U.S stocks were up slightly as the S&P 500 total return index (includes company dividends) increased 0.28% for the three-months ending June 30, 2015. World markets, as measured by the MSCI World Index NR, performed similar to that of the U.S, increasing 0.31% in the same time period. Weakness in India and Latin America may have negatively impacted emerging market performance as the MSCI Emerging Market PR Index declined -0.24%. Growth portions of the market performed better than their value counterparts. This divergence was seen most in smaller company stocks. According to Morningstar, the small cap growth category of funds posted a quarterly gain of 2.32% in comparison to a loss of -0.21% for small cap value funds.
The uncertainty surrounding the timing and sequence of the Federal Reserve’s rate hike campaign as well as tantrums in the European bond market sent most major bond indices lower for the quarter. The possibility of a Greek exit from the European Monetary Union caused a de-risking within the credit markets that weighed on bond performance. Further, movements in bond yields pressured fixed income pricing. Remember, as interest rates rise, bond prices decline. The 10-year treasury moved from 2.17% at the end of 2014 to 2.38% at the end of June. As such, the Barclays U.S. Aggregate Bond Index TR declined –1.68%, a notable loss for a historically low volatility asset class. If we dissect the performance of various bond categories, it is noted that the longer-dated maturities of the bond market (both government and non-government bonds) were impacted most negatively. This is consistent with the theory of fixed income that longer duration securities are more sensitive to changes in interest rates, and that investors will reposition (sell in this case) in anticipation of rate movements. Sectors of the bond market with limited interest rate hike exposure, such as ultrashort bonds and bank loans, were the few bright areas from the quarter as they increased slightly.
The trend from Q1 sector performance, for the most part, carried into Q2. The leaders were healthcare and consumer discretionary, and the laggards being utilities and energy.
Healthcare: within the sector, Biotech and healthcare providers have been outperformers. The very strong absolute and relative performance to other sectors has paved the way for an increasing market cap weighting of 15% in the S&P 500. Though valuation richness is a concern, there remains some very favorable dynamics for the sector (aging population, ACA federal exchange subsidies, mergers and acquisitions).
Consumer Discretionary: Internet retailers and hotels are the notable strong performers. Falling oil prices continue to provide a tailwind to the sector, as well as declines in unemployment. The outlook is a bit more cautious as rate hikes could damper consumer spending on non-essential items.
Energy: The limited partnership (LP) portion of the energy sector continues to get battered. The leverage component as well as the smaller size of these LPs are creating financial hardship as lower revenue from a decline in oil prices are draining cash reserves. Currently the high cost/low oil price environment is proving unbearable for some of the smaller oil operations and share prices have been reacting as such. Healthier oil companies and those with the cash coffers to withstand a period of declining cash flow may stand to benefit from purchasing energy assets at depressed prices.
Utilities: despite a decline of more than -10% on the year, valuation of the sector remains mixed. According to Ned Davis research, the sector is trading at 1.7x book value, and 1.6x sales, an expensive reading. However, Morningstar notes a fair valuation according to their metrics. Sector dynamics looked mixed as well. First, excess capacity has been and remains a major hurdle to improve profitability. Secondly, utilities tend to underperform under a Fed rate hike environment. However, outside of the Eurozone, fundamentals remain strong with solid balance sheets, and moderate payout ratios.
Cory Nakamura CFA, CFP®
Chief Investment Strategist and Financial Advisor
CERTIFIED FINANCIAL PLANNER™ professional
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