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Special Report - Released 1/18/16

  • 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 

The stock market has gotten off to a rocky start in 2016, to say the least. Through January 15, the S&P 500® index had fallen 8%, marking the worst two-week start to any year on record. Many of the same problems that plagued the markets last year are once again creating fear and uncertainty around the globe, with some even calling for a 2008-style collapse ahead. The three main culprits have been China, the Federal Reserve and oil. While these could continue to weigh on the markets for some time, we do not view any of these factors as having a catastrophic impact on the U.S. economy or stock market.

Indexes used for Figure 1: U.S. Large Cap Stocks – S&P 500 Index, U.S. Investment Grade Bonds – Citigroup US Broad Investment-Grade Bond Index, Developed International Stocks – MSCI EAFE (Europe, Australasia and the Far East) Index, Emerging Market Stocks - MSCI Emerging Markets Index

China

Perhaps the biggest contributor to the recent global market volatility has been China. The country has grown rapidly in the past to become the world’s second largest economy. However, growth has slowed in recent years as it transitions towards a consumer-based economy. Amid the slowdown, China’s central bank has made many efforts to stimulate growth, including devaluing its currency. These currency devaluations (Figure 2) in particular have sparked selloffs in risky assets around the globe, as investors fear that China will no longer be a major driver of global economic growth.

However, we do not view China’s moves to devalue its currency as a harbinger of global economic calamity. Central banks around the world have made – and continue to make – moves to devalue their currencies and stimulate growth as well. China appears to be merely keeping up with other countries in this regard, although their efforts have been interpreted as desperate. We do believe that China is a legitimate concern for investors and that its economy will likely continue to slow, which will negatively impact global growth. Major commodity exporters and firms with a significant presence in the emerging markets are likely to continue feeling the most pressure. Yet, we do not foresee China’s slowdown causing an economic recession here at home. The U.S. economy is not heavily dependent on exports to China, and economic data remains solid overall.

Amid slowing growth, China has devalued its currency.

The Federal Reserve

While many central banks have recently eased monetary policy, the Federal Reserve just increased interest rates for the first time since 2006. (Figure 3) The Fed also projects that more rate hikes are coming this year. This seems to have fueled fears that rising rates will slam the brakes on the U.S. economy. We believe these fears are unwarranted. The Federal Reserve has simply moved rates off of emergency, rock-bottom levels as the economy has continued to recover from the Great Recession. The labor market is now near full employment, and while inflation remains low, core inflation (excluding food and energy) is actually close to the Fed’s target of 2%. It is only because of the strength of the economy that the Fed feels confident to begin normalizing rates.

Monetary policy remains very accommodative overall, and interest rates remain very low by historical standards. We do not believe that a 1/4 of 1% increase in interest rates will have a significant impact on the economy. While further rate hikes this year are unlikely to derail the U.S. economy, we note that a rising rate environment could very well remain a headwind for the stock market.

U.S. monetary policy remains highly accommodative.

Oil

Meanwhile, oil prices have plummeted to their lowest levels since 2003, even breaking through their lows during the Great Recession. Some worry that plunging oil prices are a signal that a recession is coming soon. We argue, however, that the primary catalyst behind the collapse in oil prices has been supply-driven, not demand-driven. Surging production in the United States, along with decisions by OPEC not to cut its output, have led to an oversupply of oil. While demand has not been robust, thanks in large part to a slowing China, it certainly hasn’t been weak enough to warrant the historic fall in oil prices. There are signs, however, that the oversupply in oil should begin to moderate soon. (Figure 4) This should help stabilize prices, albeit at low levels relative to recent years.

We caution that low oil prices do place a significant strain on producers, as well as on major oil-exporting countries. Given the substantial increase in oil production in the United States over the last several years, this could have negative effects throughout the labor and credit markets. However, we believe that the positives of low oil prices continue to outweigh the negatives for the U.S. economy, as lower prices at the gas pump and lower heating bills benefit millions of Americans.

The oversupply in oil should begin to moderate soon.

Outlook

There is a lot of fear gripping global financial markets right now. Concerns over slowing growth in China, rate hikes by the Fed and low oil prices could certainly remain headwinds for the stock market throughout the year. However, we do not believe that any of these factors will have a similar impact on the economy or market as the bursting of the housing bubble did in 2008.

We do not advocate investors try to time the market or change their investment strategy based on the recent volatility. While it is difficult to foresee what will happen over the short-term, we continue to expect 6-9% average annual returns from stocks over the next 5-10 years. Also, with the dividend yield on the S&P 500 greater than the yield on the 10-year Treasury note (Figure 5), we continue to favor stocks over bonds. However, bonds remain an important part of a diversified portfolio and should provide stability during periods of market turbulence, as we are experiencing now.

Stocks remain attractive relative to bonds.

Definitions
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 MSCI EAFE Index is broadly recognized as the pre-eminent benchmark for U.S. investors to measure international equity performance. It comprises the MSCI country indexes capturing large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada.

The MSCI Emerging Markets Index captures large and mid-cap representation across 23 emerging market countries. With 836 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

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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Investment management, retirement, trust and planning services provided by COUNTRY Trust Bank.

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.

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 lower-rated 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.