Most investment categories finished the first quarter of 2016 with modest gains. Large-company U.S. stock indices eked out small gains; broad small-cap benchmarks declined, though many value-oriented funds advanced. Overseas, developed-economy markets were mostly lower; emerging-market returns were mixed, though positive on average. Real-estate investments generally produced strong results, though timber-related issues declined. Commodity prices were modestly higher, on average, though gold jumped more than 15%. Bond yields fell: the 10-year Treasury ended the period at 1.79%, down from 2.27% at yearend; credit spreads were volatile, but ended roughly unchanged, resulting in positive three-month returns for most fixed-income investments.
Among U.S. stocks, relatively strong results came from companies in the Capital Goods, Business Services, Consumer Staples, and Utilities sectors. Weaker groups included Financial Services, Health Care and Technology. After lagging badly last year, value-oriented names bested those in the growth category.
Benchmark Performance – Equities
|First Quarter 2016||Last Twelve Months|
|S&P 500 Index||+1.4%||+1.9%|
|Large-Cap Core Mutual Fund Avg. (Morningstar)||+0.3%||-2.2%|
|Small-Cap Stocks (Russell 2000)||-1.5%||-9.8%|
|Non-U.S. Stocks – Developed (MSCI EAFE)||-2.9%||-7.8%|
|Non-U.S. Stocks – Emerging (MSCI EM)||+5.7%||-11.7%|
Benchmark Performance – Fixed Income
|First Quarter 2016||Last Twelve Months|
|Intermediate Gov’t/Credit Index (taxable; Barclays)||+2.5%||+2.0%|
|Intermediate Municipal Mutual Fund Avg. (Morningstar)||+1.4%||+3.2%|
The modest three-month gains posted by most portfolio sectors belie what was actually an eventful quarter. After rallying to within a few percentage points of all-time highs just before yearend, global equities sold off precipitously early in the New Year. By the second week of February, U.S. stock benchmarks had fallen between 14% (for large-caps) and 26% (for small-caps) from their 2015 highs, marking the first full-fledged correction since 2011. Commodity prices also tanked, paced by oil, which plummeted 25% during the first six weeks of the year. The bond market, too, was hit by a severe widening of credit spreads, especially among issuers in commodity-related industries and, more worrying, financial services; non-investment-grade (‘junk’) bonds, as an asset class, traded at yields not seen in years. Heightened investor anxiety drove the VIX ‘fear gauge’ up by almost 50% compared to yearend, while gold – the ultimate safe-haven asset – rallied by 20%.
The early-year swoon was caused by an abrupt change in investor sentiment regarding the near-term global economic and monetary-policy outlook. As 2015 drew to a close, the U.S. Federal Reserve, having just raised short-term interest rates for the first time since 2006, was signaling its view that the American economy was sufficiently robust to withstand as many as four additional rate hikes during 2016. The prospect of a more normal interest-rate environment was initially welcomed by investors, briefly causing bond yields to rise and bank shares to rally. This rosy assessment soon succumbed, however, to a raft of data indicating flagging global economic growth and a rising threat of deflation. These data fed a growing sense among investors that the world’s central bankers were committed to divergent policies (raising rates in the U.S., aggressive easing featuring negative rates elsewhere) that were deemed likely to be ineffective or worse. Exacerbating matters, commodity prices resumed their multi-year downward spiral, spawning fears of cascading loan defaults by resource-sector firms. Combined with the specter of negative interest rates spreading across a growing swath of the global economy, these concerns weighed heavily on the shares of large commercial banks and insurers.
As rapidly as things fell apart early in the period, they came back together beginning in mid-February. Commodity prices began to firm: oil jumped 35% between mid-February and the end of March, buoyed by less-gloomy economic data, hints of renewed coordination among OPEC members, and a fresh assessment of declining U.S. shale production from the International Energy Agency. Importantly, central bankers in Europe and Japan reacted to financial-market turmoil by down-playing the role of negative interest rates. Meanwhile, Fed officials began to soften their projections for near-term rate increases, citing threats posed by slowing global growth and tightening financial conditions (the rising dollar, widening credit spreads). As investors sensed an ebbing of ‘tail risks’ (recession, deflation, financial crisis), stocks and non-investment-grade bonds rallied swiftly and powerfully. By the end of March, most equity and high-yield bond benchmarks had reclaimed all the ground lost during the swoon; the VIX eased by more than half. And, discounting less-divergent central bank policies, the dollar fell back against the yen and the euro, while firmer commodity prices buoyed emerging-market currencies.
