McGill Advisors, Inc.
A Registered Investment Advisor
Investment Commentary
2nd Quarter 2015
Robert V. Sytz, Jr., CPA, CFP®
Jeffrey A. Harrell, CFA
Brett S. Miller, CPA, CFP®
K. Warren Poe, Jr., CFP®
Eric A. Harbert, CPA, CFP®
Below you will find our investment commentary for the most recent quarter. We hope you find it informative and will consider
our investment services in the future. If you have any questions or concerns about the market or your investment portfolio,
please call our office to schedule a meeting or conference call.
Economic Review & Outlook
In late June, the final GDP revision for Q1 was released confirming the economy shrank by 0.2%. A year ago, Q1 2014 GDP
came in even worse contracting 2.1%, so the recent Q1 slowdown wasn’t without precedent. Fortunately, just like last year, Q2
appears to be showing signs of a rebound with preliminary forecasts sitting at 2.6%. For the year, economists are predicting a
slightly slower growth rate of 2.1%. Fully six years removed from the most severe recession in any of our lifetimes, many
economists are perplexed as to why the economy can’t generate more momentum. Simply the massive size of our economy is
one major reason this growth rate is below previous recoveries. At $17.4 trillion, we are by far the largest economy in the
world. The entire European Union generates GDP of $18.4 trillion for comparison. The second and third largest countries by
GDP are China and Japan at $10.3 and $4.6 trillion, respectively. Growing an economy of our size is no easy task, so while the
degree of growth may be disappointing, the consistency has been remarkable. With the GDP having grown by more than 2%
every year since 2010, economists and politicians may not be giving it enough credit.
While an expanding economy is something
everyone likes to talk about, what more
directly affects most Americans is the
unemployment rate. Fortunately the news on
this front has been encouraging. As you can
see from the chart, the unemployment rate has
been in a steady downtrend since the recession
ended in 2010. It currently sits at 5.5% and
most economists are forecasting this will drop
further. Although arguments can be made
about the quality of the job gains, as well as
the number of people who have left the labor
force, most would agree the job market has
improved significantly over the past couple of
years. While this is good news for employees, investors need to be aware of the potential for this to result in inflationary
pressures. The job market is typically one of the last areas to fully recover from a recession. If the employment situation
continues to improve, it may result in what economists refer to as “cost-push inflation”. This type of inflation occurs when
wages or material costs rise, resulting in a need for employers to raise prices on their goods or services. Over the past couple of
years, core inflation has remained well contained, rarely showing year over year gains of 2% or more. Rising wages could bring
an end to this relatively subdued period of inflation. Should this become more of an issue over the next couple of months, you
could see interest rates rise and corporate profits slow further. This would not be a good combination for financial markets,
which in turn could adversely affect the economy.
With the economy showing signs of strengthening, the Federal Reserve has begun preparing financial markets for an interest
rate increase later this year. This would be the first time the Federal Reserve has raised interest rates since June 2006!! While
some market pundits are worried this is still too soon and the Federal Reserve should maintain its easy monetary policy, David
Rosenberg, Chief Economist and Strategist at Gluskin Sheff throws cold water on that premise suggesting, “It’s not the first rate
hike that is the problem. No cycle ended at first, second or third rate hike. The big concern is the last hike, not the first one.”
We echo this view and expect the economy to continue marching ahead in the second half of 2015. Growth may not live up to
some expectations, but further improvement in both employment and economic growth still appear to be on the horizon.
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Bond Market Review & Outlook
For bond investors, it was a bit of a wakeup call in the second quarter as the much anticipated rise in interest rates may have
finally commenced. The benchmark Barclays Aggregate Bond Index delivered a loss of 1.7%, its worst performance since the
second quarter of 2013. Improving economic conditions combined with a firmer commitment by the Federal Reserve to raise
interest rates were the catalysts behind the losses. The poor performance could have been worse, had bonds not caught a nice
bid just two days before the quarter ended in the wake of a potential Greek exit from the Eurozone. This news resulted in an
immediate flight to high quality assets such as U.S. Treasuries. Should the Greek situation worsen during the third quarter,
interest rates could drop further causing bond prices to rise. This type of uncertainty should highlight the importance of having
some high quality bonds in a portfolio for diversification purposes.
For the year, most bond indexes are close to breakeven with the exception of longer term U.S. Treasuries and high yield bonds.
U.S. Treasuries are amongst the worst performers, down 2.3%. These securities tend to be the most interest rate sensitive, so
their poor performance in a rising interest rate environment is to be expected. High yield bonds have held up much better,
delivering a positive return of 2.5%. This divergence can be attributed to the difference that drives the short term performance
of these two distinctly different bond asset classes, interest rate risk versus credit risk.
