Investor Discussions - Q1|2016 Commentary
Wealth & Pension Services Group
William Kring, CFP, AIF - Chief Investment Officer
Matt B. Bailey, CFA, CMT - Portfolio Manager
Mark Twain was once quoted as saying, “History doesn't repeat itself, but it does rhyme.” As the first quarter has come to a close, the S&P 500 index once again finds itself near all-time highs even as many lingering issues remain. These include: slowing global growth, election jitters, and contracting U.S. corporate profits - just to name a few. Although no market or economic cycle is identical, comparing the current environment to past periods helps us form an opinion about the future. Currently, we’re cautious as we see red flags that suggest more volatility lies ahead.
During the quarter, global equities fell sharply before bouncing to return to the levels seen at the end of 2015, high-quality bonds provided a counterweight to stocks and finished up modestly, and commodities rallied after recently making multi-decade lows. However, even though the recent rally gives the appearance of stability, it’s worth noting that the returns for most global equity indexes have been flat or down over the last 5-6 quarters.
Looking ahead, the rest of 2016 will likely require investors to display patience and fortitude as the markets attempt to make sense of the current state of global affairs.
Domestically, the economy continued its slow-growth trajectory as final Q4 GDP came in at an annualized rate of 1.4% (GDP figures are released with a one quarter lag in order to gather all the data) and actual full year 2015 GDP came in at 2.4%. The strong U.S. dollar and persistently low energy prices remain a drag on domestic growth. In addition, consumers remain focused on deleveraging and saving and are not spending the way many economists expected. Effects of these negative factors can be seen in recent manufacturing and services data as both have moved into or near contractionary territory.
One silver lining is the labor market which remains healthy. The unemployment rate is currently near a cycle low of 5.0% with a 63.0% labor participation rate. Additionally, wages have recently seen some upward pressure which may lead to increased spending by consumers.
“The strong U.S. dollar and persistently low energy prices remain a drag on growth.”
Overall, the U.S. economic growth story remains intact and strong relative to the rest of the globe, but it isn’t great (Chart 1). Odds of a recession are low; however, many recessionary indicators such as credit spreads (see Fixed Income section for more information) have been flashing warning signs over the last few months. The Federal Reserve remains accommodative via low interest rates but additional rate hikes are likely later this year. For now, conditions are stable and remain on a slow growth trajectory.
Outside the U.S., the global economy remains bifurcated as developed countries slowly grow and emerging markets struggle to expand. One common thread is the extensive use of quantitative measures by central banks in both markets.
After years of lackluster growth, the Eurozone is finally making headway as many countries within the group are showing signs of progress (Chart 1). Economic reforms and aggressive monetary policy from the European Central Bank (ECB) have received most of the credit. Even so, the region has a lot of work to do and many headwinds exist. The potential for a U.K. exit (Brexit) from the Eurozone and slowing global growth remain real threats to future prospects.
On the contrary, the outlook for Asia isn’t as positive. Japan and China are the largest economies in the region and both seem to be caught in a cycle of slowing growth (Chart 1). Their central banks, the Bank of Japan (BOJ) and Peoples Bank of China (PBOC), continue using every lever available to stimulate growth; nevertheless, the results have been uninspiring and their effectiveness appears to be diminishing.
Finally, the emerging markets (ex-China) and frontier markets remain in a difficult position. Much of their pain is linked to low energy prices which they’re dependent on for export revenue. Additionally, weak foreign demand for goods has plagued these export driven economies. Looking ahead, an increase in global growth or higher energy prices are needed before these regions can stabilize.
Volatility reigned supreme during the quarter as the S&P 500 index fell by over 10% to start the year. In fact, it was one of the worst starts on record. Yet, after a substantial rally, the S&P 500 index (large caps) and Russell 2000 index (small caps) finished up 1.35% and down a modest -1.52%, respectively.
Much of the initial weakness was attributed to recessionary fears, slowing top line revenue growth and lackluster earnings. Over the last few years, U.S. corporations have become increasingly efficient which has directly benefited their profit margins. However, there is only so much fat they can trim and at some point margins are likely to normalize. Additionally, many firms have borrowed at the current low rates and used the proceeds to buy back their shares rather than reinvest in their business. This has artificially inflated their earnings and isn’t sustainable over the long term.
“None of the major U.S. or global stock market indexes have made new highs since last summer.”
