expectations of continued falling production as companies in the oil patch continue to lay off workers. Gold climbed 24.3%, completing its best quarterly gain since 2007, while gold and silver mining stocks went through the roof, up 115.6%!
As a result of resurgent oil prices, Canada’s energy laden stock market gained 8% while the Canadian dollar firmed against the US to the same degree, handing US investors in the Canadian stock market a 16% return. Brazil, beset with political, environmental, and a myriad of social problems, was one of the strongest markets in the world, roaring ahead 19%. With all the turmoil noted above, we continue to feel that the ability to collect steady, secure and relatively high dividends is still the bedrock of our style of defensive investing. If and when interest rates start rising, investors could abandon high dividend stocks in order to move into bonds but in our view, that is unlikely to happen soon.
However volatile the stock market seems, the bond markets are where the action is taking place. Interest rates, also known as yields, on decent quality government debt worldwide have fallen to record lows. The 10 year German government bond is negative -.048% while US 30 year Treasuries ended the first half of 2016 near their historic low at 1.5%. Prime rate is now 3 ½%, as is the average 30 year mortgage rate. As a result, over the last year, US treasuries had a total return (interest plus price appreciation) of 8.79% while municipals were at 7.03%. The average interest rate on US treasuries is down by almost a third since the beginning of 2016. High-yield bonds, the debt of weaker companies, had a zero return as investors fled to the most commonly perceived safe haven of all – U.S. government bonds.
Even while the UK is cast as a villain on the world stage, its government bonds have gained 12.2% so far this year, indicating a long-term vote of confidence in that country’s ability to adjust to the new political environment. Worldwide, bond markets are pointing to an extended period of very slow economic growth and continued accommodative central bank policies. Interest rates paid on two-year United Kingdom government bonds went below zero briefly after the vote, with almost $11 trillion in global government bonds now paying negative interest rates. Even Spanish and Italian bond yields dropped to all-time lows as the European central bank continues to loosen the rules for the kinds of securities it allows as collateral.
There is very little left that the Bank of Japan, Bank of England, and the Federal Reserve can do to try and stimulate economic activity. If Japanese yields continue to remain below zero, it will force their government to try and add more stimuli on top of its last three failed programs. The latest idea, called “helicopter money”, is to give cash away to everyone living on the island in order to promote higher consumer spending. This is a slippery slope as anxiety about the fiscal responsibility and the endgame in Europe has sent investors scurrying into US government bonds.
Yields on the 10 year US treasury touched their lowest level in history at the end of the second quarter, yielding 1.385%. It has been over 70 years, near the end of World War II, since interest rates have been at the same levels as today. As historical context, when the US government first borrowed money in 1790, they paid around 5%. When the Civil War broke out in 1861, US government bonds earned slightly over 6% and in October, 1929, after the great crash, bonds were paying around 4%. Why are they paying 1.4% now? The short answer is lack of fiscal and political leadership. Calming investor fears and lending comfort to investors seems to be the central banks’ main focus. Weak economies worldwide and low to negative interest rates are harbingers of extremely soft global economic growth and point to potential market instability.
Wall Street and the investing public’s biggest fear should be a government bond default, either by a sovereign nation, city or state. Any failure of a US government entity to pay its debts will send out vibrations that nervous investors may take as a signal to exit other, seemingly unrelated markets and that could create a stampede. States such as Illinois and cities like Chicago have severe structural deficit problems but their underlying real estate and civic assets present a solid backstop that should support investor confidence. Even Detroit, now climbing back from the abyss, has an art collection which local patrons stepped up to save albeit after drastic cuts in civic services.
