In the video above, David Spika answers four questions on investors’ minds regarding today’s markets. Below, he looks back at what happened in the markets during the first quarter.
If you like volatility, then you must have loved the first quarter of 2016. After falling some 11 percent and producing loud chatter of a coming economic recession, the S&P 500® Index rebounded roughly 14 percent to end the quarter a mere 3 percent from its all-time high reached last summer. Crude oil prices, which were very highly correlated to equities during the quarter, also suffered a roller-coaster ride by falling to $26/barrel before soaring above $40/barrel (a 50 percent + swing) at one point late in the quarter. A radical change in sentiment, from the depths of despair to the highs of exuberance, was responsible for this dramatic swing in asset prices. However, the fundamental backdrop, and all the risks associated with a maturing economic cycle and slowing global growth, remained in place as the calendar turned over to April, so volatility is likely to persist for at least the near term.
Macroeconomic fears drove the downturn in stocks, oil and credit (high yield bonds suffered a steep decline as well) during the first half of the quarter. The year began with little conviction on the part of equity investors, as 2015 ended on a relatively sour note. Then, during the first week of January, Chinese policy makers announced an accelerated depreciation of their currency, the yuan, which led to renewed fears of an economic implosion in China. This was followed by a rapid decline in crude oil prices and significant angst about the slowing pace of global economic growth and the potential for a major deflationary scare. Global central banks exacerbated the situation by employing the use of negative interest rates as a policy tool (initiated by the Bank of Japan in late January), which had the effect of significantly reducing central bank credibility and damaging the earnings prospects for commercial banks. As a result, stocks and high yield bonds suffered steep declines, with both asset classes effectively predicting a U.S. recession on the horizon. Importantly, the performance of U.S. financial assets to this point did not reflect the relatively healthy state of the U.S. economy, but was simply a reflection of the fears produced by global macroeconomic events.
Sentiment turned sharply positive in mid-February as a number of factors convinced investors that the bearishness had gone too far. First, Chinese policy makers moved swiftly to support the value of the nation's currency, while also going to great lengths to effectively communicate its plan to shore up growth. Then, several OPEC producers began discussing a plan to "freeze" oil production at January levels. These comments, combined with large capital spending and production cuts announced by a number of U.S. shale producers, ignited the rally in oil prices. Next, global central banks began to voice a disinterest in using negative interest rates, while the European Central Bank surprised the markets by announcing a greater-than-expected increase in its bond-buying program, i.e., Quantitative Easing, in order to stimulate growth. Finally, the U.S. Fed met in mid-March and, to the market's delight, opted not to raise the Fed Funds rate while also reducing the number of expected rate hikes for 2016. This action helped drive the U.S. dollar roughly 4 percent lower during the quarter, which is positive for global economic growth and commodity prices.
Risky asset classes performed well during the rebound, as did higher yielding asset classes. The belief that interest rates will stay low and central banks can continue to provide a degree of support to the economy, coupled with very attractive valuations, created somewhat of a "goldilocks" scenario for investors during the second half of the quarter. The MSCI Emerging Markets Index rose 5.71 percent, as the increased risk appetite, combined with a weaker U.S. dollar and stronger commodity prices, made emerging market stocks very attractive. Foreign-developed market stocks, as measured by the MSCI EAFE, did not fare as well, however, falling 3.01 percent. Global REITs benefitted from the demand for yield, rising 5.23 percent, while high yield bonds participated in the second half rally, posting a gain of 3.35 percent during the quarter. Investment grade bonds, as measured by the Barclays U.S. Aggregate Index, rose 3.03 percent as credit spreads contracted and investors sought out yield-oriented investments.
Commodities suffered from the volatile environment as well, with mixed results for the quarter as a whole. Despite the bounce back in February and March, crude oil fell 4.6 percent during the quarter, but metals, including copper and gold, produced nice gains, rising 2.0 percent and 16.3 percent respectively. The rally in gold was largely a function of the fear-induced panic of the first half of the quarter, while other commodities rose as sentiment surrounding global economic growth improved later in the period.
U.S. economic growth continued at a solid, yet unspectacular, pace. The employment market remained strong, as job gains topped 200k/month on average, while the participation rate rose and wages expanded by 2.3 percent over last year. The manufacturing sector showed signs of life, as the Institute of Supply Management Index rose to an eight-month high of 51.8 in March, while housing and auto sales remained solid. Most importantly, the consumer stayed resilient despite all the volatility, with consumer confidence trending higher as the quarter ended. The combination of a strong employment market, low gasoline prices and limited inflation continues to support consumer spending.
One aspect of the economic cycle that continues to give us pause is the decline in U.S. corporate earnings growth. If first quarter earnings decline on a year-over-year basis as expected, that will mark the fourth straight quarter of year-over-year declines, an event that hasn't occurred since the last recession. We do not foresee a recession this year, but do acknowledge that it will be difficult for stocks to move much higher given this trend. In fact, a near-term decline in the stock market, as investors digest the recent gains and acknowledge the suspect fundamental environment, would not surprise us. In addition, the positive impact of aggressive Fed policy, which has supported stock prices for the past seven years, is now in the rearview mirror. Slowing global economic growth, a strong U.S. dollar and weak commodity prices have been at the forefront of this earnings decline. A reversal of these factors would go a long way toward improving the anticipated outlook for corporate earnings growth.
We remain in the camp that believes 2016 will be similar to 2015 in terms of economic growth (slow but positive) and asset class returns (lower than historical norms). We expect the heightened level of volatility experienced over the past nine 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 rebound 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. To manage this environment, we believe that the typical investor should consider practicing prudent diversification while maintaining a long-term investment focus. For many investors, it may be sensible to stay with their long-term allocation, but increase their retirement savings rate to offset the weak investment returns, especially if they are nearing retirement.
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