Technically speaking, the S&P 500 appears to be forming a large topping pattern going back to late 2014. This suggests that we may see lower prices before making new highs. In addition, the long-term bull market trend going back to 2009 appears to have been broken or at least damaged. Finally, it’s worth noting that none of the major U.S. or global stock market indexes have made new highs since last summer (see Chart 2). These technical factors coupled with the weak fundamentals mentioned earlier don’t bode well for stocks in the near term. We remain long-term stock market bulls but are cognizant of how far the market has run since 2009 and feel caution is warranted.
Overseas, the international developed markets were just as volatile as U.S. stocks. After initially falling by double-digits, the MSCI EAFE index rallied during the second half of the quarter to finish down -3.01%. As we’ve previously noted, the international developed markets tend to trade in a similar fashion to domestic stocks. Unfortunately, many international markets are exhibiting a lot of the same negative characteristics as U.S. equities. For instance, the MSCI EAFE index hasn’t made a new high in over a year and is currently in a severe correction (see Chart 2). Unless something changes soon, it appears these markets could be headed back into bear market territory (a bear market is defined as a drawdown of 20% or more from a previous peak).
Emerging Market (EM) and Frontier Market (FM) equities, as represented by the MSCI EM index and MSCI FM Index, finished the quarter up 5.71% and down -0.91%, respectively. These markets rallied hard after significant declines going back many quarters. Even so, these types of “bear market” rallies are expected during strong downtrends and historically end with prices returning to lower levels. Investor sentiment, fundamentals, and the technical outlook all remain negative. Looking ahead, these markets will likely require significant improvements to the global economy and much higher energy prices to once again garner long-term investor capital.
For the first time in a while, the main topic of discussion in the bond market wasn’t interest rates - it was high yield bonds. Unfortunately, the attention wasn’t positive. In fact, the conversation was centered upon weakness linked to widening credit spreads. Credit spreads are used to determine the riskiness of a bond or bond index relative to a similar treasury bond or index (click here for more info). During the quarter, credit spreads blew out to their widest levels since 2011 (see Chart 3). Many pundits point to this data and suggest that the risk of a recession is much higher than perceived by most. On the other hand, some analysts think the weakness will remain contained within the energy and mining sectors. Either way, it’s worth monitoring as credit spreads have historically been a good indicator of potential risk in the equity markets.
During the quarter, the U.S. 10-year Treasury index (10-yr) finished lower at 1.77%. Falling rates helped the Barclays US Aggregate Bond Index end the quarter up 3.03%. Coming as a surprise to many, the Barclays Corporate High Yield Bond Index finished up 3.35%. As noted in the International Equity section, “bear market” rallies such as this are normal during strong downtrends and are typically followed by lower prices. Lastly, the Barclays Global Aggregate ex-USD Bond Index finished up 8.26% due to U.S. dollar weakness and falling global interest rates.
From here, it’s our view that intermediate and long-term interest rates will likely go lower. Strong demand for relatively higher yielding U.S. treasuries and volatility in the equity markets are the most obvious catalysts. High yield bonds remain risky as indicated by credit spreads, and international developed and EM bonds remain unattractive.Commodities
The Bloomberg Commodity Index finally received some positive attention and finished the quarter up 0.42%. As mentioned last quarter, energy and precious metals turned out to be good places to invest and led the index higher. Oil appears to have found a bottom for now and the precious metals are starting to once again attract investor assets. Additionally, the U.S. dollar fell around 4.0% and likely helped push commodities higher (the U.S. dollar and commodities tend to be inversely correlated). Overall, the commodity complex still faces many headwinds but a sustainable bottom may be forming.
The current bull market turned seven in March and is becoming a little long in the tooth. Although not a negative on its own, it’s worth mentioning that this is one of the longest bull markets on record. There’s an old Wall Street adage which states, “bull markets don’t die of old age.” Unfortunately for this bull market, it currently has a number of other ailments in addition to its age. Slowing earnings growth, contracting margins, global economic weakness, and increasingly ineffective central bank policy are just a few of the obstacles in the way of higher prices.
In the near-term, we are cautious and have taken a defensive posture. This includes reducing stocks and increasing bonds and cash. Longer-term, we think stocks will once again become attractive but feel a revaluation of risk assets is due. We plan to continue focusing on risk-management and protecting against downside volatility.
As always, please feel free to contact us with any questions you may have.
William Kring, CFP®, AIF®
Chief Investment Officer
Matt B. Bailey, CFA®, CMT®
Senior Portfolio Manager
Source: Bloomberg.com, Morningstar, PIMCO, St. Louis Federal Reserve, MSCI, Investing.com.