The situation in Puerto Rico, however, is different. There, the combination of government spending on social services, poor management of scarce natural resources and a debilitating change in the demographic composition of the working population have combined to create a potential disaster. Puerto Rico recently failed to make a $2 billion principal repayment on bonds that came due on July 1, 2016. The Commonwealth stated that it had “become a colony of Wall Street” and vowed to take back fiscal control of the island for its own people. Supporting the political posturing, the island’s financial mess has been put on temporary hold through Congressional action, which doesn’t provide any guarantee of long-term relief but allows the territorial government temporary protection against the inevitable litigation by its creditors. Puerto Rico’s population has declined precipitously as many working age, educated people flee the island for the mainland US. About 40% of Puerto Ricans rely on some form of government assistance to get by day to day while utility and basic service costs average three times the national average. Learning how governments can fail and what the effects are on both the stock and bond markets is an issue that we will see surfacing many times over the next several years. For now, as is the case with the British exit from the European Union, investors have shrugged off the threat of any long-term consequence and gone blithely on investing with impunity.
The US real estate market has provided a safe haven for investor capital since the onset of the financial recession of 2007 – 2008. It appears that this trend may be cooling as some of the more astute endowment funds start to trim their real estate holdings. Southern Methodist University decreased its real estate holdings 14% over the last year while Yale University trimmed its allocation by 31%. US commercial real estate prices have started to fall following six years of uninterrupted increases. There are two factors going forward which could affect the US commercial real estate market: maturing loans and political instability overseas. Over the next 3 to 5 years, about $200 billion of commercial real estate loans will mature and private real estate funds will unload their holdings as they disband, releasing more inventory on the market. Negative interest rates in Europe and Japan and fears of currency devaluation in developing markets may offset this maturing loan problem as sovereign wealth funds in Norway and China plan to increase their exposure to US real estate. Nonetheless, the US’s increasing dependence on foreign demand for real estate creates the potential for more volatility in prices and liquidity. China may increase its control over capital movements and energy price weakness as well, and this has already temporarily halted demand for some high-end properties on the East and West coasts.
The World’s Economy
The sluggish global economy and the Federal Reserve’s hesitancy to raise interest rates in light of other countries declining fortunes has ratcheted up the global supply of money. This is the classic policy response to poor economic growth and, adding in the anxiety about the British and European banking systems health following the recent vote of United Kingdom to leave the European Union has created a “wall of worry”. An old Wall Street cliché says “the market climbs a wall of worry” so the United States, which appears to be the strongest economic player at the moment, with nominal growth in gross domestic product of about 2%, makes our stock market prospects better than most anywhere else. US consumer spending continues to account for two thirds of US growth and we are half as reliant on exports as China, who in turn is half as dependent as Germany. Approximately 50% of Germany’s economic activity comes from exporting activity while about 10% of our real economy depends on global trade.
The political environment in Europe indicates the depth of severe frustration of the developed world’s middle and working classes. Rising unemployment in most of the world makes it difficult for central banks to stimulate economic growth as there are fewer people with discretionary spending money. May’s employment numbers in the US showed the smallest pace of job growth in more than five years. While US manufacturing expanded at the end of the first half of 2016 due to improving consumer spending, this has not helped the job situation.
In response to a potentially deteriorating economic situation, the Bank of England is planning to cut corners and allow its banks to get around financial capital requirement qualifications with lower quality portfolios. Banks worldwide are scared about the lack of loan demand and even though many US banks recently passed the “stress test” promulgated under the Dodd – Frank act, their stability and earnings are highly dependent on subsidies from the government.
In an era of tepid economic activity, with rising populations in developing worlds but shrinking populations in the developed world, we will see more conflicts between countries. Russia’s economy is in a shambles even though it has been temporarily boosted by the recovery in energy prices. It may be too little, too late as Russia has had to sell off some of its state assets to China. Russia has, through its activities in Syria, helped propel the mass immigration of refugees into Europe and so it accomplished, mostly through its astute political manipulation of the Middle East, what it could never accomplish directly in Eastern Europe. The former Soviet satellite countries, who have worked hard to join the affluent nations of Western Europe, have the most to lose by the British exit from the European Union as Russia’s influence may strengthen on its periphery while Europe tries to reestablish some kind of stability.
