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SECOND QUARTER

INVESTMENT LETTER

July 2016

 

Greetings,

 

The major themes driving global financial markets over the last year and a half have seemingly begun to shift in subtle, but significant ways. The major themes that we have been following are:

  • Central Bank Monetary Policy

  • Commodity prices

  • Growth Expectations for Europe and Asia

 

Monetary Policy: Negative Interest Rates?

Last December, the U.S. Fed raised its overnight borrowing rate for the first time in seven years. At the time, expectations of future hikes were a main focus for investors. Since then, the January/February equity sell-off, subsequent rebound, and recent concerns about the U.K. referendum on European Union membership, have staid the Fed’s hand. Expectations for the next U.S. interest rate hike have gone from four in 2016 to one in 2017. This dramatic change in view has pushed U.S. Treasury bond prices to all-time highs and has weighed on the value of the U.S. dollar against most major currencies.

Meanwhile, monetary policy from the European Central Bank and the Bank of Japan are still negative. So far there has been no clear benefit to negative interest rate monetary policy (NIRP). Admittedly, it is still far too early to see any lasting impact. However, costs like weakening the banking sector and hurting savers are immediately apparent. NIRP is being pursued to stimulate economic activity and to produce some inflation in these economies that are barely running above stall speed. If NIRP is not able to stimulate these economies toward meaningful growth, it might sway the political tide toward more fiscal stimulus, which has been notably absent as an ongoing economic policy since the recent financial crisis.

Geopolitics: Populism is HERE

Across the globe we are seeing a rise in populist political movements. As investors, we are watching this trend to see how it may affect the global economy.  Just this month, the Japanese electorate awarded the incumbent Liberal Democratic Party with a landslide victory and a super-majority in parliament. This could clear the path for more fiscal stimulus in Japan. The U.K. referendum has sent a message to the world that citizens are fed up with the status quo. Additionally, the U.S. presidential election has been defined by the rise in populism for both Republicans and Democrats. The long term implications of the rise of populism around the globe are unclear at this stage. It is important to recall that in the after-math of the surprise vote in the U.K., stock markets around the world initially fell. In just a few short days these moves were quickly reversed and, in the case of U.S. stocks, moved to new highs. History has shown that attempting to time these types of events is exceedingly difficult to say the least.

Inflation Expectations on the Rise?

The significant shift in the political climate may be enough to produce policies that will have an impact on the global economy. If politicians are given a mandate to pursue policies that will provide for fiscal stimulus, like they have in Japan, this could be a catalyst for growth that has been absent in recent years. Such a move would complement the extraordinarily accommodative monetary policy described above and could create a path toward inflation and relative normalization in monetary policy. We have already seen a rise in inflation-protected bonds this year, which suggests that market participants are already preparing for higher levels of inflation.

Commodity Prices Stabilizing

Another factor that will help support inflation in the short term is the recent stability in commodity prices. Falling petroleum prices have been a major market theme over the last year and a half. A combination of supply disruptions, falling production, and increased demand for petroleum has worked together to stabilize the market for the time being. Barring some unforeseen event, it may finally be time for commodity prices to play a lesser role in driving the direction of both stock and bond markets.

As we mentioned in our last quarterly note, the stabilization of oil prices along with that of the U.S. dollar will remove the most significant headwinds to the U.S. stock market from last year. So far this has come to fruition and has occurred against a back-drop of a strong labor market, a strong U.S. consumer, and a healthy housing market. Looking abroad the picture has been improving. As mentioned above, in Japan there is a new mandate for the government to stimulate the economy. Chinese markets have stabilized since their correction at the end of last year. Also, European stocks have bounced considerably since the U.K. referendum.

U.S. stocks have traded up to all-time highs along with bond prices making this an extremely challenging environment for investors. This is exactly why we favor the use of low-correlated alternative investments as well as building in buffered protections to our portfolios. Recently, we were able to expand our set of investment opportunities with an investment in an Alternative Lending strategy. This strategy enables us to pursue our mission of identifying opportunities for capital growth while undertaking an acceptable level of risk.

As always, if you have questions, please contact us.

 

Regards,

 

The Cornerstone Advisory Team