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Second Quarter 2016 Financial Market Review

Compared to the first quarter of the year, the second quarter was positively tranquil. Financial market volatility was much more subdued, while investor sentiment was buoyed by better-than-expected U.S. economic data, continued strength in oil prices and lowered expectations for a near-term Fed rate hike. The late June surprise Brexit vote results did create a brief surge of volatility, but U.S. stocks quickly recovered the 5%+ loss and finished the quarter near all-time highs. However, despite the 2.46% gain produced by the S&P 500® Index during the second quarter headwinds still remain for U.S. equity investors, while the outperformance of classic safe haven assets like government bonds and gold is a potential warning sign for stocks. As a result, volatility is likely to rear its ugly head again later in the year.

Falling interest rates and bond price appreciation were big themes over the past three months. Following weaker-than-expected U.S. employment reports in May and June, the expectations for a Fed rate hike were pushed back several months. As a result, and due to continued global economic weakness and central bank monetary accommodation, the U.S. 10-year Treasury yield fell (and the price rose) throughout the quarter, ending at a level near its all-time low. The surprise results of the Brexit vote, in which voters in the United Kingdom (UK) elected to leave the European Union (EU), further exacerbated the decline in yields as investors around the world rushed for the safety of government bonds. The Brexit results also pushed out expectations for the next Fed rate hike until 2017, while gold continued to rally during the quarter and has now gained roughly 26% year-to-date. Because bonds and gold generally appreciate when investors have little confidence in future economic growth, the stock market rally (which is seen as a forecast of a stronger economy) appears unsustainable at this point. In addition, the best performing stocks year-to-date have been traditional safe haven securities, such as low beta, high yielding and slower growth companies. Such an environment is not generally viewed as bullish for the broad equity market.

Over the past few months, investors have demonstrated a certain degree of complacency regarding the key risks in the market, including falling U.S. corporate earnings, weak U.S. and global economic growth, a continued decline in the Chinese currency and the potential for tighter financial conditions as the Fed raises the Fed Funds rate. In addition, stock valuations do not seem to be reflecting the uncertainty arising from the UK’s exit from the EU. The process has more political than economic implications, but no country has ever departed the EU before, so the process and outcome are very unclear. In addition, the EU and UK together account for almost 25% of global GDP, so there is likely to be volatility associated with the transition. There is also now a fear that other EU countries, particularly those that employ the euro currency, may attempt to leave the EU. Such an event would likely have a dramatic impact on financial markets.

Commodities and currencies played a role in asset class returns during the second quarter. Oil continued to rally, rising another 28%, while gold jumped 9%. U.S. production cuts spurred oil prices higher, while mounting uncertainties about global growth and concerns about aggressive central bank policies contributed to the gold rally. Currency moves were also a factor as the Japanese yen continued to move higher, while the Brexit results caused a U.S. dollar rally and a decline in the British pound and the euro.

Other asset classes had mixed returns during the quarter. Foreign equity markets generally underperformed the U.S. as dollar strength and the impact of Brexit had a bigger impact on these markets. Specifically, the MSCI EAFE Index fell 1.46%, with the June Brexit vote being a key negative, while the MSCI EM Index rose a scant 0.66% during the quarter. Stronger commodity prices were positive for EM markets but could not offset the impact of a rising U.S. dollar. Bonds and REITs benefitted from falling interest rates and the demand for yield during the quarter. U.S. Investment Grade bonds, as measured by the Barclays U.S. Aggregate Index, rose 2.21%, while High Yield bonds gained 4.60%. Global REITs were also bid up by investors, gaining 3.46% during the quarter.

U.S. economic growth continued at a slow but relatively solid pace, generally beating expectations and providing a boost to investor sentiment. The manufacturing sector expanded, as the ISM Manufacturing Index jumped to a 15-month high, while retail and auto sales both rose materially and the housing sector continued to grow at a solid pace. Importantly, despite the weakness in employment, consumer confidence jumped to an eight-month high in June. Strong economic data, especially related to the all-important consumer, has been a key factor in the improved investor sentiment witnessed since February.

One aspect of the economic cycle that continues to give us pause is the decline in U.S. corporate earnings growth. Earnings have now declined on a year-over-year basis for four straight quarters, an event that hasn’t occurred since the last recession. With the economy being at full employment, and the resulting pressure on wages, corporations may be hard-pressed to generate meaningful earnings growth in the near term. We do not foresee a recession this year, but do acknowledge that it will be difficult for stocks to move much higher given this earnings trend, especially if global economic growth remains weak. In fact, a near-term correction in the stock market, as investors digest the recent gains and acknowledge the suspect fundamental environment, would not surprise us. However, the significant rise in oil prices year-to-date, coupled with somewhat moderate U.S. dollar strength, may allow earnings to grow more than expected over the coming quarters, which would be a welcome development.

As far as our near-term outlook is concerned, we expect the remainder of 2016 to be similar to what transpired in the first half of the year, specifically slow but positive economic growth and muted asset class returns. We expect the heightened level of volatility experienced over the past 12 months will persist through the rest of the year, while various macroeconomic factors will continue to keep investors on edge. Despite the improvement in sentiment and powerful equity rally since mid-February, the current bull market and economic expansion are now another three months older, and with a maturing cycle comes higher levels of risk and modest investment returns across all asset classes. We believe the best strategy for investors to manage this environment is to practice prudent diversification while maintaining a long-term investment focus. We would not recommend a material change in your long-term asset allocation, but do believe that an increase in your retirement savings rate, to offset the weak investment returns, would be sensible today — especially if you are nearing retirement.


You should carefully consider the investment objectives, risks, charges and expenses of GuideStone Funds before investing. For a copy of the prospectus with this and other information about the funds, please call 1-888-98-GUIDE (1-888-984-8433) or download a prospectus. You should read the prospectus carefully before investing.

S&P 500® is a trademark of The McGraw-Hill Companies and has been licensed for use by GuideStone Funds. The Equity Index Fund is not sponsored, endorsed, sold or promoted by Standard & Poor’s and Standard & Poor’s makes no representation regarding the advisability of purchasing the Equity Index Fund.

All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.

GuideStone Capital Management, a controlled affiliate of GuideStone Financial Resources, serves as the investment adviser to GuideStone Funds.