We held our third quarter investment strategy meeting on
June 26. We see the financial markets in a transition period as we move into a
new phase of Federal Reserve policy. A new regime of rising interest rates,
when that occurs, would change the investment landscape somewhat. Based on the
history of previous rate cycles, we believe stocks can continue to rise in an
environment of rising interest rate.
Uncertainty over the timing of the Fed rate increase and a
slowing in corporate earnings growth have kept a lid on the stock market so far
this year. As of this writing (June 29), the stock market as measured by the
S&P500, is flat year-to-date on a price basis. As we have mentioned previously,
we expect stock market returns going forward will be lower than the past 5-6
years largely due to lower expansion in equity valuations. A resumption of
corporate profit growth later this year and in 2016 should support higher stock
prices despite less tailwind from valuation expansion.
A big question now is what would a Fed rate increase mean
for stock and bond prices? Based on history, stocks should do OK, in our view. Looking
back on five previous Fed tightening cycles, stocks outperformed bonds. Stocks
rose on average by 14% during the first year of the cycle and 16% over the
entire cycle. We believe a gradual tightening should not be an impediment to
further rise in stock prices assuming reasonable earnings growth and continued
moderate inflation. Bonds typically underperform in a rising interest rate
environment.
In term of meeting outcomes, we have maintained an
overweight exposure to stocks in all major categories. One significant change
in the large-cap sector was the sale of technology stocks (XLK) and replacing them
with a position in financial stocks (XLF, primarily large banks and insurance
companies), which we believe offer attractive relative value. Within the
developing equity sector, we added a position in U.S. homebuilder stocks (ITB) as
we believe the sector is poised to show above average growth over the next
several years. Within fixed income, our allocations remain essentially unchanged
(underweighting long bonds), however we introduced a position in the PIMCO
Total Return actively managed bond ETF.
A note on Greece: As
of today, it appears negotiations on Greek debt payments (to meet a June 30
deadline) have failed, and it now appears Greece will default on its debt. Greece
represents a very small portion of the developed world debt and economy and,
therefore, we do not believe a Greek default would have significant
repercussions in other larger economies. The greater concern is that Greece
could pull out of the Eurozone and set a precedent that could be repeated by
other Euro area countries. As of now, we believe the probability of both a Greek
exit (from the Eurozone) and that event being repeated by other Euro are
countries is very low. Therefore, as of now, we have not taken specific steps
to hedge an event such as this. We believe the situation with Greece will
eventually be settled and as of now, we do not see sustaining ramifications
that would cause us to materially alter our strategy.
June 29, 2015