Earnings reported by U.S. companies during the period (covering the final months of 2015) continued the dismal trend of the past several quarters, falling by nearly 14% compared with the year-earlier period. For 2015 as a whole, earnings declined 11% – a highly unusual result in a non-recessionary environment. With currency and commodity-price headwinds moderating, first-quarter 2016 earnings (to be reported in coming weeks) should be down considerably less. Wall Street analysts, expecting this effect to intensify as the year unfolds, are currently calling for a full-year gain of 17%; though we expect their optimism to moderate in coming months, an improving trend seems likely.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to give us the 1.4% S&P 500 total return?
|First Quarter (January-March) 2016|
|+ Change in Earnings||-2.6%|
|+ Change in Valuation||+3.4%|
|= Total Return||+1.4%|
Our read: If the dollar and commodity prices cooperate, the earnings component is likely to turn positive later this year, providing helpful support for stock prices.
The marked improvement in financial-market conditions over the past eight weeks has been predicated on stabilizing commodity prices and a perception of lessening divergence among the policies being pursued by the world’s central bankers. Gauging the likelihood these favorable developments will persist is a useful starting point for assessing market prospects for the balance of the year.
As discussed in our January letter, we are relatively sanguine with regard to commodities. While previously noted supply-side developments have been important, the recent firming of commodity prices may also signal improving global growth, centered on an inflection point in China. Recent data have been relatively upbeat – certainly not auguring an imminent ‘hard landing’ for the world’s second-largest economy. Importantly, Beijing’s policymakers have also begun to acknowledge the importance of addressing excess industrial capacity and non-performing loans as they steer their economy toward greater reliance on services and consumer spending. Commodity price stability, if sustained, would be salutary on multiple fronts: boosting beleaguered industrial-sector profits; lessening the threat of defaults looming over the financial sector; and presenting a welcome respite to resource-dependent emerging-market economies.
The outlook for monetary conditions is somewhat murkier. Despite recent dovish signals from the Fed, the U.S. economy has shown scant evidence of slowing from the roughly 2% pace that has prevailed for much of the post-financial-crisis period. Resilient consumer spending, buoyed by persistently strong employment gains and a healthy real-estate market, continues to offset a weak manufacturing sector contending with limp industrial demand and a strong dollar. Moreover, inflation has accelerated sharply over the past several months (albeit from a very low starting point) and may soon reach the Fed’s 2% target. Were these trends to persist, few would be surprised if the Fed shifted its rhetoric back in a hawkish direction in coming months. Meanwhile, European, Japanese and (perhaps to a lesser extent) Chinese central bankers all face fragile economic conditions and persistent threats of deflation that call for additional policy easing. This dichotomy sets the stage for a replay of the policy-divergence scare – accompanied by a resurgent dollar and a retracement of commodity prices – that prompted January’s global market riot. And if market volatility returns, the Fed seems likely to respond by backing down again. How the global economy and financial markets would escape such a cycle is unclear, though an unambiguous uptick in growth outside the U.S. – reassuring investors that Fed tightening would not lead to global recession – would be an important step in the right direction.
If commodity-price and monetary-policy developments fail to provide sufficiently compelling signals, investors may take their near-term cues from elsewhere. In this vein, we have our eye on a number of political developments, domestic and global, that could have market-moving potential. If a Trump nomination comes to be seen as a near certainty, the real-estate developer’s sky-high ‘unfavorable’ polling numbers might lead markets to discount major Democratic gains in the general election, with predictable consequences for financial services, health care and possibly energy names. Overseas, the challenges posed by terrorism and migration will continue to pressure civil society across Europe; June’s ‘Brexit’ referendum in the U.K. has similar potential to dent the perceived viability of the European Union. Finally, we worry that Vladimir Putin may contrive new adventures to distract his subjects as his Syrian foray winds down. These (as well as other, unforeseen) developments could easily rekindle the volatility that flared so brightly early in the year.
In closing our January letter, we pointed out that the divergent market currents of 2015 had resulted in more intriguing investment opportunities than we had seen in some time. These included the beaten-down stocks of high-quality companies in out-of-favor industries, as well as complementary asset categories that, after multiyear periods of relative under-performance, seemed to offer a high probability of prospective out-performance. The relatively strong results posted by many value-oriented U.S., emerging-market and commodity-related investments over the past three months were a welcome, and we hope only partial, vindication of that assessment.
We welcome your questions and observations regarding our management of your investments.
Alan Purintun, CFA Robert W. Phelps, CFA
Principal & Portfolio Manager Principal & Portfolio Manager