- 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
According to legend, when asked what the stock market was going to do next, a top executive on Wall Street quipped, “it will fluctuate”. That may have been one of the most accurate financial predictions in history. Although the stock market has risen tremendously over time, it has taken a notoriously bumpy path to get there. With two 10% corrections in the S&P 500® since August, investors have been harshly reminded of the vacillating nature of equity markets.
Yet, as is often the case for investors, a little bit of patience has been handsomely rewarded. From the start of the new year to its low on February 11, the S&P 500 fell 11.4%. Since then, stocks have rebounded sharply, and the index finished the first quarter in positive territory. To turn an old adage on its head, investors would have been well served heeding the advice of “don’t just do something; stand there”.
Many of the same issues that plagued the markets in 2015 carried over into the new year (unfortunately, economic problems don’t magically disappear once the ball drops in Times Square). Fears over a continued economic slowdown in China, tumbling oil prices, and uncertainty over the Federal Reserve’s interest rate policy rattled markets, handing them their worst start to any year on record. However, solid economic data here in the United States and a rally in oil prices has helped spark a rebound in stocks. (Figure 1)
U.S. Economy Shows Resiliency
Despite concerns of China’s slowdown spilling over onto our shores, the U.S. economy continued to show its resilience in the first quarter. A big reason for this is that American consumers are in their best financial shape in years. Some positive indicators include:
- A strengthening labor market (Figure 2) as job growth averaged a solid 209,000 in the first three months of the year;
- An unemployment rate at 5%;
- Accelerating wage growth;
- Remarkably low interest rates;
- An improving housing market;
- Record high auto sales;
- Multi-year low gas prices;
- Solid consumer spending levels even as savings rates rise.
This all bodes well for our consumer-driven economy in 2016.
The labor market continues to strengthen.
Nonetheless, economic growth is far from robust. Some of the issues we continue to monitor and evaluate include:
- A strong dollar, which remains a headwind for manufacturers and exporters;
- A potential increase in debt defaults later this year by North American fracking companies amid sustained low oil prices, which could have negative consequences for credit markets;
- Weak economic growth overseas. Overall, we believe recession risks have risen but still remain fairly low.
Interest Rate Watch Continues
After hiking interest rates for the first time in nine years back in December, the Federal Reserve held rates steady at its January and March meetings. The central bank also lowered its projections for interest rate hikes this year from four to two. The consensus among Federal Open Market Committee members is for the federal funds rate to end the year at 0.9%, down from its previous projection of 1.4%. Interest rates may seem shockingly low, especially when you consider how close the labor market and core inflation are to the Fed’s targets. Yet, they dwarf the rates of many other developed nations. (Figure 3)
Key interest rates are now negative in other developed markets.
To combat deflation and sluggish economic growth, central banks in Japan and Europe have begun experimenting with negative interest rates. In other words, investors buying short-term government bonds are now actually paying for the privilege of loaning out their money. We don’t remember seeing this concept in any of our economics textbooks. While this is bad news for savers in these countries, it has been a boon for manufacturers of personal safes! Talk about a flight to safety.
Despite their central banks’ best efforts, most major currencies actually strengthened against the U.S. dollar in the first quarter while their stock markets fell. Nonetheless, the greenback remains strong overall, which continues to be a headwind for many multinational companies. This, along with continued low oil prices, led to the third consecutive quarter of declining profits for the S&P 500. While the U.S. economy has managed to avoid the dreaded “R” word, corporate profits have not.
What We See
As stated in our market review and outlook at the end of 2015, we expect muted returns and continued volatility for the stock market in the near future. Given the lack of earnings growth, somewhat elevated valuations (Figure 4), and what is likely to be a rising rate environment, it is difficult to envision a scenario in which the market soars from here
Profits are declining while valuations remain elevated.
Overall, though, we believe that the U.S. economic recovery is still mid-cycle and expect continued moderate growth this year. An improving U.S. economy should continue to provide support for both corporate earnings and equity prices, and, absent a recession, we view a sustained bear market as unlikely.
With bond yields so low, however, investors aren’t likely to receive much lift from the fixed income portion of the portfolio. Yet, bonds showed earlier this year exactly why they still belong in a welldiversified portfolio. Amid economic fears and a plunging stock market, investors fled to the relative safety of U.S. government and investment grade bonds, driving their prices higher and interest rates lower. Credit spreads widened considerably, particularly in the high yield (junk) bond space, but have narrowed just as considerably since February 11. (Figure 5) Overall, high quality bonds provided a much-needed stabilizing force to investors’ portfolios during the quarter.
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,
Treasury and investment grade bonds provided stability in the first quarter.
While the Federal Reserve is expected to continue hiking short-term rates this year, yields should remain low overall for quite some time. However, we believe that inflation could finally start to accelerate a bit this year given the tightening labor market and improvement in household balance sheets.
We expect the U.S. economy to continue growing at a moderate clip this year and see recession risks as low. We remain overweight stocks relative to bonds compared to our long-term asset allocation targets. However, we continue to expect returns from both asset classes to fall below their historical averages long-term. (Figure 6)
In the recent past, the stock market experienced an extended period of strong tailwinds and stunningly low volatility amid rising profits, relatively low valuations, and quantitative easing from the Fed. Those abnormally tranquil times appear to be over for now, as stocks have a much tougher hill to climb.
We still believe the stock market can deliver solid returns long-term; it is just likely going to be a bumpier ride along the way. Or in the words of that prophetic Wall Street executive, “it will fluctuate”.
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.
Brent oil is a major trading classification of sweet light crude oil that serves as a major benchmark price for purchases of oil worldwide. Brent is the leading global price benchmark for Atlantic basin crude oils. It is used to price approximately two thirds of the world’s internationally traded crude oil supplies.
The federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. The Federal Open Market Committee, which is the primary monetary policymaking body of the Federal Reserve, sets its desired target range.
The Bank of Japan discount rate is the interest rate charged by the Japan’s central bank when extending loans to private financial institutions which have accounts at the Bank.
The European Central Bank deposit rate is the interest rate which banks may use to make overnight deposits with the Eurosystem.
The price-to-earnings ratio is a valuation ratio which compares a company's current share price with its earnings per share (EPS). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be derived from the estimates of earnings expected in the next four quarters (projected or forward P/E). The ratio is also sometimes known as "price multiple" or "earnings multiple."
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 US Broad Investment-Grade Bond Index tracks the performance of US Dollar-denominated bonds issued in the US investment-grade bond market. Introduced in 1985, the index includes US Treasury, government sponsored, collateralized, and corporate debt providing a reliable representation of the US investment-grade bond market.
Chart data comes from Thomson Reuters Datastream a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis.
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Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies, and they may be expected to do so in the future.
Stocks of mid-capitalization companies may be slightly less volatile than those of small-capitalization companies but still involve substantial risk and they may be subject to more abrupt or erratic movements than large capitalization companies.
International investing involves risks not typically associated with domestic investing, including risks of adverse currency fluctuations, potential political and economic instability, different accounting standards, limited liquidity and volatile prices.
Fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lowerrated and nonrated securities present a greater risk of loss to principal and interest than higher-rated securities.
Diversification, asset allocation and rebalancing do not assure a profit or guarantee against loss.
All indexes are unmanaged and returns do not include fees and expenses associated with investing insecurities. It is not possible to invest directly in an index.