If other countries follow Britain’s example, which is highly unlikely in the short term, the potential of a breakup of the European Union becomes more real. We expect to see significant economic, financial and political turmoil over the next six months but that does not mean that the stock or bond markets will plummet. Some people hope that the British election is a wake-up call to elected officials about how frustrated their citizens are with slow to no economic growth. The impact on major international corporations is likely to be moderate as the ambitions of companies to trade and make money will not change due to the recent vote to exit.
One interpretation of the British vote sees it as a sign of frustration directed at the euro union bureaucrats or as a reaction against the wealth garnered by London’s financial district, who have reaped most of the financial and economic benefits of the last decade. It could also be seen as a sign that uncontrolled immigration is unacceptable for societies that wish to retain their historical national characteristics. One result will be that England will need to rely more on the inflow of foreign capital to finance its growing deficit because Britain’s position as a net exporter of services, primarily to the Continent, is in jeopardy. About half of England’s exports are to the EU and some difficult trade negotiations lie ahead which may result in tariffs and other inhibitory economic practices. The French led movement to install protectionist gates around the EU is likely to prevail over the more free-market leanings of countries like Scandinavia and Germany.
If the new trade agreements yet to be formed between the UK and Europe turn out to be unfavorable or inefficient, Britain’s economic growth could drop by up to 4% per year which would push it into recession. Some of the larger European banks may skirt with insolvency, while other businesses are already putting hiring and spending plans on hold while things get sorted out. Tension among the remaining EU member states will likely escalate as a result of strains between the rich northern countries and the poorer southern ones. The euro union leaders in Brussels may feel they need to send a strong signal that other countries’ move to depart central control will not be tolerated. We expect to see some major political battles take place before any euro zone reform takes place. The goal would be to produce a genuine banking union, some kind of fiscal union, and have stronger safeguards for democratic processes. The current situation looks to be moving in the opposite directly and it provides an opportunity for both Russia and Turkey to increase their influence and economic power.
The Upcoming US Elections
We have a presidential election coming up where both major party candidates are highly unpopular. The main factors that will guide voters and therefore impact future US policy are unpredictable and third-party movements, such as the Libertarian and Green parties, may play pivotal roles, much as Ralph Nader did in 2000, when the votes he garnered in Florida took that state and the presidency away from Al Gore and gave it to George Bush.
The potential impact of third and fourth parties on the Congressional races could also cause a switch in leadership in both the House and Senate, but not in a traditional way. If Green or Libertarian party candidates make their way into Congress, we might have something that looks very different to what we have today and that could potentially allow for a change of course away from those traditionally espoused by both the Democrats or Republicans.
The Democratic policy platform will likely be influenced by followers of Bernie Sanders who has made a call for a higher minimum wage, a focus on renewable energy, better job security, universal healthcare and free education, all issues that the Democratic nominee cannot ignore. The presence of former New Mexico Gov. Gary Johnson as the Libertarian party’s candidate appeals to many disaffected voters who want, as a top priority, smaller government overall.
As a result of these pressures, the Democratic Party is calling for US corporations to no longer be allowed to defer paying taxes on their overseas earnings and also is proposing for a financial transaction tax on Wall Street high-frequency traders. Nonetheless, Ms. Clinton is clearly the favorite of Wall Street and the market believes that she will continue the accommodative policies of the current administration on most issues.
While Donald Trump continues to garner considerable free media coverage with his incendiary statements, his candidacy may fail to garner enough exposure to the majority of Americans who are somewhere in the middle of the road on most issues. Without a monumental change in his approach, Trump’s lack of organization and funds may mean that he is unable to have a meaningful presence on the national stage other than through theatrics. The Republican Party faces a dilemma in that many of Trump’s positions run counter to its traditional conservative message and so they may be reluctant to help Trump finance and run a campaign up until Election Day.
