Financial markets have not been boring in the last six months with each day appearing equally or even more volatile than the day before. Each piece of news seems to result in changing opinions, forecasts and reactions from a multitude of people with differing viewpoints and investment objectives. This volatility does begin to make more sense if we step back and look at the big drivers of risk and return in the capital markets over the long-term. JP Morgan’s Chief Global Strategist, Dr. David Kelly, regularly says, “the key to successful investing is not predicting the future, but looking at the present with clarity”. These are our current views on the present.
After all the dust has cleared from the first quarter of 2016, the U.S. stock market has ended roughly where it started. This was after the worst start to the stock market in history with large cap stocks (S&P 500) down -10.3% at the low point in mid- February, followed by a rally that ended the quarter up 1.35%. Smaller companies (Russell 2000) returned -1.52% for the same time period. It is not unusual for markets to dip 10% quite frequently. It just normally doesn’t happen in the early months of the year and grab headlines.
Three Main Drivers of Risk
In our year-end review, we discussed three main drivers of risk and return over the shorter and intermediate terms: China, low oil prices, and interest rates. These still remain dominant themes, but as we suggested might occur, the sentiment around these themes is changing. Over the last several months, the price of oil and U.S. stocks have been highly correlated. This decline and then subsequent rebound in stocks was heavily influenced by a decline and then recovery/ stabilizing in oil prices. While oil is still a wildcard, prices have rebounded a bit, and although prices remain low and inventories high, the demand-side of the equation seems fairly strong, and there is hope that the market will start to work through some of those inventories over time. The silver lining of low gas prices for consumers is rarely discussed, but it most certainly does exist. While many factors impact the prices of financial assets, we believe that market participants felt some comfort that oil prices might stabilize, eventually moving higher; the Federal Reserve might continue to exhibit patience with raising interest rates in 2016; and that emerging markets might also stabilize in the short-run to brighten long-term prospects. These factors may have felt like new revelations to some market participants and was a change in attitudes from January and early February. When sentiment changes, the prices of all “risk assets” like stocks and bonds change accordingly.
International, Emerging, and Bond Markets
International markets have remained somewhat troubled, but we feel still present opportunity. They, too, had a tough start to the year dropping 12.5%, followed by a rebound to finish the quarter down -3.01%. The European Central Bank (ECB) has been continuing its efforts to spur economic growth through negative interest rates (charging you to hold your money!). While we are skeptical of this new policy, bank lending does appear to be increasing, unemployment is declining slowly, and GDP growth is anemic, but positive. These modest positives, combined with relatively attractive valuations, make this still an area we want to stay invested.
Emerging markets returns have been dominated by news about China. This is a little tricky in the sense that many investors apparently don’t trust Chinese government data, but independent research and looking at neighboring economies such as Korea and Taiwan, does give us some comfort that China’s economy might be stabilizing and the extreme volatility seen in their markets might subside. Stability is a key goal for the second largest economy in the world and it is important to remember that a slowing economy does not necessarily mean a slow economy. Part of the maturing process for an economy like China is to slow to a sustainable growth rate which is good for them and the rest of the world. With China growing at double-digit rates, they consume every commodity on the globe and cause inflation and resource depletion. Slowing to a more modest 6% or even lower growth rate is really still strong enough to help global growth and achieve targets they have set. Emerging markets are up 5.71% in the first quarter – a welcome change.
Bond market performance is heavily influenced by central bank policy both in the U.S. and around the globe. These interest rate policies are influenced by inflation expectations and employment (proxy for economic health/growth). The U.S. does appear to be in a stable place with the employment picture brightening and inflation low, but stable. With this backdrop, the Federal Reserve could argue for higher interest rates in an effort to get back to a “normal” interest rate environment, but it has favored a more subdued approach and tone. The real complicating matter is that most of the world has gone to a ZIRP or NIRP (Zero Interest Rate Policy or Negative Interest Rate Policy) in an effort to spur economic growth. Since money flows globally to the best opportunity, these policies make it difficult for the Federal Reserve to raise interest rates without dramatically increasing the value of the dollar, which has already appreciated a great deal against other world currencies. As a result, we believe that we are likely to be in a low interest rate and low return environment for bonds for an extended period of time. While interest rate increases are not only possible, but probable, we think they will be very incremental over time and the risk to bond investors is fairly low. If interest rates stay low and thus bond returns low, this also has a secondary effect of keeping stock returns lower than the historical returns we have been accustomed to seeing. Lastly, the high yield bond market (lower credit quality company bonds) had a rocky 2015 due to fears primarily related to energy companies, but these have subsided as we had hoped and returned 3.32% this first quarter. The aggregate bond index was up 3.03%, and the short-term corporate bond index up 1.14%.
When to React, When to Ignore
The volatility experienced in the first quarter continues to reinforce our belief that emotions are rarely our friend when investing. Additionally, watching every tick of the tape or hanging on each economic report is rarely helpful either. Instead, we feel it is best to major on the majors and minor on the minors. We should seek to understand the big risks and return drivers of asset returns and resist the temptation to over-react based on short-term volatility. This should not be confused with “set it and forget it”, but rather pursues thoughtful adjustments to current conditions. I can remember as a child sitting on my Dad’s lap and learning to steer a car. (This seems very irresponsible today, but it was fine at the time). As a child, you have a tendency to not recognize veering early enough and then have a tendency to saw on the wheel to correct, then re-correct the course. An experienced driver rarely has to do this, but rather makes small adjustments both to the speed and direction of the car. Successful investors, likewise, should learn to see the current environment clearly and know what to react to, and what to ignore. This is the challenge, but it is a task that is made easier with a philosophy, process, and group of people who collaborate on your behalf to make these decisions. We thank you for your trust.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine what is appropriate for you, consult a qualified professional.
No strategy assures success or protects against loss. Investing involves risk, including possible loss of principal. International and emerging market investing involves special risks such as currency fluctuations and political instability and may not be suitable for all investors.