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.
Macro Quarterly Overview
The US economy was not particularly inspiring in the third quarter, growing a mere 1.4%. Employment growth was strong, bouncing back from a weak second quarter (see Chart 1). Consumer spending drove second quarter GDP which will likely continue to be the case as business investment remains lackluster. If consumer spending weakens, US economic growth is likely to fall even further below the expected modest growth rate of 2%. Inflation remained subdued, but showed signs of rising toward the Fed’s 2% target (see Chart 2). Much of this is due to the stabilization in oil prices and steady increases in rent. Though no tangible and significant acceleration can be detected in the underlying economy, the US economy is growing consistently around 2%.
Central bank decisions did not disappoint during the third quarter. The European Central Bank (ECB) kept its stimulus package unchanged, but commenced a review of its quantitative easing (QE) strategy. ECB President Mario Draghi stated the ECB has not discussed tapering its QE as some investors had worried. With a limited number of levers to pull at this point, the ECB decision to continue easing at current levels seems sensible. Meanwhile, the Bank of Japan (BoJ) became more creative. Prime Minister Abe of Japan announced a $265B fiscal stimulus package. Initially in the quarter, the BoJ disappointed investors with less stimulus than expected. At their September meeting, the BoJ decided to employ the strategy of yield curve targeting instead of purchasing a specific amount of bonds each year, as well as committing to push inflation higher than its 2% goal. With little-to-no inflation pressure, this implies a very long time horizon for easing in Japan.
The global fixed income market has continued to perform well versus numerous pessimistic forecasts that existed at the beginning of 2016. Although the Federal Reserve had guided investors to expect four increases in the federal funds rate during 2016, moderate economic growth in the U.S., the mid-year decline in oil prices, the result of the Brexit Referendum, the evolving economic situation in China, and other geopolitical factors have kept the Fed largely on hold and allowed yields to continue to decline. As a result, central banks have continued their close-to-zero or negative interest rate policies (NIRP). Although many U.S. market participants are desirous of higher interest rates, our European counterparts have a very real understanding that just when the economic picture seems to be improving, there are no bonds left to buy. As a result, interest rates can continue to decline.
While our fixed income team is frustrated by low interest rates, we realize that timing a reversal is difficult and opportunities may arise in unlikely places. We continue to maintain the view that a cyclical flattening of the yield curve, in which long-term interest rates decline faster than short-term rates, is a likely scenario. Nevertheless, we remain open to the possibility that we will need to adjust our view in the event of signs of bubbling inflation from indicators such as the CPI, PPI, wages or inflation protection spreads in the bond market.
Conflicting signals from the Fed continue to confound market expectations for interest-rate increases in the near term. Recent releases of notes from meetings of the Federal Reserve include both the hawkish comment that “the Committee judges that the case for an increase in the federal funds rate has strengthened” as well as the dovish conclusion that the Committee has decided to “wait for further evidence of continued progress toward its objectives.” Although the latter comment increases the probability that rates will remain at current low levels for a while longer, our belief is that the impact of these low rates will continue to diminish. We believe that the U.S. economy remains in a slow growth mode that will result in mixed data, and that although the Fed is in a tightening cycle, there is little urgency to move quickly or before data indicates improvement. Our portfolios are positioned for yield in excess of current levels, while balancing our positions against a bevy of possible outcomes, including potential shocks from the election, commodity prices, credit markets or global central policy direction.
The volatility experienced in the first half of 2016 largely disappeared in the third quarter as investors’ expectations rose regarding the potential for better economic growth in the second half of the year. The quarter opened with a two week, 3.3% continuation of the June Brexit rally in the S&P 500 Index, after which the market traded in a tight range, adding only the dividend to this return over the following 11 weeks of the period. A more optimistic global growth outlook, plus continued accommodative monetary policy by the ECB appeared to outweigh currently weak economic fundamentals and Brexit concerns, fueling a 6.9% gain in international stocks (MSCI World Ex-US). Small-cap stocks, as represented by the Russell 2000 Small Cap Index, surged 9.0% in the quarter.
The third quarter witnessed a notable change in sector leadership as the defensive, yield-oriented sectors that drove the market in the first half of 2016 gave way to the fundamental themes of economic recovery and improving earnings, as well as the mathematical inevitability of mean reversion after record-setting differences in returns in the first half. Dispersion among the returns of different economic sectors remained high as economically sensitive technology (+13%), financials (+5%) and industrials (+4%) led the rebound while utilities (-6%), telecoms (-6%) and consumer staples (-3%) lagged.
Investors in the current public equity market continue to be forced to grapple with the mosaic of historically elevated equity valuations and generationally low-interest rates in a slow growth, low return world. The impact of these factors has created a market in which companies with exposure to the economic cycle represent opportunities with more attractive valuations but higher earnings risk, and companies with low exposure to the economic cycle represent the opposite. We believe that organic growth in the current economic environment is one of the rarest, and potentially most valuable, traits in the market. As such, whether in the U.S. or in international markets, or in large cap or small cap equities, we continue to aim to identify companies that have a combination of products, services, end markets or management teams that can prosper in a slow growth world.
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The Good Ole Days Aren't Coming Back
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The Federal Reserve's Anti-Volcker Inflation Revolt
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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
Second Quarterly, 2017
First Quarter, 2017
Fourth Quarter, 2016
Third Quarter, 2016
Second Quarter, 2016
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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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