Avalon produces a variety of investment commentaries.
Our perspectives and quarterly commentary are issued throughout the year and cover a range of investment-related topics.
TPP Is Dead. What Now?
January 25, 2017
The Possibilities of Trump's U.S.
December 9, 2016
Reversal Rates Are the Next Big Challenge for Central Banks
November 23, 2016
The Good Ole Days Aren't Coming Back
October 13, 2016
The Federal Reserve's Anti-Volcker Inflation Revolt
August 24, 2016
Why the Fed Needs to Raise its Inflation Target
August 18, 2016
Is the Rest of the World Ditching America to Trade with China?
August 3, 2016
Has the Federal Reserve Become Congress's Golden Goose?
July 20, 2016
The Fed Must Avoid the 'Credibility Trap'
June 21, 2016
Why the Fed Needs to Make a Policy Error
May 18, 2016
The Fed Faces Its 'Anti-Volcker Moment'
May 9, 2016
The Fed's Critical Global Mandate
April 29, 2016
Why the Federal Reserve Is All Talk
April 26, 2016
Is the Global Middle Class Really Here to Stay?
April 12, 2016
Quarterly and Monthly Notes
Fourth Quarter, 2016
Third Quarter, 2016
Second Quarter, 2016
News | Press
Avalon Advisors Announces San Antonio Expansion
December 21, 2016
Avalon Advisors Announcement
December 16, 2016
April 11, 2016
Avalon Advisors Announcement
October 1, 2015
March 1, 2014
Fourth Quarter, 2015
Second Quarter, 2015
First Quarter, 2015
Fourth Quarter, 2014
Third Quarter, 2014
Second Quarter, 2014
U.S. equities were little changed in the second quarter, with the S&P 500 Index and the Russell 2000 returning 0.3% and 0.4%, respectively. For the first half, the S&P 500 returned only 1.2%. Even with its recent meager performance, this index returned 120% for the five years ending June 30. Within the S&P, only 5 of the 10 sectors posted positive returns in the quarter. Health Care was the best performing S&P sector, up 2.8% in the quarter and 9.5% in the first half. Utilities, the worst performing sector, continued to reverse last year’s strong performance, down 5.8% in the quarter and 10.7% in the first half. After rebounding early in the quarter, the Energy sector sold off strongly and lost 1.9% for the quarter and 4.7% for the first half. Oil prices rose to end up 25% for the quarter and up 41% from their March 18 lows; but still down 44% from a year ago.
International stocks were also up less than 1% in dollars in the quarter. Following a strong first quarter, stocks in most European countries pulled back in the second quarter. European and Japanese equities have generally performed well this year, although returns to U.S. investors have been negatively affected by the stronger dollar. The dollar weakened in the second quarter after peaking in March, but it is still up significantly this year. For the first half, the MSCI Europe Index returned 13.3% in euros and 4.4% in dollars, while the Nikkei Index returned 17.2% in yen and 14.8% in dollars. Chinese equities, as represented by the Shanghai Composite, peaked in mid-June and began a sharp decline that continued after the end of the quarter. Even with the end of quarter selloff, this index returned 14.8% in dollars in the quarter and 32.9% for the first half.
U.S. bond indices generally had negative returns in the quarter, as interest rates rose. This marked the first quarterly loss for Treasuries since 2013. With increasing positive economic news in the U.S. and Europe’s recovery picking up some steam, investors became more convinced of a rate hike happening this year. The 10-year Treasury ended the quarter at 2.35%, up 41 basis points from March 31 and up 71 basis points since touching a low of 1.64% on January 30, 2015. The 10 year German Bond hit an all-time low of 0.05% April 17 before rebounding to 0.76% at the end of the quarter. The Barclays U.S. Aggregate Bond Index was down 1.68%, while Municipal Bonds held up better, down 0.89%. High Yield Bonds were one of the few fixed income segments posting positive returns.
Continued Moderate U.S. Economic Growth
The U.S. economy appears to have recovered from another weak first quarter, suggesting that first quarter weakness was significantly affected by weather and West Coast port closures. In fact, the estimate of the first quarter GDP decline was revised upward during the second quarter and second quarter GDP growth is now expected to be about 2.5%. Retail sales started to improve in the quarter along with housing statistics. Several homebuilders reported strong earnings results, which were tempered by a lack of supply rather than weaker demand. Employment gains have been strong and initial jobless claims continue to decline. Consumer sentiment has been hovering near the highest levels seen since the recovery began, boding well for consumption expenditures, even with relatively modest nominal wage growth.
