April 19, 2016– If you had gone to sleep on New Year’s Eve 2015 and emerged from your hibernation on April 1st 2016, a cursory review of first quarter market performance would have likely left you scratching your head and wondering what all the fuss was about. Yet, the first quarter was a wild ride from start to finish with investors forced to deal with extreme levels of volatility and market pessimism. In the words of Mark Twain, “history never repeats itself but it rhymes.” As has played out many times in the past, the sharp market correction caused weaker hands to sell high quality assets indiscriminately and favored those with the ability to take a longer term perspective and act opportunistically.
In retrospect, the first day of trading in 2016 was an ominous sign of things to come. The Chinese stock market declined -6.9% as newly implemented circuit breakers, designed to reduce volatility and large market moves, appeared to have the opposite effect causing widespread panic selling among Chinese investors. Fears related to a slowing global economy continued to mount, with investors questioning the risk of a US recession in the face of weak manufacturing data due to lower global demand and the impact of a stronger dollar on US exports. Money continued to flow out of emerging market economies, causing currency depreciation and forcing a number of central banks to implement capital controls. Oil remained a major destabilizing force with global stock market performance closely tracking the direction of oil prices which plunged in January and hit a 13 year low of $26.21 by early February. As oil prices continued to collapse, even the largest integrated oil companies were forced to make further budget cuts and in some cases cut dividends in order to preserve cash. Global banks were particularly hard hit during the market correction, as investors questioned future profitability and risks associated with low interest rates and energy loan exposure. Questions surrounding the safety of bank capital structures resulted in European bank shares declining -27% by early February with shares of Deutsche Bank declining -40%. Similarly, Japanese banks faced heavy losses as the Bank of Japan joined the European Central Bank in implementing negative interest rates in late January.
As fears mounted across global stock markets, bond yields on high quality US government debt continued to fall (often referred to as a “flight to safety”) driving the 10 Year US Treasury yield down to 1.64% which was the lowest level since 2012. At these levels, factoring in a core inflation rate of 2.3%, investors were willing to accept a real return (yield – inflation) of -0.66% for the perceived safety of owning US Treasuries. As is typically the case, global stock markets bottomed on February 11th at the height of investor pessimism. From the start of the year, the S&P 500 had declined -10.5%, developed international markets had declined -12.8% and emerging markets had declined -13.3%. In a timely move, the CEO of JP Morgan announced a personal investment of $26.5M in company stock on February 12th providing another signal of the oversold conditions across much of the banking sector. As oil prices stabilized and rose from the February lows, global stock markets rallied with the closely watched high yield bond market turning positive for the year by early March. Helping to calm market fears, the European Central Bank announced additional stimulus measures in March while the Federal Reserve put on hold further interest rate hikes.
Despite a bleak outlook only months earlier, the S&P 500 returned +1.35% for the quarter. Financial services and health care were among the worst performing sectors of the market, with communications (telecom) and utilities producing the highest returns. The health care sector was hurt by the turmoil at Valeant, as well as renewed political discussions surrounding drug pricing practices. Investor preference for quality defensive companies led to higher yield dividend paying stocks significantly outperforming the broader US market returning +4.14%. Small capitalization stocks lagged larger cap peers declining -1.52% in the quarter. In a reversal from previous quarters, value outperformed growth as many of the previous years “high flyers” experienced sharp declines during the early quarter correction.
Returns across developed international stock markets were disappointing, with the MSCI EAFE index -3.01% and European stocks declining -5%. The Eurozone has continued to struggle with weak economic growth and deflationary pressures, while negative interest rates designed to boost economic growth have had the unintended consequence of weakening financial institutions critical to future growth initiatives. European exporters were hurt by a stronger Euro and weaker global demand particularly from China, while major European drug companies declined due to similar politically-related pricing concerns faced by US competitors. After strong performance in 2015, Japanese markets reversed course in the first quarter declining -6.5% (-12.7% in local currency). Japan’s economy contracted for the fourth time in seven quarters, with the strengthening yen hurting Japanese exporters and recently implemented negative interest rates battering Japanese banks. Emerging markets were the bright spot for international investors rising +5.71% in the first quarter primarily driven by a rebound in energy and commodity prices, expectations that interest rates will remain lower for longer and stimulus actions by global central banks. Despite a rebound from market lows, China’s stock market declined -5%.
