June 2015 Recap

Drachmas, Dragons and Bears

The summer is usually a time to relax. School lets out, and you don’t have to deal with as much traffic. You might have already squeezed in a vacation or hosted a cookout or two, but the markets have not been so relaxed. Over the past three years both temperatures and blood pressures rose on different issues and news headlines. In 2013, stock and bond prices plummeted violently when the Fed hinted at the end of easy monetary policies. It was dubbed the “Taper Tantrum.” In 2014, it was both Russia “invading” Crimea and Ebola which shook stocks. This summer it’s the debt crises in Greece and Puerto Rico, and the unknown implications of China’s quickly cooling economy and possible stock market bubble. Let’s spend a few minutes to take a closer look at these issues.

Dra(ch)ma abroad

The Greek government (conveniently) announced over the final weekend of June that Greek banks wouldn’t open on Monday and would remain shuttered through July 6th. This announcement only added to the anxiety of the Greek debt crisis that built in the closing days of June. Athens continues to find a way to delay paying its debts. By way of a loophole, Greece delayed its mid-month debt payment of €3.5b to the European Central Bank until month-end, and then defaulted on the payment anyway. Obviously, the delay was a tactic to buy more time to hammer out some sort of a deal with creditors, but the deal never materialized. With very few assets available to put towards meeting the bill due, the ominous news got out, and the Greek people began making large withdrawals from Greek banks. It was a run on the banks, but in slow motion … sort of. Billions of Euros were pulled and moved to safer havens in other European countries. Who can fault them, right? Rumors of aid from Russia surfaced around Father’s Day. Investors welcomed this “progress”, and international stocks rallied. However, the deal eventually came apart, and on Monday June 29th, European stocks plummeted again.

The big uncertainty around Greece is how their possible exit from the European Union (EU) would affect the Union itself. When the Euro went live in 1999, the expectation was that the EU and its members were permanent. Now that premise stands on shaky ground. European policymakers only have a few choices, and all of them are bad. If they forgive and/or continue to extend Greece’s debt repayment commitments, sure, Greece remains in the EU, but this sets a potentially dangerous precedent with troubled economies such as Spain, Italy, Ireland, and Portugal lining up to get similar deals. If policymakers tell Greece to pay up or else, Greece will almost certainly exit the EU, which may potentially unravel the EU and the Euro as a currency. Who knows for sure?

Default risks closer to home

Greece isn’t the only country staring a debt crisis in the face. The other is much closer to home: it’s Puerto Rico. Okay, technically Puerto Rico isn’t its own country, it’s a territory of the United States. The Puerto Rico Electric Power Authority (PREPA), a Puerto Rican utility, carries about $9b in debt, and they sought out a big restructuring deal to avoid default on July 1. No deal has finalized yet, but they were able to make good on some of their debt payment.

A Puerto Rican default poses a great risk to investors. Some of the largest creditors of Puerto Rican bonds include big U.S. banks and investment firms, so any losses due to a default or just market losses would be felt right here at home.

To complicate things even more, bankruptcy court may not be the proper venue for claims against the PREPA. Some claim that entities like PREPA can’t access Bankruptcy Code Chapter 9 protections available to municipalities and U.S. state-affiliated authorities. If that’s the case, PREPA’s creditors could very well be forced to sue for payment directly, and that kind of a situation could get very nasty.

The Chinese Dragon Retreats

The Chinese Dragon had been flying high in terms of stock price returns, until just recently. From January 1, 2014 through June 12, 2015, the China CSI 300 index was up roughly 128%. Over this time period, China made significant economic and investment advances to become more transparent and to garner inflows of capital from foreign investors. The Chinese have opened their stock markets to domestic and international investment, and the Chinese public has plowed billions of Yuan into their markets, much of it leveraged by borrowing money to purchase securities. Since June 13th, Chinese markets, as measured by the CSI 300 China Index, have given back nearly 22% of returns year-to-date. By definition, Chinese stock markets have officially entered bear market territory. This is obviously a trend we are watching closely.

On U.S. Soil

Market participants in the U.S. looked to the Federal Reserve for direction, especially as the Fed released its much anticipated statement on June 17th. The Fed left rates unchanged, essentially at zero, due in large part to mixed signals from economic measures such as jobs, inflation and GDP. Unsurprisingly, stocks rallied after the release of the statement. However, for most of the year, large cap stock indexes have stayed range-bound, but smaller and mid-size company indexes have moved higher. Why? The answer involves currency. Generally, smaller and mid-sized companies have customers inside the U.S. who buy their goods with U.S. dollars. In contrast, many large companies bring in revenues from all over the globe, and they have to convert their earnings from foreign currencies to U.S. dollars. At the moment, the dollar is strong, and the near-term strengthening-trend looks likely to continue. Thus companies that must convert international revenues to U.S. dollars will see a strong dollar continue to weigh on their earnings reports, a factor likely to disappoint shareholders.

This is why a strong dollar is problematic for the Fed. If they raise rates, making the U.S. dollar more attractive to foreign investors, the dollar could become so strong that U.S. corporate earnings could be further squeezed by currency conversion, causing markets to sell off, not to mention curtailing jobs growth. This could even cause some companies to implement lay-offs, and the dominoes continue to fall until we find ourselves back in economic recession. So, while a strong dollar makes the cost of that trip to Europe you’ve been planning a little easier to stomach, it could also negatively impact your investment portfolio.

History has shown that stocks can do fine early into the first few rate hikes, but it’s not difficult to see how a bear market could emerge. Fed Chair Janet Yellen held a press conference the afternoon that the Fed statement was released, and she offered some comments worth noting regarding the interest rate outlook. She opined:

“…monetary policy will likely remain highly accommodative for quite some time after the initial increase in the federal funds rate in order to support continued progress towards our objectives of maximum employment and 2 percent inflation."

And that’s exactly how the official Fed statement ended, expressing the possibility that the federal funds rate could remain at levels well below historical norms for some time.

Design and Discipline

School may be out for the summer, but we are hard at work, monitoring the markets and how they are affecting the model portfolios. There’s a lot of noise in the finance world right now, and it is likely that the noise gets louder into the second half of the year. In spite of the noise, we have a plan: We stay the course.