Global markets started the year with a wild ride. Just looking at quarter-end returns doesn’t tell the whole story. The S&P 500 started the year in the red, falling nearly 6% in the first five trading days in January. The slide continued and by February 11th, the market was off by more than 11% as the “Three C’s”—China, Commodities, and Central Banks—spooked global markets. Then a funny thing happened: the sky didn’t fall and the world didn’t instantly plunge into a recession. The stock market rebounded sharply with a 14.4% return over the final six weeks of the quarter to finish in the black with a 1.5% gain. Of note, as the market declined, both growth and value stocks fell but value proved more resilient. The S&P 500 Value Index recovered its losses and was back in the black by March 7th and ended the quarter ahead of the S&P 500 Growth Index by about one percent.
The Three C’s
China—Worries about slowing growth in China dominated early headlines in January. An attempt by the government to stabilize the Chinese market with new regulations had the opposite effect, causing stock prices to tumble. Like other global markets, the Chinese market began to stabilize in February when the People’s Bank of China announced another reduction in interest rates. This comes on the heels of an earlier cut in November. We expect Chinese market volatility and surprise economic announcements to continue as China transitions from a manufacturing economy driven by government investment to a service economy driven by consumer spending.
Commodities—Oil has been the most volatile commodity in recent years. West Texas Intermediate crude oil prices fell as much as 29.72% during the first quarter but then reversed course dramatically to end the quarter with slight gains. Crude oil production has remained steady in the US even as producers have reduced the number of rigs in operation and laid off thousands of employees. Inventories have risen sharply as shown in the chart at right. This phenomenon combined with talk among OPEC nations about maintaining current production levels means oil prices aren’t likely to post significant gains in the near future.
Central Banks—Entering the year, there was much hand-wringing about the Fed beginning to tighten monetary policy while foreign central banks continue or even accelerate their own easing policies. Japan’s Prime Minister Shinzo Abe recently said he was considering a new economic stimulus package while the European Central Bank made cuts to push rates negative and increased its bond buying program. When the Fed raised rates in December for the first time since 2006, it made clear its desire to normalize policy and move away from near-zero interest rates. Coming into the new year, it looked like the Fed would raise rates four times in 2016 and possibly another four times in 2017.
With the fall in commodities and general global weakness, the Fed decided economic conditions weren’t robust enough to raise rates in either January or March (the Fed did not meet in February). Looking ahead, it appears it isn’t likely to raise rates until at least June, meaning we may be looking at two rate increases in 2016 instead of four. The market has responded positively to this expectation. The effects were clearest in the returns of stocks of utilities, probably the most interest-rate-sensitive sector. The S&P 500 Utilities Index rose 15.6% in the first quarter. The Fed’s dovish position on rates also contributed to the rebound in commodities prices as it pushed the US dollar lower.
The labor market in the US continued to improve, adding 628,000 new jobs during the quarter. It may sound counterintuitive but the fact that the unemployment rate ticked higher to 5.0% from 4.9% in March is good news because it means more people are confident enough to rejoin the labor force, as shown in the chart on the next page. The civilian workforce has grown by 1,453,000 people since December, according to the Department of Labor. It is a small tick up from the participation rate trend but a step in the right direction nonetheless.
Europe—The big story in Europe right now is the possible “Brexit” vote coming in June, when British citizens will vote on whether to remain in the European Union. A vote to exit would mean trade agreements and financial regulations would need to be renegotiated, creating a good deal of uncertainty for both the British and EU economies. Polls are currently showing voters are leaning towards staying in the EU.
Presidential Election—So far, the upcoming presidential election hasn’t seemed to have had much impact on the market. While all of the candidates tend to talk about how bad the economy is, the US economy continues to grow slowly and has been the strongest among global developed economies. The market will likely begin to take more notice after the conventions, at which point there will be more scrutiny of the specifics of each candidate’s platform.
US Economy—The US economy continues to grow at the slow pace we have seen throughout the entire recovery. First quarter GDP growth hasn’t been released but is likely to come in stronger than in recent years because we didn’t see the same type of crippling winter storms that we saw in 2014 and 2015. While businesses are still hesitant to make investments in growth, the situation for the American consumer continues to gradually improve as highlighted by job growth and wage gains.
Corporate Earnings—First quarter earnings are projected to be weaker than in recent quarters, with the energy sector being the biggest detractor. These projections are likely already priced into the market as analysts have been lowering estimates over the past few months. Historically, lower estimates have led to more upside surprises, which has been good for stocks. The fact that the US dollar index fell 4.7% relative to foreign currencies in the first quarter will help make US products more competitive globally going forward. This may already be showing up in the numbers. The Institute of Supply Management Manufacturing Index (ISM) moved back up to 51.8 in March—the first reading showing expansion in manufacturing since last July.
Lessons—Market action in the first quarter offers investors a learning opportunity. Recall that six weeks into the quarter, stocks were down 11% and interest rates were higher. Headlines such as “Stocks have worst ever start to a new year!” and “Higher rates spell trouble for bond investors!” and “Some economists predicting recession!” were the norm. It looked like the perfect time to hunker down in cash. Just six weeks later, the stock market was back in the black for the year, interest rates had fallen back below the levels they ended the prior year and economic headlines had turned mostly positive. We are reminded of the value of maintaining a disciplined long-term investment plan and of the benefits of rebalancing the portfolio amid the volatility.