In This Issue - Trust Pointfor slower growth: debt, demographics, deleveraging, and developing economies’ slowdown (our 4 Ds). We have also explained why equity markets can still

Third Quarter 2016 | Issue No. 15

An Economic & Market Commentary from Trust Point

In This Issue:Economic And Market UpdateEquity Market UpdateFixed Income Market Update

Third Quarter 2016Market Point

An Economic and Market Update from Trust Point

For the past few years, slow growth, ultra accommodative mon-etary policies, and ongoing geopolitical risks have been three re-curring themes. So far, 2016 has followed the same script. Following the U.K.’s surprising Brexit vote in June, inves-tors now wonder if the U.S. election means another surprise.

Global Growth: Too Slow for Too Long

Slowing gross domestic product (GDP), in the U.S. and globally, has been a major theme of this publication in recent years. We have explained the reasons for slower growth: debt, demographics, deleveraging, and developing economies’ slowdown (our 4 Ds). We have also explained why equity markets can still perform reasonably well in a slow-growth environment. Slow-growth environments provide a catalyst for earnings growth without pushing inflation higher and forcing central banks to raise rates quickly. But GDP is an imperfect measure of true economic health and happiness. For example, slowing

population growth naturally translates into lower potential GDP growth but that doesn’t mean individuals are less well off. In fact, research performed by Ned Davis Research shows that, in most countries, GDP per capita has grown at a faster rate than GDP itself, which means that most countries are getting richer on an actual per capita basis. A growing problem, however, is that wealth is increasingly being accumulated at the top. The most common measure of inequality, the Gini coefficient, measures the income distribution of a nation (Chart 1). It shows that among developed markets, the U.S. stands out as the most unequal.

Source: Bloomberg

Source: Wikipedia, World Bank

Chart 1: 2014 Gini Index


Election Day Is Coming UpThis year’s U.S. election is certainly historic. To start with, the two front runners have the lowest favorability ratings ever, as both candidates continue to battle separate issues that have damaged perceptions about their trustworthiness. Currently, polling and betting markets suggest a Clinton win. As Clinton’s views tend to favor the status quo and a continuation of existing policies, we suspect that equity markets would react more favorably to a Clinton victory

(Chart 2). In fact, since mid-summer, the positive correlation between the S&P 500 and the market-implied probability of Clinton defeating Trump has been strong. Trump’s unpredictable mixture of pro-growth tax, regulatory reforms, and protectionism views, brings more uncertainty to the table. As markets hate uncertainty, a Trump victory would likely bring increased market volatility and the build-up of a “Trump risk premium.”

Is Fiscal Spending Coming Back?Following the G20 finance ministers meeting in July, a communiqué stated, “Monetary policy alone cannot lead to balanced growth. Fiscal strategies are equally important to support our common growth objectives.” A spike in fiscal stimulus talk during non-recessionary periods is unusual (Chart 3), but in a world where sentiment towards anti-cooperation and anti-integration is on the rise, policymakers seek solutions to counter the backlash against globalization. And why not? Given how low interest rates are, governments should have an incentive to borrow and invest, especially at a time when there is growing evidence that some of the unorthodox monetary

policies adopted over the past few years have not provided the benefits expected. The addiction to lower interest rates has started to bring unintended consequences. In our opinion, other solutions must be contemplated to revive growth and inflation globally. We believe the idea of fiscal stimulus is not on investors’ minds but could be an interesting catalyst for asset markets in the next 12-18 months. We have positioned portfolios accordingly. Trump and Clinton disagree on many topics, but both agree that the quality of our infrastructure needs attention as both have favored increased infrastructure spending in their plans.

Source: MRB Partners

Chart 2: Key Views of Our Presidential Candidates

Source: Bloomberg

Chart 3: A transition from monetary to fiscal?

An Equity Market Update from Trust Point


The 3rd quarter provided little in terms of market moving news, but with the impending election and increased probability of another Federal Reserve rate hike this year, volatility will likely pick up in the 4th quarter.

Low Interest Rates Are Affecting Stock Markets

For some investors, income in the form of dividends and interest is the most important investing factor. Historically, interest rates from bonds offered higher income than dividend yields from stocks. In recent years, the rapid decline in interest rates has pushed income from bonds below the yields received from stock dividends (Chart 4). In particular, low-volatility sectors like Utilities, Real Estate, Telecom, and Consumer Staples currently offer above-average yields that are well above the interest rates of most bonds. Investors have flocked into these sectors, driving up stock prices to extreme valuations, which are currently two to three standard deviations above their historical mean

(Chart 5). Although these sectors have historically offered safety and stability relative to other equity sectors, their current valuations are creating risks that are not typically associated with these stocks. These market sectors may not be in bubble territory yet, but there is undoubtedly significant downside risk if interest rates begin to move higher. These stocks make up about 20-25% of the overall market. Should rates rise and the bubble burst, their impact on the overall market should be limited as investors will likely rotate money into lower valuation sectors that benefit from rising rates, such as financials, keeping the overall market afloat.