As we have discussed at length over the past couple of years, all bonds are not created equal. Many market pundits like to lump
all bonds together when describing the risk/return profile of “bonds”. As you can see from the aforementioned performance
discrepancy, this clearly is not the case. Although we still do not expect interest rates to rise quickly, we continue to favor
credit sectors over interest rate sensitive sectors. This allocation has been beneficial to our clients this year and we do not
anticipate deviating from this recommendation anytime soon. The news out of Greece will likely support interest rates
remaining lower for longer, which should benefit U.S. Treasury prices in the short term. However, it is unlikely the Greek
situation will adversely affect U.S. corporate profits or the financial strength of most U.S. based companies, thus credit sectors
should also continue to perform well. On the Monday after debt negotiations between the Greek government and the Eurozone
finance ministers broke down, high yield bonds barely budged. While stock investors should be concerned with elevated
valuations, slowing earnings growth and elevated geopolitical fears, bonds are primarily worried about solvency. The U.S. has
never been brought into a recession by another country and we don’t expect that to start now. While volatility may be elevated
over the next couple of months in both stock and bond markets, we don’t anticipate a material increase in corporate bond
defaults over the next 12-24 months. Thus, credit sectors of the bond market should remain one of the most attractive asset
classes for all investors.
Stock Market Review & Outlook
2nd Quarter Index Performance
4.00%
It came down to the final day of trading this
quarter to determine if the stock market would
2.00%
keep its quarterly winning streak intact. By the
slimmest of margins (literally the dividend),
0.00%
stocks managed to eke out their 10th consecutive
quarterly gain, posting a 0.3% total return as
measured by the S&P 500 index. The DJIA
-2.00%
suffered a small loss of 0.3%. Gains for small
caps were similar to large caps at 0.4% as
-4.00%
April
May
June
measured by the Russell 2000. The NASDAQ
DJIA
S&P 500
Russell 2000
NASDAQ
EAFE
fared better than most returning 1.8%. Finally,
international stocks didn’t distinguish
themselves much from their domestic counterparts as the MSCI EAFE gained 0.6%. Although the second quarter might have
resulted in little in terms of returns for investors, stocks are likely to be dramatically affected by many events that transpired
over the preceding couple of months. The Greek situation may be the headline news story as the third quarter begins, but it
certainly isn’t the only issue markets will have to deal with in the second half of the year. Others include a possible Puerto Rico
default, a bear market in Chinese stocks, Iran delaying a nuclear deal and finally the Federal Reserve poised to begin raising
interest rates. With stocks already at record levels, any of these could send shares down for at least a momentary pause.
Accordingly, investors may want to make sure their seat belts are fastened tight as we enter the always volatile summer months
ahead.
Russell Style Indexes
As you can see from the Russell Style Indexes,
Q2 Performance
large cap and mid cap stocks were flat to
3.00%
slightly down last quarter. To the surprise of
2.00%
many investors, small cap growth stocks
1.00%
performed relatively well, while small cap
value stocks suffered losses. This performance
0.00%
discrepancy can most easily be explained by
-1.00%
the performance of Real Estate Investments
Trusts (REITs) last quarter. The Russell 2000
-2.00%
Value index is comprised of nearly 20%
-3.00%
REITs. Many REITs suffered losses of more
Russell 1000
Russell MidCap
Russell 2000
than 10%, as rising interest rates make these
Growth
Value
securities less attractive. They have been one
of the top performing sectors over the past
couple of years, but with investors now expecting interest rates to finally begin to rise, the REIT party may be coming to an end.
We have never invested a sizeable amount of our assets in REITs and do not have any intention of increasing this exposure in
the wake of the selloff.
Although we remain cautiously optimistic that stocks will rise further in 2015, investors must begin to prepare themselves for
the possibility of lower future stock market returns. With stocks trading at elevated valuation levels and earnings growth
slowing, it seems unlikely double digit or even high single digit returns can be expected over the next couple of years. Further
if the Federal Reserve begins hiking interest rates later this year, stocks may quickly find themselves with more competition,
namely bonds. Many investors have shunned bonds over the past couple of years due to the paltry yields they offer. However
as interest rates rise, these securities will become more and more attractive, possibly luring some investors out of the stock
market, especially if the recent volatility continues.
The last time the stock market experienced any material investor anxiety was the 3rd quarter of 2011, which turned out to be a
good buying opportunity. The turbulence back then was mostly attributed to the turmoil and headline news in Europe. For
some, the unpredictable outcome of current worldly events might be enough to suggest throwing in the towel and moving to the
sidelines is a good move. However, we caution investors from making such rash decisions because the track record of investors
trying to time the market in this manner has not been good. We have often cited the annual study from Dalbar, indicating
investors lose 4.5% of their annual return to poor decision making and excessive fees. Therefore, we would encourage all of
our clients to resist the urge to make emotional decisions should volatility pick up in the second half of the year. Instead of
trying to get out of the stock market, we are focused on making sure our clients are positioned to participate in further market
gains, while protecting them from excessive losses, if in fact the next bear market is right around the corner. Making sure your
current asset allocation is in line with your risk tolerance is the most important strategy an investor should be reviewing right
now.
Sincerely yours,
M
Wealth Management Team
McGill Advisors, Inc.