By: Russell Swansen, Chief Investment Officer; David Francis, Vice President, Head of Equity Investments & Mark Simenstad, Vice President, Fixed Income Mutual Funds January 21, 2016
Financial markets delivered mixed results in 2015, pressured by slowing economic growth in China and plunging prices for oil. The Standard & Poor’s 500 Index posted its first annual price decline since 2011, even as a handful of popular technology stocks carved out sizeable gains. In the fixed-income markets, shorter-maturity, better-quality bonds mostly delivered positive results, but riskier assets fell. While our investment outlook is generally positive, many of the same issues that weighed on the markets in 2015 remain unresolved. We believe they will likely contribute to volatility again – and also temper returns – in 2016.
The U.S. economy continued its fitful but persistent recovery in 2015, expanding at a 2.2% average annual pace through the first three quarters of the year, in line with what it has done since the end of the Great Recession in mid-2009. Strong consumer spending and a vibrant housing market helped drive the expansion, offset in part by sluggish business spending and export activity. Although businesses were reluctant to invest in new facilities and equipment, they continued to spend on their workforces, creating more than 2.6 million nonfarm jobs. That was the second biggest one-year jobs gain since the recovery began—trailing only the 3.1 million jobs created in 2014—and helped drive the unemployment rate down to 5.0% from 5.7% at the start of the year.
Despite the improvements in the economy, corporate profits fell in 2015. The decline was due in large part to plunging energy prices, which made things difficult for a broad swath of companies ranging from oil producers to coal miners. On an annualized basis, the U.S. Bureau of Economic Analysis calculated that corporate profits fell 1.1% through the first nine months of 2015.
Inflation remained low throughout the year—well below the Federal Reserve’s 2% target—and so did interest rates, despite widespread expectations that the Fed would raise short-term rates during the year. It finally took action in December, raising its target for the federal funds rate—the rate at which banks lend to each other overnight—by a quarter of a percentage point, to a range of 0.25% to 0.50%. Fed Chair Janet Yellen said the increase reflected the Fed’s “confidence in the U.S. economy,” suggesting the economy is now strong enough to get by with less support from the central bank.
In China, the world’s second largest economy, the economic climate was stronger yet simultaneously more worrisome. China grew at around 7.0% during the year, handily exceeding growth rates in the developed world—the Euro Area grew just 0.3% in the third quarter and Japan contracted 0.8%. However, China’s advance was its slowest since the 2008 financial crisis. Investors worried that China’s slowing expansion could derail fragile economic recoveries elsewhere around the world. They also blamed the slowdown for reducing demand for oil and other commodities, which China had been absorbing at a gluttonous pace several years ago when it was spending heavily on infrastructure and its economy was growing in excess of 10% annually. Shrinking global demand for oil, combined with abundant supply, helped drive the price of crude from more than $100 a barrel midway through 2014 to about $37 a barrel by the end of 2015.
Stock Market Review
Judging strictly by broad market averages, U.S. stocks had an unremarkable year, finishing about where they started. While the S&P 500 posted its first price decline since 2011, it only fell by 14.96 points, or less than 1%. If you add in reinvested dividend income, the index actually generated a positive total return of 1.38%. Nonetheless, it was the index’s worst performance since 2008. What’s more, the final performance figures don’t reflect how volatile the stock market became over the course of the year, or how wildly divergent returns were for different industry segments. Over the course of six trading days in mid-August, for example, the S&P 500 plunged more than 11% following disappointing economic data from China and a surprise devaluation of the Chinese currency—factors which created even more turmoil in China’s stock market. For the year, energy stocks in the S&P 500 were down nearly 24% on a price basis, while consumer discretionary stocks—shares of companies that sell non-essential goods and services—rose 8.4%. Remove energy stocks from the index, and the S&P 500 would have delivered a total return of 3.44%.
In addition to offering only modest gains, stock market leadership narrowed dramatically in 2015. Among the stocks in the S&P 500, only 43% advanced, down from 75% in 2014 and 92% in 2013. Removing just a handful of big stocks that did very well—Facebook, Amazon, Netflix and Google, whose price gains ranged from 34.1% to 134.4%—would have left the S&P down much more for the year. All four of those stocks are traded on the Nasdaq exchange, which helped the Nasdaq Composite Index post a total return of 7.11%.
In developed economies outside the U.S., Japan turned in one of the year’s best performances, with the Nikkei Stock Average generating a total return of 10.63%. Although Japan continues to struggle to ignite its economy, its central bank has embarked on an extraordinarily aggressive quantitative easing program in which it is buying financial assets in a bid to keep interest rates low and stimulate business activity. That helped prop up stock prices. European stocks lost 4.47% as measured by the Euro Stoxx 50 Index (USD), but the loss was largely due to a continued decline of the euro against the dollar. Tracked in its own currency, the index of blue chip European stocks generated a total return of 6.42% as European economies showed fresh sparks of life.