This is a critical issue for the Republicans because a loss of majorities in either of the legislative branch of government would set them back more than the loss of just the presidency. The stock and bond markets would likely suffer under the uncertainty generated by a Trump victory. The real economy might well be bolstered if Trump could garner enough support , through some kind of a landslide popular vote victory, to have a mandate to take on the dysfunctional tax code, ever increasing government bureaucracy and drifting foreign policy.
Rob: The Rikoon Group’s office and gardens are looking very good this year, with abundant fruit and colorful flowers. We have an exciting Santa Fe Opera season underway and are experiencing our annual influx of out-of-town visitors. This is enjoyable, but a bit frustrating as we locals are not used to waiting for more than one traffic light change to go on our way!
Kyle: It has been a good summer for my family. My sons have been attending a summer program at the Geneva Chavez Community Center where they play games, ice skate, and swim daily. All together we have been enjoying the many community activities Santa Fe offers during the summer, particularly the outdoor music offered free around town. I recently started a kitchen remodel which has left our house in flux as I am trying to do a majority of the work myself. It will be great when the project is finished and the results should look nice and be a large practical benefit to everyone.
Jeff: My wife and I decided to downsize so we recently sold our house and bought a condo. Our house has a large, beautiful backyard. We enjoyed landscaping and working on it together over the years but decided that it requires more time and energy than we care to devote to it any longer. The purchase of the condo is scheduled for August 1 and the sale of our house is scheduled for September 1st so there is a one month period to complete our move. We hope to get through it as gracefully as possible. We are looking forward to having a smaller place that we can enjoy and maintain going forward.
Lauren: The summer is here and my wedding is just a few short months away. The weekends and evenings seem to fill up quickly with planning and preparations for the event, though I have managed to get in quite a bit of yard work, including planting some ornamental grasses in my backyard and beginning to lay down a flagstone pathway. The nine alpacas we care for were shorn the end of May and I shipped off 50lbs of fiber to a mill in Arizona to be washed, carded and spun. I look forward to all the weaving projects that await!
Dana: This summer appears to be about finishing up some hardscape and landscaping at home. In spite of the heat and rock hard soil, the job is done. Now I will pray for rain and wait to see what takes hold. In any event, I’ve drawn the planting line for the season! I got an early harvest of honey from one of my hives. That was quite a welcome surprise. I’ve enjoyed visits with my children in CA and have enjoyed day tripping around northern NM environs, especially to those places with water features.
Robyn: After 9 months in NM, I finally feel like I am settling in and unpacking from my move from North Carolina. The garden is blooming and it is so wonderful to see the plants grow! I am learning how to experiment with different techniques of raising vegetables and comprehending the power of observing nature on a new level. I am grateful to Rob, who is doing a lot of the grunt work in the garden, while I take care of harvesting in the evening. I am also gearing up for another theater show, this time at Warehouse 21, a local alternative performance space. This will take place towards the latter half of September and features a comedy by television writer Ron Bloomberg (One Day at A Time, Three’s company).
We would like to introduce everyone to Anthony Penner, who will be joining the Rikoon Group team on July 25th. Anthony will be assisting with client services and joins us after spending the last 12 years working in commercial banking. He is Santa Fe native who enjoys spending time with his wife, Victoria and their one-year-old daughter, Amaya. He brings a strong set of skills and will be a great addition to the office team. We look forward to everyone getting the chance to meet and get to know Anthony.
Please join us for our quarterly gathering to discuss economic and market related events at 2218 old Arroyo in Santa Fe on Tuesday, August 23 at 3:30 PM. We generally go until 5:00 PM. We will serve treats from the office garden to go with the stimulating conversation. The conference call, open to all out-of-town clients and friends, will occur on Wednesday, August 24 from 3:30 to 4:30 PM. The call-in number is: 719-234-7872, after which you will be prompted to enter the code: 470070#.