Investors will most likely remember 2015 as the year that volatility and fear returned to the financial markets. Following several years of aggressive monetary stimulus provided by the Fed, and the positive impact of global economic growth driven largely by Emerging Markets, investors had become accustomed to “buying the dip” anytime markets wobbled. This philosophy led to a strong demand for risky assets and better than normal investment returns. However, following this period of very low volatility and high investor risk appetite, in 2015 we witnessed a number of factors that conspired to alter the tone of the markets:
- The Federal Reserve (“Fed”), which had supported asset prices for many years with aggressive monetary stimulus, initiated its first Fed Funds rate hike since 2006, thereby beginning the process of removing the safety net investors had grown accustomed to. Notably, this move is in direct contrast to other global central banks, including those in Europe, Japan and China, where policy makers continue to promote lower interest rates and aggressive monetary stimulus in order to spur economic growth.
- China’s economic growth slowed, and investors began to extrapolate the negative impact of a weaker China on global GDP and Emerging Market currency valuations.
- Commodity prices, which began their descent in late 2014 based on concerns about excess supply, fell some 30 percent lower, while many began to believe that the extended weakness may also be a sign of slowing demand and weaker global growth.
The fact that these events all occurred as the U.S. economy neared the seven-year mark of the current expansion, a long cycle by historical standards, added fuel to the angst already developing and brought up talk of a potential recession on the horizon. However, as is generally the case, diversified investors experienced much lower levels of volatility than did less-prudent investors.
The tone of the markets began to change in August as the S&P 500® Index was experiencing its first decline of 10 percent or more in over three years (it would eventually fall 12 percent). The correction was precipitated by an announcement by the Chinese government that it would allow its currency, the Yuan, to depreciate against the U.S. dollar. Many saw this as a sign that the Chinese economy was faltering, so the sell-off in global equity markets began. As a result, volatility spiked, investor risk tolerance fell and traditional safe haven assets outperformed for much of the remainder of the year. A rally in the U.S. dollar, an acceleration in commodity price declines and fears of the impact of the anticipated Fed rate hike contributed to the desire to move away from risky assets. Such a change in risk appetite is a normal occurrence as the economic cycle matures and is not necessarily an indicator of a looming bear market or recession.
The U.S. stock market produced a robust rally in October as sentiment temporarily improved and closed the year at a level near the point where the correction began. In fact, despite all the volatility (the S&P 500® Index crossed the unchanged line a record 30 times!), equities managed to eke out a total return of 1.38 percent for the year.
For the full year, investment returns were meager at best and painful at worst, while “safer” asset classes outperformed “riskier” asset classes, namely:
- Large-cap equities beat small-cap equities
- U.S. equities beat foreign equities
- Developed Market equities beat Emerging Market equities
- Investment Grade bonds beat High Yield bonds
- U.S. REITs produced small gains for the year while commodity indices fell more than 30 percent
- The U.S. dollar rose more than 8 percent vs. the currencies of key trading partners
- The best-performing sectors in the S&P 500® Index included defensive sectors such as Health Care and Consumer Staples, while the worst performers were the cyclical Energy and Materials sectors.
U.S. economic data, including employment, consumer confidence, auto sales and housing, remained in positive trends throughout the second half of the year. Inflation remained benign, and consumer spending was supported by low gasoline prices and the strong U.S. dollar. On the other hand, warning signs could be found in the weakening Manufacturing sector, a decline in corporate earnings growth and the significant widening of High Yield bond spreads, especially in the beleaguered Energy sector. In addition, stock market breadth was very narrow, with gains being concentrated in a handful of large companies, while the median stock in the S&P 500® Index actually produced a loss of 2.6 percent. However, stimulus remained robust globally, as central banks in Europe, Japan and China continued to promote growth through monetary stimulus, and the U.S. Congress approved a $1.1 trillion government spending bill that could add up to 1 percent to GDP in 2016. As a result, fears of a near-term recession or bear market had abated somewhat by year-end. Interestingly, 2015 was the first year on record during which notably negative U.S. High Yield bond returns were not met with a concurrent economic recession.
What to expect in 2016: A muddle-through, modest return year
We believe that 2016 will be similar to 2015 in terms of economic growth (slow but positive) and asset class returns (lower than historical norms). In addition, we expect that the heightened level of volatility experienced in the second half of 2015 (including a potential stock market correction) will persist into the New Year, while various global macro-economic factors will keep investors on edge. One important point to realize is that the current bull market and economic expansion are now quite mature, at almost seven years old, and with that come higher levels of risk and more modest investment returns. 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 we do believe that an increase in your retirement savings rate, to offset the expected weak investment returns, would be sensible today — especially if you are nearing retirement.
As we correctly predicted in last year’s letter, we continue to expect the following factors to have a major impact on global economic growth, investor sentiment and asset class performance:
- The divergence between U.S. central bank monetary policy and that of key trading partners around the globe
- The potential for weaker-than-expected growth in major economies such as Europe, Japan and China, as well as in commodity export-dependent Emerging Market nations
- The elevation of geopolitical risks, including terrorism and aggressive tactics employed by nations such as Iran and Russia
- The impact of much lower commodity prices, specifically crude oil
Potential differences between 2015 and 2016 may include: (1) the U.S. dollar rises by a lesser degree vs. foreign currencies (or remains stable), (2) oil prices stabilize (or rise) and (3) higher government spending has a greater impact than expected on the economy. All three of these factors could result in stronger U.S. economic growth than we currently project, but likely not enough to drive asset returns above their long-term averages. The most likely scenario, then, is more of the same “muddle-through” we experienced in 2015.
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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.