- Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
- Jeff Clark, CFA, CFP® - Manager, Investments & Wealth Management
- Kent Anderson, CFA - Senior Investment Officer
- Andy Finks, CFA - Investment Officer
- Todd Bunton, CFA - Investment Officer
- Chelsie Moore, CFA, CFP® - Investment Analyst
- Jonathan Strok, CFA - Investment Associate
- Global stock returns have been weak this year – the S&P 500® index is up just 2% and international stocks are down 5%.
- The U.S. bond market has delivered a return of just 0.7% thus far in 2015. Interest rates have been volatile throughout the year but remained relatively low.
- Between August 17th and August 25th , the S&P 500 index fell 11.2%, marking its first correction of more than 10% since the summer of 2011.
- The Federal Reserve raised short-term interest rates in December for the first time in over nine years. The Fed is likely to be careful and gradual about further rate hikes and long-term rates are likely to remain low by historical standards.;
- The U.S. economy continues to muddle along. Economists expect real GDP to grow by an average of 2.5% in 2015, near the high end of its post-recession range but still low by historical standards.
- Heading into an election year, many investors begin to wonder how the outcome of the elections may impact their portfolios. We do not recommend changing investment strategies based on changes in leadership within government.;
- We continue to expect stock and bond returns to fall short of their historical averages over the next ten years. Investors should temper their expectations for portfolio returns.
- We continue to favor stocks over bonds relative to our long-term asset allocation targets.
Following an extended period of relative tranquility, investors were reminded this year that the stock market can indeed be a volatile place. In the span of just eight days in August, the S&P 500 experienced an 11% drop, marking its first correction since 2011. Despite the ups and downs, U.S. equities were more or less flat in 2015. Bond returns were also lackluster as long-term interest rates finished the year about where they started.
The economy and labor market continued to improve in 2015.
Nonetheless, the U.S. economy continued to make measurable forward progress in 2015. As estimated by the Bureau of Labor Statistics, the economy added approximately 2.3 million new jobs through the first eleven months of the year. This brings the total since the beginning of 2010 to greater than 13.2 million jobs added, more than enough to offset the nearly 8.7 million jobs lost in the recession of 2007 to 2009. This steady job growth has pulled the unemployment rate down from its peak of 10% over six years ago to just 5% currently. The unemployment rate is now nearing levels where most policymakers consider the economy to be at “full employment” (there is always some level of joblessness in the economy). To be sure, the healing process has been slow and is not yet complete. Many remain out of work, many more have seen their wages stagnate in recent years, and inflation readings continue to fall short of the Fed’s target of 2% annually. Nevertheless, sufficient damage has been repaired to convince policymakers that the economy is now healthy enough to begin weaning off of near zero short-term interest rates.
As such, in a historic event on December 16, the Federal Open Market Committee (FOMC) raised its target for the overnight lending rate for the first time since mid-2006. The federal funds rate was lowered to near 0% in early 2009 to support an economy and financial system in crisis. The rate was kept near zero for much longer than generally anticipated due to the persistently sluggish pace of economic recovery and lower-than-historical levels of inflation. Now, with the economy largely healed from the crisis, the Fed sees this extraordinary interest rate policy as no longer required. At this stage in the economic expansion, continued low rates could risk stoking inflation to unwelcome levels or encourage excessive risk taking throughout the economy and financial markets, both outcomes the Fed certainly wishes to avoid. And so we now say goodbye to the era of the zero interest rate policy and begin down the path toward normalcy.
The Federal Reserve raised interest rates for the first time since 2006.
The Fed’s new target range for overnight rates is 0.25% to 0.5%, a hike of 0.25% from the previous target range of 0% to 0.25%, which prevailed for nearly seven years. This mere ¼ percent increase should not in itself be all that meaningful for the markets or the economy. After all, the new target range is still quite accommodative at more than 2% below the average effective rate of 2.6% over the past 20 years. More impactful for the economy and financial markets will be the pace at which the Fed continues to hike rates in the future and how high rates ultimately go before leveling off. Based on projections released with its policy statement, the committee anticipates its target rate to increase by about 1% per year over the next three years. However, the FOMC took pains in its press release and commentary to stress its expectation that rate hikes will be gradual. Furthermore, the Fed stressed that future decisions will be data-dependent, meaning the committee will continue to raise rates only if the economy remains relatively strong and inflation progresses toward the committee’s 2% target.
