Will the First Half be a Hard Act to Follow?

A friend of mine once said that the hardest shot in golf is the one after a great drive.  The same could be said for equity markets after the first half of this year.  Year to date the S&P TSX Composite, S&P 500, and MSCI EAFE Indices have gained, in local currency, 16%, 19% and 14% respectively.  In addition, North American indices recently achieved new all-time highs.  This has prompted many investment observers to urge caution for the second half.  Here is what we think: 

  • North American bond indices have returned over 6% year to date as lower interest rates have boosted bond prices. At current levels, global government bond yields trail the current rate of inflation.  This means fixed income as an asset class is producing negative real returns.  It is an extraordinary situation for long-term investors and suggests that fixed income allocations must be managed very carefully.  For us, it supports our continued position of minimum bond allocations with below average duration and minimal credit exposure.
  • While all global equity markets produced attractive returns in the first half of the year, US equities continued to stand out.  However, the S&P 500’s 19% total return was due in large part to a 27% gain in the technology sector.  The current valuation gap between US technology and the other major S&P industry sectors is significant.  We expect a rotation in the second half of the year into cheaper industry groups such as financials, industrials and materials.  Invesco’s S&P 500 Equal Weight Index ETF continues to be an important part of our overall US equity allocation.
  • The All Cap World Index ex US (ACWI ex US) is a great proxy for non-US equities as an asset class.  The stellar returns from a few US technology stocks combined with a rising US dollar has created a huge divergence between US equity returns and those for the ACWI ex US.  In the coming months we expect a “regional” rotation from US large cap equities into international equities to bring returns back in-line.  We continue to be overweight international equities in anticipation of this secular development.
  • Politics and accompanying rhetoric will remain a critical but unanalyzable influence on equity markets and investor confidence over the near term.  Markets will continue to oscillate between “risk on” and “risk off” as participants react to negotiating tactics and political tweets.  Market volatility (severe at times to be sure) is expected under these circumstances but, in the absence of substantive changes in the overall investment climate, will not dictate a change in our portfolio allocation.