Market Data for the quarter ended June 30, 2015:
• S&P 500 Stock Index: 2063, down 0.2%
• Ten-year Treasury Note Yield: 2.34%, up 0.41%
• Gold: $1,178 per ounce, down 0.1%
• Oil: $59 per barrel, up 22.9%
Stocks were little changed in the second quarter of 2015, with concerns over the future of Federal Reserve monetary policy and the debt crisis in Greece weighing on share prices. The bond market suffered losses on the prospect of the Federal Reserve raising overnight interest rates later in the year.
The debt crisis in Greece is a result of the Greek government and their creditors, the International Monetary Fund, The European Union, and the European Central Bank, being unwilling to compromise on the terms of a continued bailout of Greece’s overly indebted economy. This is a classic game of chicken, with both sides racing towards a cliff hoping the other side blinks first. As the situation stands now, the bailout of Greece has expired and Greece has effectively defaulted on a loan from the International Monetary Fund. Greece has closed its banks and stock market to prevent a collapse of its financial system. Greeks are only allowed to withdraw approximately $67 per day from ATMs.
The next shoe to drop will be a vote on a referendum on whether or not the Greek people want to accept the terms of a continued bailout from Greece’s creditors. These terms mandate higher taxes and reduced pension benefits. As Greece has already suffered a 25% decrease in economic production, the Greek government has claimed that these terms are too onerous. If the Greek people accept the terms of the bailout, Greece will likely remain in the group of countries using the Euro currency (Eurozone). If they do not, they will likely fall out of the Eurozone and revert to their own currency, the Drachma. As this would risk a near total collapse of the Greek economy, we believe that the referendum will pass, and Greece will remain in the Eurozone.
The market implications, in our view, will be a relief rally in world stock markets if the Greek people do in fact accept the terms of the bailout. If they do not, we expect further weakness in stocks, at least in the near term. Longer-term, we think the impact on the global financial system will be limited because Greece is a small country, and the European financial system is robust enough to sustain the shock of Greece leaving the Eurozone. One should keep an eye on the bonds of other Eurozone countries seen as economically vulnerable, principally Portugal, Spain, and Italy. If the Greek crisis spreads to these other countries, further and more significant distress will likely be in store for the US and global stock markets. Thus far, the pressure on the bonds of these countries has been quite limited.
Prior to the worsening of the Greek debt crisis, the primary concern for investors had been the future of Federal Reserve monetary policy. The current expectation is for a quarter percentage point increase in the Federal Funds overnight interest rate in September and a possible follow on increase in December, from its current level of 0 to 0.25%, where it has sat since 2008. It is widely believed that higher Federal Funds interest rates are a distinct negative for bonds and a possible problem for stocks. The thinking is that higher short-term interest rates will put pressure on longer-term debt (bonds), which in turn will make stocks less attractive relative to bonds. This effect has already been seen in the market for income producing stocks, particularly utilities, real estate investment trusts, and master limited partnerships.
For the broader stock market, some believe that higher interest rates would be indicative of stronger economic growth, which would be good for stocks. Fed Chairwoman Janet Yellen has stressed that the Federal Reserve is “data dependent”, and will only raise rates as the economy improves, and we take her at her word. Stock bulls point out that in the previous Fed interest rate tightening cycle of 2004 to 2006, stocks enjoyed a solid advance. Our view is that to the extent that low interest rates have been central to this bull market, higher rates could present more of a challenge for stocks than in prior cycles. One positive in the stock bull column is that this issue isn’t a secret to anyone, so anxiety around interest rate increases is already at least partially reflected in the price of stocks, particularly in income oriented shares.
An additional area of concern is the possible popping of a stock bubble in China. Until recently, the mainland Chinese stock market has been in a vertiginous accent, with share prices more than doubling in the past twelve months. Since peaking in early June, however, prices have fallen more than 20%, the traditional definition of a bear market. The mainland Chinese stock market had exhibited the classic elements of a speculative bubble: rapid appreciation, extreme valuation, and widespread, greed-driven popular hysteria. (As the US stock market has exhibited none of these symptoms, we feel people who claim the US stock market is in a bubble are off base.) The Chinese economy has already been flagging as of late, and a popping of a speculative bubble will not be helpful to buoying their economy in the current circumstances. As China is a major trader in the global economy, Chinese economic weakness has wider economic and financial implications.
For the remainder of 2015, we see the S&P 500 stock index trading in a range of 1950 to 2225. It finished the second quarter at 2063. If you have any questions or concerns, please do not hesitate to contact us.