The markets may be underestimating the potential for higher rates in the future.
The financial markets appear skeptical that the Fed will consistently raise rates in even the gradual manner it outlined this month. As indicated by the fed fund futures curve, the markets currently expect a target rate of about 1.4% by year end 2017 compared to the roughly 2.5% target rate forecasted by the FOMC. This cynicism may be warranted. The Fed has consistently overestimated the strength of the recovery and has now failed to achieve its inflation target for more than three years. Even so, the markets may be underestimating the potential for higher rates in the future. Energy prices, which have collapsed over the past year and pulled inflation lower, are likely to stabilize next year and may even begin to push modestly upward. At the same time, with the unemployment rate now near cyclically low levels, we are seeing the first signs that wages are beginning to rise. If these forces push inflation back up to the Fed’s 2% target, we believe the FOMC may surprise market participants and stick to its projections.
The American consumer is in much better shape than in recent years.
Overall, we would characterize the U.S. economy as fairly healthy. The outlook for the consumer, whose spending accounts for nearly 70 percent of the economy, is supported by significant tailwinds. Job growth is strong as non-farm payrolls have increased by an average of 220,000 per month over the past year. This compares to the 5-year average of 204,000 and is much higher than the 10-year average of just 86,000. Additionally, now that unemployment has fallen to relatively low levels, wage gains are beginning to show signs of taking hold. Finally, low energy prices, low interest rates and the strong U.S. dollar have given a shot in the arm to consumer finances. Lower outlays for energy and borrowing costs have given consumers more flexibility in their budgets, allowing them to spend more elsewhere, increase their savings or pay down debt. Along the same lines, the strength of the U.S. dollar, up nearly 20 percent this year relative to other major currencies, has lowered the price tags on most everything Americans import from abroad – from Swiss watches to Middle Eastern oil.
There is, however, a darker side to the forces that have conspired to strengthen the U.S. consumer. Continued job and wage growth could eventually begin to pull inflation back to the Fed’s target of 2%, or even higher if left unchecked. (Figure 2) As a result, the Fed will likely meet any signs of accelerating inflation with interest rate hikes aimed at putting the brakes on an overheating economy. Likewise, wage gains could come at the expense of corporate profitability if companies find it hard to pass along this higher cost through higher prices charged for their goods and services. As a result, companies may find it hard to reinvest for growth or increase their payouts to shareholders, a prospect that would not bode well for further hiring and wage increases.
Finally, the impacts from low energy prices, low interest rates and the strong U.S. dollar are not universally positive. For instance, firms engaged in the production and transportation of commodities have seen their profitability collapse as a result of weakening demand and lower prices. Many have had to slash their payrolls and cut their capital spending dramatically in order to weather the commodity bust. Extraordinarily low interest rates have been the bane of savers who have been forced to accept paltry rates of interest income or take increased risk to earn more. If rates begin to move up, those who have locked in investments at low rates would see their bonds fall in value, adding insult to injury. And the strength of the U.S. dollar has had a substantial negative impact on many multinational U.S. companies as their sales in international currencies are effectively worth less when translated back to dollars. Further dollar strength would mean continued profit pressure on exporters. All things considered, we still see the positives outweighing the negatives for the economy, at least for the time being.
We believe the positives outweigh the negatives for the U.S. economy.
Bull Market Enters Later Innings
After three straight years of double-digit gains, 2015 has seen the S&P 500 deliver its weakest returns since 2011. While the domestic economy continued to expand at a moderate pace, global growth was subpar. In response, central banks outside of the United States made steps to ease monetary policy, leading to significant strengthening in the U.S. dollar. This created headwinds for many multinational firms, as previously mentioned. Commodity prices also tanked, putting substantial pressure on the energy and materials sectors. As a result, the S&P 500 experienced an “earnings recession”, as growth turned negative for two consecutive quarters.
Strong corporate earnings growth seems unlikely from here.
