"The Waiting Game
Financial market returns were quiet in the second quarter, seemingly waiting for some kind of definitive signal that never arrived. The S&P 500 Index, MSCI EAFE Index, and MSCI Emerging Markets Index were each essentially flat for the quarter, with relatively limited volatility. The former two had each about a 3% gain going into the last 10 days of the quarter, but surrendered their gains as Greece threatened (for the fifth time in as many years) an uncontrolled debt default and exit from the Euro system. The Greek's gamesmanship was once again cauterized by international financial agencies only after the Greeks were very bluntly threatened back with the same medicine. This suggests that European authorities are no longer concerned that a Greek Eurozone exit would be a systemically destabilizing event.
The most curious financial action so far in 2015 is the Shanghai Stock Exchange's A Share (locals only) Index, which rose 38% from April to mid-June on a wave of speculation, before falling 22% in the last 2 weeks of June. For the year, the Shanghai A Index rose 63% by mid-June, and at its high point was up 155% in a 12-month span. It has all the markings of a dangerous, margin-fueled retail stock investment bubble that curiously commenced right around the same time as a formal crackdown on aggressive gambling and money laundering by China's citizenry in Macau. As the parabolic move went into reverse, the Chinese government instituted a barrage of selling restrictions, trading closures, and market stabilization commitments, notwithstanding the fact that stock prices have simply fallen back to where they were in April. It does not inspire confidence in their financial system.
Longer duration bond yields rose globally, with U.S. 10-year yields rising 50 bps to 2.4% from 1.9% in the quarter. The Eurozone's flirtation with negative interest rates continues on short term fixed income instruments, but longer duration 10-year yields rose dramatically, headlined by German Bund yields rising from essentially 0% in March to almost 1%, before settling in at 0.7%. These are hardly high enough figures as to act as a hurdle to equity valuations, but in raw percentage terms are big moves off of low bases.
We continue to believe that a shift away from zero percent interest rate policy (“ZIRP”) by the U.S. Federal Reserve will prove to be the most significant financial event of 2015. Markets are becoming more comfortable with the notion that this will indeed occur later in the year, and perhaps as soon as the current quarter. For now, short term interest rates have been pegged at 0% in the U.S. for over 2,400 days, meaning that most children entering the second grade this fall have never seen a positive interest rate on liquid savings (Not that they would really care, it's just interesting to think this is starting to take on lifetime proportions). The economic data is supportive of a positive rate of interest, with new unemployment claims running at exceptionally low levels, providing evidence of an increasingly tight labor market. Corporate M&A and stock buyback programs are running at exceptionally high levels, providing wholly unsurprising evidence that Wall Street will take a free lunch and run with it, as a 0% interest rate does indeed incentivize financial engineering and roll-up business strategies. Rather like the Greek situation, absent a 0% short term interest rate, would the U.S. economy and financial system careen into crisis? It seems an outdated notion. It might very well be that the longer the Fed waits to move off of the zero-lower boundary, the more destabilizing the eventual move could be." Download the full report below.