Market Commentary - July 2017

Many of our recent market commentary pieces have addressed market resiliency and ability to break record highs in the face of political uncertainty in D.C.  Although some volatility has returned we are still seeing a less volatile year than we are used to. I read broadly when it comes to the markets. There have been improvements in the global economy and I remain optimistic on the markets. In my opinion, however, there are there are two major risks that could spook the current uptrend.it 

 

One of the risks I still think about relates to the world’s central banks. I worry how equity and bond markets will react when asset purchases taper and central banks attempt to unwind their balance sheets. While the Federal Reserve has begun to slowly raise rates, the real test will come when they hike multiple times in a calendar year. Many other central banks have not yet tested the waters with rate hikes and have even pledged to keep their rates lower longer. 

 

We all know after the 2008 financial crisis, central banks aggressively intervened to keep the global economy afloat. They helped drive interest rates to near zero (negative in some countries) and embarked on a nearly decade long asset purchasing spree. Many pundits claim markets are near all time highs solely because of central bank intervention and while there may be some validity to this claim, pinpointing how much is nearly impossible. Total assets of major central banks are four times what they were in 2007. In 2016, the Swiss Central bank held over $127 billion francs in equities (equates to $132,030,362,050 U.S. dollars) and held more shares in facebook than Mark Zuckerberg. My concern is whether central banks have over stayed their welcome and backed themselves into a corner with no exit strategy. While economic growth has picked up, the question is will it continue fast enough to offset central bank stimulus dependence. No one knows for sure but if economic growth continues to accelerate, things could work themselves out and limit the amount of volatility.

 

My second concern lies with the record levels of debt on corporate balance sheets. With interest rates near zero for a decade, plenty of corporations took advantage and borrowed aggressively. On the surface, this isn't necessarily a bad thing because if an investment grade corporation can borrow for below 4%, then they almost have to do it. They can invest this capital and aim for higher returns, innovation and growth which is what stockholders want. 

 

Some of this capital, however, was used to increase dividends or participate in stock buy back programs. Can these companies still show growth when rates start to rise? Over $2 trillion of loans come due in the next five years and a majority could need to be refinanced at arguably higher rates. Will credit markets have enough liquidity to absorb this? I’m not as worried about solid investment grade companies. In my opinion the bigger risk lies with the amount of outstanding debt for non-investment grade corporations who must borrow at higher rates and thus have a smaller margin for error. 

 

It is important to remember, however, that corporations are sitting on record levels of cash and many can pay their loans with the cash on their balance sheet. This is one of the major differences between now and 2008.

 

None of the concerns above should make anyone rush out and sell, but it's something to monitor. Both equity and bond markets always present risks, sometimes more than others, but trying to interpret and time when the risk will play out has been proven to be a losing game most of the time. Having a globally allocated portfolio helps mitigate some of the risks.