Analysts currently expect high single-digit earnings growth for the S&P 500 in 2016. We believe the odds are low that these lofty growth projections will materialize. Even with negative earnings growth projected for 2015, profit margins are still near record highs, and meaningful expansion seems unlikely. In addition to accelerating wage growth placing pressure on margins, the gains from operating leverage and cost cutting appear to have passed. Revenue growth will likely remain muted too amid a struggling global economy, as nearly half of all revenue for the S&P 500 comes from outside of the United States. For earnings growth projections to materialize, the U.S. dollar would likely need to weaken substantially, and energy prices would need to rebound sharply. We view these events as unlikely in 2016.
Amid a sluggish growth environment, mergers and acquisitions hit an all-time record in dollar amount, led by deals in healthcare and technology. Stock buybacks also remained near record highs as companies attempted to boost earnings per share in a challenging environment.
This year also marked the return of volatility for the stock market, as we expected. The S&P 500 experienced a correction for the first time in nearly four years as the index dropped 11.2% between August 17th and August 25th. Small cap and international stock returns fared even worse. These sharp declines were driven in large part by concerns over global growth, particularly in China. Amid its weakest growth in decades, the world’s second largest economy devalued its currency in August, leading to heightened volatility across global financial markets. Equities recovered most of their losses fairly quickly, but we do not think this period of heightened volatility is over yet.
As expected, volatility returned to the stock market in 2015
Indexes used for Figure 5: U.S. Treasury Bonds – Bank of America Merrill Lynch Treasury Master Index, U.S. High Yield Bonds – Bank of America Merrill Lynch U.S. High Yield II Index, U.S. Investment Grade Bonds – Citigroup Big U.S. Broad Investment Grade Index,
Despite lackluster overall returns, the performance of the S&P 500 was notably worse if the so-called “FANG” stocks (Facebook, Amazon, Netflix and Google) are excluded. (Figure 6) These large cap stocks posted exceptional returns in 2015, offsetting weakness in much of the rest of the market capitalization-weighted index. In general, value stocks fell out of favor in 2015 as growth outperformed by a wide margin.
During the raging bull market of the last few years, a rising tide lifted nearly all boats. This was not the case in 2015, and we do not expect it to be the case in 2016 either. We are looking for increased dispersion, with muted overall returns going forward. Valuations no longer appear cheap, and substantial earnings growth seems unlikely. Without significant expansion in the price-to-earnings multiple – which we view as unlikely from here, particularly in a rising rate environment – equity returns could very well be below average over the next five to ten years. (Figure 7) We believe that prudent security selection will be an important strategy in this type of market environment.
We continue to expect equity returns below their long-term averages over the next several years.
Bond Returns Lackluster
Fixed income returns were not stellar in 2015 either. (Figure 8) Similar to the stock market, long-term interest rates were volatile in 2015 but ultimately remained flat. Despite the Federal Reserve hinting at a rate hike for much of the year, the yield on the 10-year Treasury note remained low. This was driven in large part by a “flight to safety” amid global economic turmoil, extremely low rates in international developed markets and low inflation expectations here at home. Despite continued improvement in the U.S. economy, credit spreads widened,
Indexes used for Figure 8: U.S. Treasury Bonds – BofA ML Treasury Master, U.S. High Yield Bonds – BofA ML High Yield Master II, Global Bonds – CGBI WGBI World All Mat Index, U.S. Investment Grade Bonds – CBGI US Big Overall Broad Inv. Grade Index
particularly in the high yield space. This was driven largely by increased fears of defaults in the energy and material sectors, which account for a large portion of the high yield bond market.
While the Fed is expected to continue increasing the federal funds rate in 2016, we caution that this will not automatically equate to rising rates at all points along the yield curve. Volatility in the equity markets and extremely low interest rates in other developed markets could put pressure on long-term rates, causing the yield curve to flatten next year.
Bonds still remain an important component of a diversified portfolio.
We believe that bonds remain an important component of a diversified portfolio as they provide more stable returns than stocks. However, we do not expect strong gains from this asset class over the next several years either. The 30+ year bull market in bonds has likely come to an end as the tailwind enjoyed from steadily falling interest rates appears to be over. (Figure 9)
The tailwind of steadily falling interest rates appears to be over.
