Economic Update 9-28-2015

Economic data for the week was highlighted by weaker durable goods orders and mixed but a bit better data on the housing side, while 2^nd quarter GDP was revised higher.

Equity markets experienced a negative week globally, which continues the fall seasonal pattern of higher volatility.  Bonds were mixed with interest rates rising slightly on the week.

There were several unique issues last week, excluding the typical recent excuse for volatility—continued slowness in the Chinese economy, particularly from manufacturing activity falling to a multi-year low.  From a sector standpoint, healthcare lost the most ground (see comments from Hillary Clinton about drug pricing below) with one of the worst weeks for the segment in some time, while utilities, staples and financials gained some positive ground.

Perhaps even more of a factor was Fed second-guessing about the lack of rate move the prior week, which heightened worries about a dreaded ‘policy mistake,’ but Janet Yellen’s dovish comments in a speech towards the end of the week helped provide further clarity on interest rate policy.  It continued to point to a rate increase this year continues to be the Fed’s base case (as opposed to a fear of global conditions putting a wrench in the plan as many investors interpreted from the formal FOMC statement).  Also included was a comment about encouraging unemployment levels fall below the ‘natural rate’ (~5.0%) for a period of time in order to improve American’s overall standard of living.  (We won’t again go into the contradictory policy dilemmas that the Fed faces with a dual mandate, but you can imagine this is one of them.)

Hillary Clinton’s comment on Twitter concerning high prescription drug prices caused a bit of backlash in the biotech and pharma space, although politicians have discussed such efforts before.  Healthcare firms argue that high prices are a necessary ‘evil’ needed to generate the levels of revenue required to fund research and development in finding the next blockbuster drugs, considering that the success rate of all early-phase drugs initially attempted is low.  Despite lower drug cost ideas being popular at the consumer level, this has traditionally been a difficult battle.

Abroad, Volkswagen shares fell sharply as emissions data was discovered to be falsified.  This was newsworthy due to the popularity of its brands, particularly in the U.S., but the company itself only represents under 3% of the German equity market (it’s fallen out of the top 10 in market cap there following the share decline).  Other global carmakers suffered as well, due to fears of a broader cheating scandal—despite claims by companies to the contrary.  We mention this case specifically since we sometimes we receive questions about the risks involved with owning individual stocks or extremely concentrated portfolios.  While mega-cap companies generally see more volatility from macroeconomic goings-on or earnings reports, relative to fraud and government investigations that are less common with firms of this size, these idiosyncratic risks remain and are important, as the fallout in the near-term from such a headline can be disastrous for the stock price.

Foreign stocks also suffered on the week, although developed market held on a little better than emerging, and losses were trimmed a bit by Friday as Yellen’s comments tended to resonate worldwide.  Commodity exporting nations continue to be sharply pressured due to lower China demand and higher supplies of certain items—sustained low pricing can threaten nations’ government budget balances (and has).

U.S. bonds generally lost ground as interest rates ticked upward a bit, running contrary to the typical risk-on/risk-off asset flow pattern.  Longer duration governments fared worst, but credit, including high yield and emerging market bonds, also lagged on the sell-off in risk assets.  Developed foreign bonds were flattish on net, but lost ground when adjusted for a stronger dollar. Continued political turmoil in Brazil didn’t help matters, as conditions there look uncertain for current leadership.

Real estate fared significantly better, with minimal losses in the U.S. and Europe overall and positive domestic results from apartments/residential, while Japanese REITs gained sharply.

Commodities ended slightly higher, with oil moving over a percent higher after trading in a fairly tight range on the week.  Agricultural contracts and precious metals also ended higher on the week, while the poor China sentiment pressured prices for industrial metals, such as copper and zinc, which ended a few percent lower.

The SEC came out with an interesting proposal last week, which could well work its way into the day-to-day fund management and asset allocation business.  In short, regulators want a better handle on liquidity, so the proposed regulation is intended to insure funds can meet redemption requests in the event of a ‘panic’—this could include a cap on illiquid assets (max 15% in holdings that would take longer than a week to sell), a minimum percentage of assets that could be sold within a few days or sooner, as well as a requirement for detailed records on cash flow/redemption patterns.  Additionally, it could create a ‘swing price,’ where larger redemptions would be penalized with a worse (lower) price than smaller redemptions.

While many larger, more conventional stock and bond funds may not have a problem with these requirements, those that delve into less liquid securities and strategies could be forced to cut back on this effort or revamp things.  This type of regulation may aid in providing better overall investor liquidity and ‘bank runs’ on mutual fund assets, but also a negative byproduct. Liquidity is equated to safety and lower risk, which is naturally a good thing in some cases.  However, illiquidity, which could mean anything from wider bid/ask spreads to going through periods where an asset may be ‘unsaleable’ has been historically a positive return component.  Intuitively, this makes sense—the higher the risk or inconvenience that’s embedded in an asset, the higher the market demands its required return to be.  This is directly related to historical return premiums for small cap (especially micro-cap) stocks, as well as contributes to higher spreads in high yield bonds, floating rate bank loans and some emerging market debt (but just a part, the larger piece is credit risk).

Years ago, when mutual funds were less common (and before the invention of index funds, let alone ETFs), well-informed investors understood that owning a fund contained risks like these—risks that you wouldn’t know what you owned on a day-to-day basis (but you could see a report quarterly or so), and were often willing to pay for a manager to take on risks in certain areas based on his/her expertise and would be rewarded/penalized commensurately based on the results of that effort.  That goal hasn’t changed, but demands for increased transparency and niche rules do add costs—either direct or indirect.

No doubt, there will be a significant comment period, as usual, as fund families lobby for loosened restrictions and an eventual compromise is ironed out, assuming this goes forward.  Ideas like this tend to start with good intentions like investor protection, better transparency, lowering volatility where possible, etc., but side effects can be significant when it comes to the ability for managers to implement potentially alpha-producing strategies, which lead to the ability of markets to remain as efficient as possible.  There is no magic bullet, though, and regulations in one area could incent behavior in more flexible areas such as futures markets or structured vehicles, which have their own set of unique risks.  More to come.

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.                                                                                 

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.