First-Quarter Market Update & Outlook
Author: Jeff Layman
Economic growth in the fourth quarter of 2015 was slightly better than initially expected, with the final revision indicating a gain of 1.4 percent in real terms.1 Personal consumption rose 3.1 percent in 2015—the best in 10 years—alongside a healthy consumer savings rate of 5.5 percent. Real growth for the first quarter of 2016 is expected to have improved marginally to about 2 percent.
The ISM Manufacturing Index rose in March, indicating that U.S. production activity expanded for the first time since August 2015. The recent rebound in oil prices and the weakening dollar have helped improve conditions for manufacturers. Meanwhile, the ISM Non-Manufacturing Index also increased, showing that activity in the services economic sector continues to be strong.
Improvements in both manufacturing and services helped drive solid job creation in March, with payroll employment rising by 215,000. The unemployment rate ticked up slightly to 5 percent, as 396,000 more people joined the labor force during the month. Average hourly earnings have increased 2.3 percent year over year, which may hint at higher inflation going forward.
The Federal Reserve kept short-term interest rates steady during the first quarter. While the Fed acknowledged the gradual improvement in the economy, it grew concerned about weakness in global growth and the associated downside risks for the United States. Due to these concerns, the Fed is likely to keep rates “lower for longer,” with only two additional rate increases expected in the remainder of 2016.
In the first six weeks of 2016, U.S. stocks posted their worst performance ever to start a year. Concern over falling oil prices and slowing economic growth in China contributed to a bottoming of stock prices on February 11. At that point, stocks were down more than 10 percent for the year and nearly 15 percent from the high of May 2015, representing the second market correction in six months.
Fortunately, stock prices staged a strong rebound through the end of March. U.S. stocks completely reversed prior declines to finish the quarter with slightly positive results, while international stocks finished just shy of even. Here are the major equity index returns for the first quarter of 2016:
The rise in share prices in late February and throughout March was largely driven by a calming of recession fears and a more dovish Fed stance. The prospect of rising interest rates has been a significant headwind for the markets since last fall. With the Fed indicating that future rate increases will come at a more gradual pace, this obstacle has been removed—at least for the near term.
Developed international stock returns tracked U.S. results fairly closely in the first quarter, since many of the same factors and concerns affected these markets. However, emerging markets—the poorest performing global market segment in recent years—posted strong returns. The MSCI Emerging Markets Index gained more than 5 percent for the quarter, along with the rebound in commodity prices and the expected benefits of a more passive Fed. After the price declines of recent years, emerging market stocks have fallen to valuation levels near the lows of early 2009. Therefore, only modest improvement in macroeconomic conditions is required for this asset class to become more attractive to investors.
Bond investors were surprised by a fairly significant decline in interest rates during the first quarter. Consensus expectations were that rates would gradually rise through 2016 on the heels of the first Fed funds rate hike last December. However, the volatility that developed in the stock market resulted in a flight to safety, causing the benchmark 10-year Treasury note yield to drop from 2.23 percent to 1.79 percent.
This resulted in better-than-expected bond returns, with the Barclays Aggregate Taxable Bond Index gaining 3.03 percent for the quarter, while the Barclays Municipal Bond Index rose 1.67 percent on a total return basis. From a portfolio diversification standpoint, bonds also provided the desired buffer against the stock market turmoil that occurred at the beginning of the year.
Satellite bond categories also performed well. The Fed’s decision to slow the pace of interest rate hikes helped drive strong gains in emerging markets bonds, with the J.P. Morgan EMBI Plus Index gaining 5.93 percent for the quarter. After a tough performance year in 2015, high-yield bonds benefited from stable credit spreads and declining interest rates. The Bank of America M/L US High Yield Master Trust II Index advanced 3.25 percent.
A major catalyst for the significant decline in stock prices at the start of the year was the plunge in oil prices to nearly $27 per barrel. Declining energy prices have typically fueled gains in the economy in past periods, but investors have been more focused on the negative aspects this time around. The dramatic price decline from more than $100 per barrel has had a damaging impact on the financial results of companies in the energy sector and also has created concern about potential loan losses at banks. So despite the very low long-run correlation between changes in stock prices and changes in oil prices, the two have moved largely in tandem so far in 2016.
Recession fears were on the rise during the first several weeks of the quarter. Ironically, low oil prices don’t tend to cause recessions, while high oil prices do. In our view, recession is a fairly low probability for 2016. Most economic indicators continue to improve, pointing toward an extension of the slow but steady growth environment we’ve experienced in recent years.
Among the uncertainties investors are facing in 2016 is the upcoming presidential election. Here’s what history shows regarding stock market performance during a presidential election year:2
- Market returns in the 22 election years since 1928 have averaged 6.9 percent
- Election-year returns have been positive 73 percent of the time
- With the exception of 2000 and 2008, in no election year has the market experienced a decline greater than 3 percent
- In the majority of election years, the market strengthens in the latter half of the year, reaching its high in the fourth quarter
While historical election-year statistics suggest that 2016 ought to be a decent year for stocks, there can be significant deviations from the norm. As an example, the third year of the presidential term is normally the best, averaging a return of more than 16 percent. But stocks were flat in 2015, which was the third year of the current term. Time will tell, but given the volatile start to the year, investors would be pleased if traditional election-year results prevail in 2016!
While several extraneous factors recently have greatly impacted stock prices, the focus is likely to return to trends in corporate profits. Aggregate profits for S&P 500 companies have declined over the past year, largely due to the implosion of earnings in the energy sector. Stabilizing oil prices and easier year-over-year comparisons should help restore positive earnings growth in the second half of the year. While concern has grown about the financial sector, bank balance sheet exposure to energy loans is only about 2.5 percent. This compares to the 33 percent exposure that banks had to mortgage loans in 2007.3 Therefore, banks may be positioned to make a larger earnings contribution later in the year. Given full valuation levels, earnings growth is likely to become a key driver of U.S. stock returns for the remainder of the year. Without a rebound in earnings, stocks aren’t likely to make much progress.
We’ve endured two market corrections in the past year, and both were reversed by fairly quick rebounds. We expect more volatility in 2016, as the investment environment continues to change. Encouragingly, both bonds and alternative investments have made a strong contribution to results and risk mitigation this year. Portfolio diversification is working and should continue to offer protection against future market turbulence.
We appreciate the confidence you have placed in the BKD Wealth Advisors team!
1Source: Bureau of Economic Analysis
2Source: InvesTech Research
3Source: Goldman Sachs
Jeffrey A. Layman, CFA®
Chief Investment Officer
BKD Wealth Advisors, LLC is an SEC registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.