Wise Investing – Elections and the Financial Markets
The elections coming this November will certainly garner much attention. Investors are likely better off tuning out the noise related to power changes in Washington. That is because there is usually too much credit given to elected officials, particularly presidents, for their influence on the financial markets. There are simply many other factors that have large effects on asset prices. Changing an investment strategy based on who is in the Oval Office or who controls Congress is not an approach we recommend.
A study by Vanguard in 2008 concluded that there was no significant difference in returns when either a Democrat or a Republican was in the White House going all the way back to 1852. Stocks averaged 8.66% per year under Republicans and 8.97% annually under Democrats. (Figure 10) Nonetheless, both parties have claimed superior stock market performance under their tenure. Some studies show that the stock market performs better when a Democrat is president. Other studies show outperformance when Republicans control Congress. However, their time frame is often cherry-picked in one party’s favor.
This is not to imply that elected officials are irrelevant for financial markets. The federal government is a large component of the U.S. economy. Through changes in spending and taxes, the government can help smooth out business cycles and act as a stabilizing force during recessions. Changes in regulations can also have a significant impact. Yet, the government is just one of many factors that influence the economy and financial markets.
Interest rates, corporate profits, valuations, inflation, currency movements, commodity prices, and consumer and investor sentiment can each have large effects too. It is also important to note that nearly half of all revenues for companies in the S&P 500 come from outside of the United States, so the state of the global economy is also very significant. That is something that the U.S. president has little control over.
Our central bank, the Federal Reserve, also has an enormous impact on the economy and financial markets (the Fed is an independent entity within the federal government, and it is structured so that it is not subjected to the same political pressures as elected officials). Through monetary policy tools, the Fed manipulates interest rates to promote full employment and stable prices in the economy. The level of interest rates directly impacts loan rates, the interest paid on deposits, fixed income prices and also greatly influences the stock market, the housing market and the price of other assets. It is no wonder that the markets seem to hang on every word of Fed officials.
It is an exaggeration to say that presidents are “in charge” of the economy or stock market given all of the factors outside of their control. When it comes to stock market performance during a president’s term, timing and luck also play a huge role. Presidents who enter office when price-to-earnings ratios are low, for example, are far more likely to see the stock market perform well during their tenure than those who enter when valuations are high.
George W. Bush and Herbert Hoover, for instance, had the misfortune of entering office at times of lofty valuations. Subsequently, real returns were negative during their tenure. Franklin Roosevelt and Ronald Reagan, on the other hand, entered office at times of low P/E's and saw positive market returns while in office.
There is also a lot written about how the stock market performs during the four years within a presidential cycle. Studies show that the third year of a presidential cycle has historically been the best for equities. The stock market has also typically performed well during an election year. We do not advocate trying to time the market based on this approach.
There is an axiom in statistics that “correlation does not imply causation”. Just because two events or variables often coincide with one another does not mean that one causes the other to move. The correlation could be completely random. For example, there is a strong correlation between who wins the Super Bowl and stock market performance. When a team from the old National Football League wins, the stock market has historically posted strong returns for the year. When a team from the old American Football League has won, the stock market has lagged, on average. Of course, there is no logical reason for this relationship; it is merely coincidental. Correlation does not imply causation.
While the presidential cycle likely has a bit more influence on the stock market than football, we would not rely on it as a predictive indicator of performance. There is also a fairly small amount of data to rely on, with just 17 presidential cycles since World War II. People who have tried to time the market around this anomaly have been very disappointed in recent years. The crash of 2008 came in an election year, for instance. Also, 2011 and 2015 marked the third years of President Obama’s two terms but were lackluster years for stocks.
Investors should not let scare tactics from either side of the political spectrum influence their investing strategy. There are too many other factors that drive the economy and financial markets. When it comes to their portfolios, investors are better off tuning out the noise around elections
The U.S. economy made measurable progress in 2015, and we expect further improvement in 2016. Nonetheless, we expect returns from both equities and fixed income to fall short of their historical averages over the next several years and believe that investors should temper their expectations for overall portfolio returns. We continue to favor stocks over bonds relative to our long-term asset allocation targets, however, and believe that continued volatility in equities could provide attractive opportunities for prudent security selection.