Source: Bloomberg

Chart 4: Dividend Yields Now Higher Than Bond Yields

Source: Bloomberg, Morningstar

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Relative Performance Is Improving

Trust Point’s investment approach combines active with passive investment funds. The passive funds provide index-tracking market returns at a low cost. Meanwhile, active investment funds are vetted through a thorough due-diligence process and offer high conviction portfolios with the opportunity to outperform the market. Trust Point typically utilizes managers who focus on high-quality companies with good business fundamentals and attractive valuations. This approach has kept active managers away from

overvalued areas of the market, which have performed the best in the past few years. Just recently, markets have started changing their tune by selling the overvalued areas of the market in favor of the more attractive market sectors. As a result, the performance from active managers has improved. Active management won’t always outperform the market, but what it typically does achieve is helping investors avoid market traps in the form of hot trends and overvalued stocks and/or sectors.

Boring Summer to Be Followed by Exciting Fall

Historically, the 3rd quarter is a quiet period for the market, as many families are vacationing and investment professionals are away from their desks. In fact, in July and August, the S&P 500 had only one trading day with a move greater than 1% (Chart 6). This will likely change in the 4th quarter as the market digests the U.S. election and the potential for another Federal Reserve rate hike. Increased volatility doesn’t mean negative portfolio returns, however. Yes, there likely will be periods of negative returns

that last days or weeks. However, regardless of the election results or a Fed rate hike, economic and market fundamentals likely will remain the key drivers of performance. With low but stable economic growth and the probability of a U.S. recession being minimal, equity investors should remain relatively upbeat. We continue to hold a neutral view on stocks, but will look closely at any sell off as a potential opportunity to increase allocation to stocks within portfolios.

Source: S&P Dow Jones Indices

Chart 6: S&P 500 Daily Change

Source: Ned Davis Research

Chart 5: Overvalued Sectors Of The Market

A Fixed Income Market Update from Trust Point


It is difficult to envision a significant rise in U.S. yields before the election given policy uncertainty that could be introduced, but there is a clear window between the election and New Year for interest rate expectations to adjust higher as the market has not fully priced in a December rate hike.

Waiting Game

Throughout the year, markets have waited to hear if Chair Janet Yellen and other Federal Reserve committee members would provide a clue as to when the next federal funds rate hike will happen. In meeting after meeting, the Fed has cited an abundance of reasons to postpone hiking rates. Weak U.S. economic data, low inflation, a strengthening dollar, and global weakness have topped the list. Market interest rates began to rise slowly in the 3rd quarter as key committee members acknowledged that the case for a rate hike had “continued to strengthen in recent months.” Ultimately, the meeting

in September played out as we expected with the U.S. Fed on hold while revising its outlook for future rate hikes lower (Chart 7). Although the outlook going forward is for a slower path toward its long-term goal, recent Fed communication suggests that committee members remain committed to gradual rate hikes. It is unlikely that the Fed would raise rates at its November meeting just prior to the election, so the waiting game will continue into December where there is a real possibility we will get an interest rate hike before the New Year, just like in 2015.

Source: Bloomberg

Chart 7: FOMC Continues to Revise Down Interest Rate Projections

Source: Bloomberg, Morningstar


Fixed Income Returns Have Exceeded Expectations Sectors of the bond market that are more tied to economic growth continued to perform well in the 3rd quarter. Corporate Bonds, Convertible Bonds, and Emerging Market Debt have benefited as Central Banks remain accommodative and low interest rates push investors into riskier segments of the bond market in search of yield. The recovery in the price of oil has also been beneficial for corporate bonds with the investment grade index up 9.2% YTD and high-yield index up 15.3% YTD. Returns from interest rate sensitive assets, such as Treasuries, TIPS, and Mortgages, have also exceeded expectations during the first half of the year but began to slow

during the 3rd quarter as interest rates bottomed and slowly rose (Chart 8). The Fed can’t wait forever, and as long as it remains committed to this gradual tightening process, prospects for returns out of interest-rate-sensitive assets will remain modest. Most investors agree that the Fed is on course to hike rates in the near future, and market interest rates appear to be too low given this outlook. Although the yield advantage in the U.S. relative to other developed nations will limit the upside for U.S. yields, interest rates have room to move higher over the next few months.

Money Market ReformNew SEC reform intended to stabilize Money Market Mutual Funds (MMMFs) during times of stress has affected the cornerstones of the money market: stability, liquidity, and yield. To protect individual investors, the SEC is introducing a floating Net Asset Value (NAV, or price) for “institutional” investors, which could expose them to money market losses. “Institutional” accounts, such as pensions, hedge funds, corporate entities, and any investor not a natural person, will be subject to a floating NAV if they want to invest in Prime or Tax-Free money markets. Prime funds invest mainly in high-quality short-term corporate debt securities. Government money market funds, exempt from

the regulations, have become the go-to money market vehicle for investors wishing to maintain a stable NAV. This is exhibited by a dramatic shift in fund flows. Money has been flowing out of Prime and into Government Money Market Funds (Chart 9), which has pushed prices higher and yields lower in already low-yielding government money market funds. At Trust Point, we believe a stable price is paramount in MMMFs, and we have made some changes to our offerings, as well as introduced an insured-deposit alternative for institutional accounts to ensure that our clients are receiving the highest yielding options available while maintaining the stability and daily liquidity long associated with this asset class.

Source: Bloomberg

Chart 8: High Quality Fixed Income Returns Stalled in Q3 as Interest Rates Slowly Rose

Source: ICI and Haver Analytics

Chart 9: Dramatic Shift in Flows From Prime Funds to Government Funds

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In This Issue - Trust Pointfor slower growth: debt, demographics, deleveraging, and developing economies’ slowdown (our 4 Ds). We have also explained why equity markets can still