This year has seen a slow and steady start in stocks, with the Dow Jones Industrial Average on track to have its tightest trading range for the first half of any year since 1896 (the high-to-low range for the Dow has been just over 6%). There's only been 19 times since 1896 that the Dow has traded in a range of 10 percent during the first half of the year. (Looking back at history, this has shown positive results for the year overall, with the Dow only closing negatively for the full year on 3 of those 19 occasions).
The last 12 months still show US stocks (S&P 500) outperforming other major asset classes, but overseas markets are awakening from a long slumber (we'll see if their year to date outperformance will persist).
On the news front, May started out with a bang as the United Kingdom election produced stunning results. The Conservative Party, led by current Prime Minister David Cameron, trounced the opposition by wider margins than even the furthest outliers had predicted. All the major opposition leaders resigned afterwards, along with many senior politicians who have dominated Whitehall for decades. In short, it was a total housecleaning of British politics.
Cameron pledged to hold a referendum on whether to continue the UK's membership in the European Union, which clearly resonated with British voters, giving the Conservatives their first outright majority in Parliament since 1992. However, the Scottish Independence Party surged to take an unprecedented 56 of 59 seats in Parliament, becoming overnight a major player in British politics. Stung by a failed referendum last year on independence from the UK (which has since been shown to have strong elements of fraud and vote-rigging), the Scottish lion roared, and it is clear that the nationalist sentiment is alive and kicking.
The UK elections look like a sign of things to come. Across the globe, voters are fed up with crisis after crisis, scandal after scandal, and "politically correct" politicians who fail to address local needs. Major elections loom in Germany, France and the United States in the next two years, and it is doubtful that things will be "business as usual". Just like volatility in markets, we are seeing a huge increase in political change that appears to be only just beginning (a change in trend).
Elsewhere, the U.S. employment report showed a continuing decline in the unemployment rate to 5.4%, with an uptick of 233,000 new jobs in April. Market observers are watching reports like this closely for clues about when the Fed will start to raise interest rates. While the unemployment rate has essentially achieved the Fed's goal of 5.5% (see chart below for longer term perspective), the missing piece is stronger GDP growth.
In that regard, the GDP report at month end was not encouraging
. Fed officials, including Janet Yellen, want further confirmation the economy is growing at the 2.3% to 2.7% pace they project. Instead, they got a contraction of -.7% in Q1 GDP
, with real final sales slipping 1.1%. Many said it was a reflection of poor winter weather, but most analysts gave the report poor marks. The U.S. economy still has a lot of recovering to do before reaching the Fed's GDP goal
Also in May, global banks were the recipient of record fines by regulatory authorities, as long running investigations into rigging LIBOR and foreign exchange rates were settled. In the U.S., the Justice Dept., led by newly appointed Attorney General Loretta Lynch, levied $5.7 billion in fines against five of the world's largest banks, including non-US banks Barclays and UBS. Four of those banks pleaded guilty to criminal charges of manipulation of the forex markets. In Britain, a Reuters study just released found that financial companies in the UK paid £12 billion in fines last year, comprising almost half of their the total liabilities.
This continues a long running practice of regulatory capture, whereby banks influence (i.e. fund) legislators to write laws and regulations that are favorable to them, in exchange for an occasional public scourging. There is no expectation that any highly placed executive will ever serve time for criminal activity, as long as the well-choreographed dance continues. Investors should be asking how long this symbiosis can continue when Main Street does not appear to be benefitting (we guarantee the 99% have not gone away and will be very vocal in the 2016 election).
Many view the repeal of the Glass-Steagall Act in 1999 as the turning point which led to an extraordinary rise in banking profits, undergirded by exponential growth in debt and leverage. Banks became unregulated entities no longer constrained by deposit-taking and loan making. Unconcerned with risk management (who would if losses could be offloaded onto the taxpayer?), banks sought transactional revenue through off balance sheet activities, primarily by acting as "counterparty" in derivatives contracts. The latest semi-annual report from the Bank for International Settlements shows that total global exposure for off balance sheet obligations is now a stunning $630 trillion (in context, US GDP was $16.7 trillion in 2013):
Source: BIS Quarterly Review, June 2015
It is a good time to re-visit this, as the European banking system is experiencing significant stress from negative interest rates and potential sovereign debt defaults (with Greece on the front burner - still!) Under European banking rules, all banks are required to hold and classify EU sovereign bonds as Tier One capital. What happens if the net worth of these banks declines as their bonds are impaired? More importantly, will market participants continue to have confidence that they will still be able to perform as a functioning counter-party to those trillions of derivatives that they "stand behind"? It is not hard to envision a scenario where a large, systemically important global bank becomes rapidly insolvent, requiring the government to step in and "bail it out" (i.e. nationalize it). We've seen this movie before with Lehman Brothers in the U.S., and it was a real thriller (not). We've got a feeling the European version (if it comes) will be a blockbuster, and probably of the disaster variety (Titanic comes to mind).
Finally, in a little noticed but highly impactful Supreme Court decision (Tibble v. Edison) on May 18th, the justices ruled in favor of 401k plan participants who had sued their former employer and the retirement plan's sponsor, Pacific Edison, for breach of fiduciary duty. The plan sponsor used high cost "A class" (retail) mutual fund shares, instead of much less expensive institutional class shares for the same funds, thereby costing participants millions of dollars in excess fees and impeding their path to retirement. The plan sponsor also did not prudently monitor their investments.
This ruling has the retirement industry abuzz, for very good reason. The most fundamental duty of those who are responsible for other people's money (i.e. a trustee of a 401k plan) is to act with a high degree of care and prudence (the fiduciary standard of care). When a multi-billion retirement plan with supposed experts in their employ cannot perform even a simple cost analysis of a mutual fund, and fails to act to correct that deficiency, then Houston, we have a problem. This ruling will shine a light on fiduciary liability, and force plan sponsors to (finally) do the right thing.
(Interestingly, last month the Department Labor issued a proposed new rule called the "Fiduciary Standard of Care", which seeks to expand the definition of "who is a fiduciary" to a retirement plan. Many are calling this the most fundamental change in retirement regulation since ERISA was first passed in 1974. Now, with the Tibble v. Edison ruling, the stars appear to be aligning to give retirement savers better plans through better plan oversight. It's been a long time coming!)