Returns on most asset classes were underwhelming in the 2nd quarter. The biggest loser, real estate investment trusts (REITs), fell just over 9 percent, while other asset classes saw almost no return at all. Only commodities showed signs of life, rising 8.7 percent—a minor bounce considering that they are still down nearly 37 percent over the past 12 months.
As you know, Monterey Private Wealth doesn't pay a lot of attention to short-term gyrations in the market, so the most recent quarter’s lackluster performance does not concern us too much. More important are the average annual returns over the past three years, which have been solid for almost every asset class. A diversified portfolio would have returned just over 8 percent per year over the past three years.
Challenging Macro Factors
Recent financial asset returns have been held back by challenging macro factors. In the United States, slower than expected economic activity has led to falling corporate profits--especially among large blue chip companies. According to Standard and Poors, operating earnings per share for the companies that comprise the S&P 500 index have declined by more than 13 percent since Q3 2014. Analysts are calling for rising corporate profits in coming quarters, but recent economic data may call those forecasts into question.
Another negative factor weighing on financial asset returns is the expectation for rising interest rates. Over the past several months, statements by various Fed officials have been atypically unambiguous that the Fed will start raising interest rate later in 2015. Their language is usually tempered with conditions and caveats; however, in this case they have been very clear in their intent. The only question is timing.
Finally, there is tremendous political and economic uncertainty stemming from the Greek crisis and the Chinese stock market meltdown. The world has become a very small place as capital markets and economies have become intertwined as never before. The volatility and risk aversion associated with foreign crises can be quickly transmitted to our markets through the banking sector and other capital flows. While longer-term benefit might accrue to our markets from disarray in foreign economies (as investors see our markets as safer and more reliable), experience shows that uncertainty rarely benefits risk assets in the near term.
In a normal world, we would expect these macro factors to lead to lower stock prices. However, in a world in which huge amounts of liquidity are sloshing about in the U.S., Europe and Asia, any selling pressure seems to attract ready buyers. The result is stock market limbo where the self-adjusting mechanism of market corrections doesn’t work and weak-handed speculators are not flushed out. Strange as it may seem, I would love to see a 10 percent correction, possibly more. Such a correction would put the market back into a more attractive valuation range and would provide the market a base upon which to build a longer-term rally.
The Greek tragedy plays out
It is interesting to me that so much attention is being paid to the situation in Greece. I agree that it is a significant event and it will be interesting to see how the euro-zone deals with what almost certainly will be Greece’s eventual exit from the euro, but there are much bigger issues at stake in the global markets, namely the unraveling of China’s stock market and possibly its model of government-directed capitalism.
Meanwhile in Beijing…
The recent slide in the Chinese stock market has been a sobering wakeup call for China’s central planners. From its June 14 peak to its July 8 trough, the Shanghai Composite Index fell over 32 percent, erasing more than $3.6 trillion in market value. (To put that in perspective, the entire annual economic output of France is $2.8 trillion.)
As of this writing, the Chinese market has recovered some lost ground (it’s now down only 25 percent), but I doubt the recovery will continue. The fundamentals don’t add up.
According to William Huggins of the University of Toronto, China’s current debacle flows directly from its pursuit of social stability through government-directed economic investment. The Chinese government has long used state-owned banks to make loans to enterprises as a means of creating employment without any concern for the profitability of those investments. As a result, bank balance sheets are riddled with bad debts. During the 2008 financial crisis, as Chinese exports to the west stalled and fragile banks began to teeter, the government started pumping up its money supply and providing other stimulus to keep the banks afloat and economic growth on track.
Huggins reports that China’s money supply (M2) tripled in the last 7 years. That liquidity flowed into Chinese real estate until 2010 when the government started to discourage it. At that point, money flowed into something called “shadow banking” until last year when the government cracked down on it. Since then, liquidity has been pouring into the stock market. At its peak, stock prices in Shanghai soared over 150% in less than a year even as corporate profitability and economic activity were shrinking.
It hasn’t just been stocks and real estate in China that have felt the power of this massive wave of liquidity. Anybody trying to buy a home or commercial property in the Bay Area has experienced it as well. According to a report by Knight Frank, a global real estate consulting firm, the value of Chinese investments in U.S. real estate grew from $600 million in 2009 to $12 billion in 2013, much of that focused in the San Francisco area. Though harder to identify, it is certain that U.S. stocks have also benefited from Chinese buying.
The bottom line
As you know, we do not attempt to forecast near-term returns or engage in market timing. Instead, we manage portfolios for the long-term, seeking returns that are commensurate with our clients' financial goals. As we mentioned last quarter, our near-term expectations for stock markets has grown more subdued. Given increasing uncertainties around the world, especially respecting China, we continue to stress the importance of proper diversification and a long-term perspective.