We do not see inflation as an imminent problem; however, we are closely monitoring wages, given tightening labor markets, and energy prices. Given the massive shut-in of production, we believe oil prices saw their lows early in the year. The North American rig count has been cut in half from a year ago, and excess supply is expected to be reduced by the second quarter of next year. However, oil continues to face a number of headwinds, including the deal with Iran, which will free up Iran’s sanctioned oil exports.
Slowing Global Growth
Exhibit 1 summarizes historical and projected economic growth for selected countries and regions produced by the International Monetary Fund (IMF) in its latest semiannual database. In the early part of this decade, Emerging Markets were growing at a rapid pace. Many companies in developed markets experienced a dramatic acceleration in earnings as they increased their exposure to these markets. Over the last few years, however, growth in these markets has slowed, and growth in the U.S. and other developed markets has not been enough to pick up the slack. In fact, 2015 is expected to be the sixth consecutive year of falling growth rates. China’s reported growth rate peaked in 2007 at over 14% per year. Since then, it has been falling and is expected to be only 6.8% in 2015. Brazil and Russia have been hurt by the fall in oil and other commodity prices, and the strong rise in the dollar over the past year has increased outflows of capital from China and other Asian countries. Global growth has slowed from an average 4.2% over the ten years ending in 2008 to an average 3.3% expected for the seven years ending 2015.
In its July update to the April database, the IMF lowered its forecast for 2015 world economic growth from 3.5% to 3.3%, primarily because of first quarter weakness in North America. However, expected growth for 2016 was left unchanged at 3.8%, and the next few years should see some improvement in world growth. While China should continue to slow, advanced economies are expected to improve further and India and other smaller Asian economies should remain strong
Weak U.S. Earnings Growth and Full Valuations
Consensus estimates for U.S. corporate earnings began to fall last year, with the decline in oil prices and the rising dollar. Current estimates are for less than 5% growth in operating earnings with slightly negative revenue growth. Energy earnings declines will continue to be a large drag on overall corporate earnings this year. This sector represents over 7% of the S&P 500 and 2015 Energy earnings are expected to be down more than 30%. The 12 month forward P/E on the S&P as of June 30 was at 16.5, above its 5 and 10 year averages of 13.8 and 14.1, respectively. With lackluster growth this year, the market will need to look more to next year’s growth rather than further P/E expansion to push the S&P upward.
European forward P/E ratios are also above their long-term averages. Comparing Europe to the U.S., the MSCI Europe Index as of June was selling at less than a 5% discount to the S&P based on 12 month forward estimates. As shown in Exhibit 2, this discount has averaged about 15% and it has narrowed this year as European equities have outperformed. Exhibits 3 and 4 help to explain Europe’s relatively stronger performance this year. Earnings in Europe are expected to increase over 40% in 2015, much faster than the 4.9% expected growth for the U.S. Moreover, although U.S. estimates for 2015 have stabilized in the last few months as the dollar has retreated from its highs, European estimates have begun to rise. Earnings in Europe have been stagnating for the last several years, while U.S. earnings growth has been strong, up 40% over their 2008 peak. It remains to be seen whether Europe’s earnings growth can continue to outpace that of the U.S. Next year, earnings for both the U.S. and Europe are expected to be up over 11%.
In the U.S., the Energy sector could be a major contributor to future earnings growth if energy prices rebound or even stabilize at these levels. The Nikkei Index is also selling slightly below its long-term historical average, with Japanese earnings expected to be up about 20% this year. As we discussed in our December commentary, both Europe and Japan should continue to benefit from quantitative easing by their central banks while their exports benefit from a stronger dollar.
As Exhibit 5 illustrates, international and developed and emerging markets equities have lagged the U.S. for several years, reflecting the better economic and earnings growth in the U.S. relative to the rest of the world. The trend reversed in the first half, as U.S. earnings growth slowed and prospects improved in Europe and Japan.
With slower global growth and relatively full equity valuations, we are less likely to get equity performance from economic growth or P/E expansion. This suggests we look for companies whose revenues are less dependent on strong economic growth. We have been seeing that play out in the U.S. market, with the outperformance of Health Care companies and those companies with strong secular growth prospects and a global presence. It is also important to note that while China’s growth rate continues to slow, it currently represents just over 13% of World GDP and a 6% growth rate on such a large base should continue to provide expansion opportunities.
Finally, the upward move in U.S. rates we saw in the second quarter suggests the market is ahead of the Fed. The consensus forecast is for the Fed to begin increasing rates in the September time period. However, the market does not expect a continuous series of hikes. Moreover, continued easing by the People’s Bank of China and the Japanese and European Central Banks and slower global growth should maintain some downward pressure on global interest rates.
The opinions expressed herein are those of Avalon Advisors, LLC investment professionals at the time the comments were made and may not be reflective of their current opinions. Nothing herein shall be construed as investment advice or a solicitation or offer to purchase or sell any securities.
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