Both the Bloomberg Barclays US Aggregate Bond Index and the Bloomberg Barclays Global Bond Aggregate Bond Index posted positive second quarter returns, despite posting negative returns in June. The US index has returned 2.27% year-to-date, including a 1.45% return in the second quarter. The Global index has returned 4.41% year-to-date (as of June month-end), including a 2.60% return in the second quarter. Both the US index and Global index posted slightly negative returns in June, -0.10% and -0.09%, respectively. The extent to which central banks around the world embark on tighter monetary policy will be a key driver to the bond market’s performance in the second half of the year.
The Federal Reserve once again raised the Federal Funds rate by 0.25% last month, the third straight quarter in which it has done so. While the Fed was expected to raise rates, this rate hike has been scrutinized more than others due to the lack of inflation present in the first half of 2017. Fed Chairwoman Janet Yellen has argued that the tepid inflation numbers are transitory, and whether or not this is in fact true will become more apparent in subsequent quarters. The Fed also laid out a plan to normalize its balance sheet by reducing the amount they will reinvest as US Treasuries and mortgage-backed securities mature. The start date for balance sheet reduction is not finalized, but will likely begin later this year in addition to another 0.25% Federal Funds rate increase. Compared to the size of the balance sheet ($4.5 trillion) the initial monthly reduction of $10 billion is small, however it represents another step towards ending a historic period of easy monetary policy following the 2008 financial crisis.
After the election in November, equity markets soared on the hopes of expansionary fiscal policy via tax cuts and increased spending. So far, little progress has been made on either, and anything substantial is likely going to happen in 2018 at the earliest. Tax cuts are certainly a major focus for Republicans and increased infrastructure spending could be the one area of bipartisanship in Washington. However, it seems that the administration’s focus on health care, immigration and trade will consume the rest of this calendar year.
It has been a year since the Brexit vote, and despite Theresa May’s commitment to leaving the EU, Europe as a united continent looks stronger now than it has in recent memory. Emmanuel Macron’s victory in the French presidential election provided the most significant boost to continued European integration in a time when populism is making inroads across the world. Macron’s victory may also signal the beginning of a new era: the election of a young centrist candidate from a brand new political party at the expense of the old guard. If Macron and his party can implement their agenda, their successful strategy could serve as a blueprint for candidates in other nations frustrated by political deadlock and sluggish growth. In the short-run, equity markets have responded positively to his victory and it should calm fears of European disintegration.
As Macron’s popularity and power rise, Theresa May has been significantly weakened relative to when she took over as Prime Minister. A disastrous result in June’s snap election combined with multiple domestic tragedies have placed an ominous cloud over May and her Brexit negotiations just as they have begun. Uncertainty regarding Brexit, combined with aging populations across the continent, bad loans at banks piling up, and new concerns about Greece’s finances, are more than enough to keep economic growth now, and down the road, limited. However, with a Macron-led Europe paired with signs of inflation taking hold and business confidence rising, Europe can remain an area of relative stability in uncertain times.
Elsewhere on the global front, perhaps “complacency” should be the word of the year for financial markets. On July 4th, North Korea announced to the world it now has the ability to launch intercontinental ballistic missiles (ICBM). US intelligence officials confirmed the successful launch of the ICBM, which flew 1,700 miles into space and posted a 37-minute flight time. Financial markets did not blink. Frankly, we find this puzzling. To some extent, the degree of complacency may be tied to the fact that index-based exchange traded funds now own 37% of the S&P 500. (Some experts believe this may be driving valuation distortions as there is less and less price discovery.) Regardless, it is as if the market is saying “don’t worry, he will never actually nuke another country”. Let us all hope Mr. Market is correct on this one.
The sun is shining and it appears to be smooth sailing across global financial markets despite underlying concerns regarding valuations, geopolitical risk and a changing monetary policy landscape. That said, we construct portfolios with a mind towards durability. While we are happy to be profiting from the rising markets, choppier seas will not catch us off-guard.
Carl Hall, CFA
Chief Investment Officer