Driven by falling bond yields, the US bond market returned +3.03% in the quarter and outperformed developed stock markets. The US corporate and high yield bond market (referred to as the credit market) experienced losses during the market turmoil, though rebounded in the second half of the quarter with high yield bonds returning +3.25% and corporate bonds returning +4%. Expectations of further delays in Federal Reserve rate hikes as well as subdued inflation levels have helped to support bond prices in recent months. Yields on high quality US corporate debt and US government bonds remain attractive on a relative basis to international investors since much of the world is grappling with near zero or negative bond yields.
Allocations to high quality dividend stocks and mid-quarter rebalancing benefitted quarterly performance. We entered the first quarter with higher cash balances and a more defensive positioning across client accounts. Individual dividend-focused holdings added in 2015 across the telecom and utilities sectors were among the best performers, as investors rushed to add high yielding dividend stocks to portfolios in an attempt to reduce portfolio volatility. The same was true for client investments in value-oriented and equity-income focused mutual funds that tend to shine in difficult market environments. As the market decline continued into early February, we took advantage of depressed prices to rebalance client portfolios and add to existing positions, while also adding new investments in the financial services and media sectors. It can be difficult and oftentimes frustrating to buy when the market seems to move lower each day and media headlines scream the worst is yet to come. Yet, I have found that at those times where investing is the most painful and gut wrenching the greatest long term opportunities tend to emerge. As one noted value investor commented during the market selloff, “The stock market is the only place where when things go on sale no one wants to buy.” Efficient markets make sense in theory, but all too often we see fear and emotions driving short term market moves which provide excellent entry points for longer term investors.
Given the current market backdrop, what can we expect going forward? Many of the fears plaguing markets in the first quarter appear to have subsided, with oil prices rebounding, higher interest rates in the US failing to materialize, the US dollar weakening vs. foreign currencies and no immediate sign of an imminent collapse in the Chinese economy. With the Federal Reserve turning more cautious in recent months and recent policy actions from major international central banks, the current interest rate environment remains supportive of stock prices. Low interest rates drive investors into riskier assets seeking higher returns, which tend to drive stock prices higher and support higher market valuations. Low interest rates have also driven demand for dividend paying stocks, an area we continue to focus on with an emphasis not on the highest dividend yields but rather companies with attractive dividend payment policies and sound balance sheets, strong cash flow generation, good growth potential and reasonable valuations. Market valuations across US and developed international markets are in-line with historical averages, albeit more attractive on a relative basis vs. the low returns expected from bonds. While the S&P 500’s consolidated earnings have surpassed levels reached prior to the Great Recession, earnings remain depressed relative to historical levels across the MSCI EAFE index suggesting greater future return potential in developed international markets. That being said, US companies are expected to benefit from easier comparisons in the second half of 2016 as the prior year challenges related to a strong dollar and collapsing oil prices become less of a headwind.
Though markets have stabilized for now, a number of risks remain on the horizon warranting caution. The role of central banks across the globe has changed dramatically as countries prioritize monetary policy over fiscal policy to boost growth and inflation. The long term negative consequences of the current global experiment with negative interest rate policies remain unknown, and leave central banks with limited options in the future should the world face another major economic downturn. With upcoming presidential elections in the US, a scheduled UK referendum in June related to European Union membership and impeachment proceedings underway in Brazil, it would be naïve to think that we have seen the last of market volatility this year. Despite these risks, we remain optimistic that investment opportunities will continue to emerge and confident in the investment strategies implemented across client portfolios.
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