We take pride in the effort we put into identifying opportunities and spotting trends in the financial markets. However, there are risks associated with any forecast and the themes described in this outlook should not be considered as personalized investment advice. We believe most investors are better served by focusing on their long-term goals as opposed to the day-to-day ups and downs in the markets. Any investment plan should be designed with consideration for the objectives and constraints of the individual investor.
The S&P 500® Index is an unmanaged index that contains securities typically selected by growth managers as being representative of the U.S. stock market. The Index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.
The Citigroup U.S. Broad Investment-Grade Bond Index tracks the performance of U.S. Dollar-denominated bonds issued in the U.S. investment-grade bond market. Introduced in 1985, the index includes U.S. Treasury, government sponsored, collateralized, and corporate debt providing a reliable representation of the U.S. investment-grade bond market.
MSCI All Country Indexes include both Developed Markets and Emerging Markets countries across particular regions. For example, the MSCI AC Far East Index includes Developed Markets countries such as Hong Kong and Singapore along with Emerging Markets countries such as Indonesia and Thailand. The MSCI ACWI Index covers 46 countries. It is not possible to invest directly in an index.
The MSCI U.S. Broad Market Index represents the universe of companies in the US equity market, including large, mid, small and micro-cap companies. This index targets for inclusion 99.5% of the capitalization of the US equity market. The MSCI U.S.
Broad Market Index is the aggregation of the MSCI U.S. Investable Market 2500 and Micro Cap Indexes. It is not possible to invest directly in an index.
The Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the USB-denominated, investment-grade, fixedrate, taxable bond market of securities. The Index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM pass throughs), ABS, and CMBS sectors. It is not possible to invest directly in an index.
The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true smallcap opportunity set. The Index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.
The Bank of America Merrill Lynch Treasury Master Index tracks the performance of U.S. dollar denominated sovereign debt publicly issued by the U.S. government in its domestic market. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $1 billion. Qualifying securities must have at least 18 months to final maturity at the time of issuance.
The Bank of America Merrill Lynch U.S. High Yield II Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Index constituents are capitalization-weighted based on their current amount outstanding times the market price plus accrued interest.
The Citigroup (CBGI) World Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment grade sovereign bonds. The WGBI is a widely used benchmark that currently comprises sovereign debt from over 20 countries, denominated in a variety of currencies, and has more than 25 years of history available. The WGBI provides a broad benchmark for the global sovereign fixed income market
The Citigroup (CBGI) U.S. Broad Investment Grade (USBIG) Bond Index is designed to track the performance of U.S. dollardenominated bonds issued in the U.S. investment-grade bond market. The USBIG Index includes institutionally traded U.S. Treasury, government-sponsored (US agency and supranational), mortgage, asset-backed, and investment-grade securities. It provides a reliable and fair benchmark for an investment-grade portfolio manager.
Net profit margin is the percentage of revenue remaining for a company after deducting all operating expenses, interest, taxes and preferred stock dividends.
The price-to-earnings ratio is a valuation ratio of a company's current share price compared to its per-share earnings (EPS). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). Also sometimes known as "price multiple" or "earnings multiple."
Chart data comes from Intrinsic Research Systems, Inc. and Thomson Reuters Datastream, a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis.
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Past performance does not guarantee future results. All investing involves risk, including risk of loss.
All information as of the report date unless otherwise noted.
All indexes are unmanaged and returns do not include fees and expenses associated with investing in securities. It is not possible to invest directly in an index.
This material is provided for informational purposes only and should not be used or construed as investment advice or a recommendation of any security, sector, or investment strategy. All views expressed are based on the information available at the time of writing, do not provide a complete analysis of every material fact, and may change based on market or other conditions. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the analysis and opinions provided are those of the COUNTRY Trust Bank investment team identified above and not necessarily those of COUNTRY Trust Bank or its affiliates.
Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in asset backed and mortgage backed securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments.
Diversification and asset allocation do not assure a profit or guarantee against loss.