Stocks in emerging markets generally fared poorly, hurt by the slump in commodities, which are important to their economies. The MSCI Emerging Markets Equity Index posted a total return of -14.92%.
Bond Market Review
Like stocks, bonds delivered mixed results in 2016 as investors, parsing the implications of the oil-price meltdown and potentially higher short-term interest rates, favored lower-risk assets. The Barclays Aggregate Index, which is dominated by U.S. Treasury bonds and other government-backed securities, posted a total return of 0.55%. Investors also favored shorter-term securities, which generally suffer less than longer-term maturities when interest rates are rising. For example, the Barclays U.S. Corporate Investment Grade Index posted a loss of -0.68%, while the shorter-duration Barclays U.S. Corporate 1-5 Year Index earned 1.23%. Similarly, returns on shorter-term U.S. Treasury bonds ranged between 0.41% and 1.31%, while the return on 30-year Treasuries was -3.17%.
Municipal bonds were the best performing sector of the bond market, generating a total return of 3.3% as credit problems, apart from Puerto Rico, remained rare among municipal bond issuers. Municipal bonds also may have been helped by the additional 3.8% top bracket tax surcharge related to the Affordable Care Act, likely making the asset class more attractive to higher-income investors.
High-yield bonds, which carry credit ratings below investment grade, were among the market’s worst performers, in large part because most of the bonds issued by energy companies trade in that sector. The Barclays U.S. Corporate High Yield Bond Index posted a total return of –4.47%. Here, too, though, returns varied dramatically within the sector. Higher-quality high-yield bonds with BB credit ratings lost only about 1%, while many CCC-rated bonds posted double-digit declines. High-yield bonds issued by oil exploration and production companies were down 35.6%, and those issued by metals and mining companies were down 23.7%.
The economic climate in developed markets is generally positive. Our models suggest the U.S. economy should continue growing at about a 2% pace in 2016. While consumer spending and housing prices have been strong, weakness in retail sales, manufacturing and business investment remain worrisome. Growth rates in developed economies outside the U.S. should improve slightly, to about 1% in Japan, 2% in the Euro Area and 3% in the U.K. China appears poised to grow about 6%.
Short-term interest rates are likely to continue higher, albeit at a modest pace and with minimal disruptions to the financial markets. Comments by Federal Reserve officials indicate they expect short-term interest rates to climb to just under 1.5%, although trading in futures markets suggests investors believe rates will climb to only about 1%, a target we believe to be more realistic.
It is difficult to imagine any material increase in inflation until and if oil prices stabilize and ultimately begin to rise. We anticipate that oil prices will, in fact, begin to recover in 2016, assuming some moderation in production coupled with an increase in demand as the global economy expands. Combined with a tightening labor market, this would tend to push inflation higher, although we would not anticipate any sharp increases.
We expect modest returns from financial assets in 2016, with downside risks somewhat greater than they were in 2015, and periodic bouts of volatility inevitable. That said, the risk of recession in the U.S. remains moderate. Absent a recession, selloffs in financial markets typically correct fairly quickly.
Stocks in most developed markets were expensive relative to historical norms heading into 2016. This does not preclude modest gains in the year ahead, although it does suggest there is more risk to the downside than the upside. European shares could outperform U.S. shares if Europe’s economic recovery gains further traction, as U.S. companies are operating with profit margins near historic highs while European margins are near historic lows, giving European companies more runway for earnings improvement. Segmenting the market by industry, we see opportunities in the information technology and healthcare spaces and in the downtrodden energy sector, although it may take some time for valuations there to rebound.
Stocks are cheaper in emerging markets than they are in developed markets, in part because many emerging markets companies operate in the troubled commodities sector. However, we are not particularly enthusiastic about their prospects pending further evidence that the commodities slump has run its course.
Several sectors of the bond market look promising despite the prospect of rising short-term interest rates. High-yield bonds on average were yielding about 7 percentage points more than comparable-duration U.S. Treasury bonds at the end of 2015, and although we continue to view the sector cautiously it could rally if oil prices stabilize and improve. Still, the risk to the downside is significant. If oil prices don’t rebound, defaults on energy-sector bonds could skyrocket and the sector could be saddled with additional losses.
Investment-grade corporate bonds look attractive on a valuation basis. Returns in that sector were dampened last year by a heavy supply of new issues as companies took advantage of the low rate environment to issue bonds to finance mergers, acquisitions and stock buybacks. Over the course of the new year we expect the pace of new issues to moderate.
Finally, the outlook for municipal bonds remains positive barring any significant change in economic conditions. Municipal tax receipts have been healthy, moderate new issue activity has kept the supply of bonds from becoming inflated, and valuations look fair.
As always, there are numerous potential threats to the markets. Any material worsening in China’s economy, or any further sustained weakness in oil prices, could derail both the equity and high-yield bond markets. Conversely, if China and other major economies improve their growth rates, and oil and other commodity prices reverse course, it would add more momentum to the U.S. economy. That would likely put more pressure on wages in the U.S., and ultimately drive up inflation—which in time could be detrimental to the bond market.
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