Benchmark Returns through 12/31/2015
T-Bill 3-mo (Cash): 0.05%
Barclay’s Aggregate Bond Index: 0.55%
Barclay’s Municipal Bond Index: 3.30%
S&P 500: 1.38%
Russell 2000: (4.41)%
MSCI EAFE (International Stocks): (5.68)%
MSCI Emerging Market Stocks: (14.92)%
GSCI Commodity Index: (32.86)%
HFRX (Hedge Funds): (2.33)%
Data provided by Thomson Reuters
FINANCIAL MARKET PERFORMANCE
The fourth quarter of 2015 was marked with a recovery in asset prices from the third quarter. The U.S. large cap, U.S. small cap, international stocks and emerging market stock indices all finished the quarter higher. High yield bonds continued to struggle and didn’t rally with global stocks as oil prices, global growth fears, and decreased liquidity maintained downward pressure on riskier bond prices.
Gains in US stock indices were concentrated in some of the largest growth stocks. The positive performance of the S&P 500 in 2015 was not representative of most of the stocks traded on the NYSE. Much of the gains in the S&P 500 were attributable to the largest technology companies referred to many market commentators as the “FANG” stocks. This includes Facebook, Amazon, Netflix, and Google. These 4 stocks account for approximately 5.3% of the total market capitalization of the S&P 500 index.i Facebook, Amazon, Netflix, and Google rose in 2015 a respective 34.15%, 117.78%, 134.38%, and 46.60% for Google’s A Share Class. These Stocks contributed approximately 3.31% of the S&P 500’s total return of 1.38%. Without these four stocks, the S&P 500 would have finished the year down nearly 2%.
This is as crude oil finished the year at $37 per barrel. We expect oil prices to eventually recover from these levels, but this will only occur as the continued low prices drive lower investment in drilling new wells. As existing wells deplete at a faster rate than new wells are being drilled, the excess supply will shrink and the oil price will recover towards a higher equilibrium above the current levels.
GROWTH SLOWDOWN FEARS GROW
Chinese economic growth has continued to slow down. Survey data suggests that China’s broad industrial sectors are experiencing a recession. The People’s Bank of China, China’s Central bank, has been working to lower interest rates and increase liquidity throughout its financial system. Due to the ability of the People’s Bank of China to continue with further easing and the Government’s ability to engage in further stimulus measure, we believe a significant and widespread recession in China is unlikely in the near term. The effects of a slowdown in the industrial sector of China’s economy has significant ramification on the Chinese Yuan; as well as, the regional and global trade balances. This manufacturing slowdown has been felt globally as manufacturing focused economic data reflected slower manufacturing growth across a number of economies. Much of this is linked to oversupply in both energy and mining as well as larger than typical inventory reported by industrial firms.
Emerging economies have been impacted to a more significant level as more of their economic growth is tied to manufacturing, and natural resources when compared to many developed nations such as the United States.
The United States, and most developed economies rely much more on services and knowledge based industries such as retail, healthcare, and financial services for the majority of economic growth rather than mining or manufacturing. The services segment is typically more insulated than the industrial sectors of the economy. Some specific areas of the service sector, such as wholesale trade and transportation, are more sensitive than others, though they provide the U.S. economy a degree of insulation from the manufacturing slowdown.
The consumer based economy is slowly improving as employment numbers are still strong though some surveys shows an expectation for employment growth to struggle in certain industries. There is evidence of some wage inflation which will is expected at this stage of the recovery. The official unemployment rate is low and as there are fewer qualified employees, companies will be forced to compete with one another by offering higher wages.
There isn’t a labor shortage yet as people who were no longer looking for a job and have left the labor force are slowly entering. The industry specific issues and changes are also changing the mix of labor in the US. Some industries have been decreasing in size (based on total number of employees), and others have been growing steadily. The complexity and specialization required for many industries has increased significantly over the past few decades and these major shifts in employment often require significant resources in the form of employee training, frequently an undergraduate degree or in many cases a more advanced graduate degree. The number of employees in the manufacturing and construction industries have shrunk over the past decade while the number of people employed in the healthcare and education industries has risen. However retraining an individual working in manufacturing to a physician’s assistant is not a quick and cheap process.
The Federal Reserve’s Predicament
The Federal Reserve raised the Fed Funds Rate during its December meeting by 0.25% to a range of 0.25% to 0.50%. This decision was driven less by an expectation of higher inflation, though some inflation metrics are showing evidence of a slight increases, but rather the decision was driven more by the low unemployment rate and the Federal Reserve still maintaining an interest rate policy that was adopted during the emergency circumstances of the financial crisis.
While the overnight borrowing rate is a key metric to utilize when measuring the ease of obtaining credit by companies and individuals under normal circumstances, the effects of regulation and the difficulty experienced by many banks in lending to consumers fundamentally changed the impact of the benchmark interest rate in relation to the overall credit markets. This is evidenced by a statistic developed called the Shadow Fed Funds Rate, which was designed to show what the Fed Funds Rate would look like if it was not locked between 0% and 0.25%. This surrogate rate showed the benchmark rate bottoming at -3% in the summer of 2014 and starting to quickly rise in December 2014 to match the current level of the Fed Funds rate in December of 2015.ii This metric greatly explains the change in ability for many companies and individuals to borrow, as well as the broader tightening in credit markets. The effect is similar to a larger Fed Funds Rate hike given a more normal interest rate environment. The Federal Reserve had been signaling an intent on hiking interest rates 4 times in 2016, however most market participants expect this projection to be brought down, at maximum, to one hike in 2016, as recent economic data has disappointed. The effect of four hikes on the U.S. Dollar relative to other currencies would significantly impact exports and further slow glow. As many other central banks around the world continue with large scale unconventional monetary policies, the Fed is aware that increasing interest rates will have an outsized effect on the US Dollar, and commensurately growth expectations.
Although the benchmark rate was still near zero in the summer of 2014, the tightening cycle began with the taper. The end of QE3 was not an outright tightening, but it had the effect of reducing marginal liquidity in the marketplace. The removal of excess liquidity which was provided by the fed created an environment during which the effects of the Quantitative Easing programs in suppressing the volatility in riskier assets disappeared. While global growth fears grew in the second half of 2015, and earnings growth expectations fell the liquidity present during the past several years was removed, causing valuations of riskier financial assets to quickly drop while simultaneously the volatility rose sharply.
International developed equities continue to look attractive relative to other equities. Emerging markets face pressure from a normalizing US interest rate, and the long term prospects remain compelling, however the current environment is still negative for many of these economies. As these economies stabilize, the current valuations will likely offer opportunities in the future, however this is not likely to occur quickly. As the impact of lower commodity prices diminish, emerging market currencies stabilize, and investment flows return to emerging markets, these economies will offer attractive returns to investors. US stocks are less overvalued on an absolute basis, and appear to be reasonably priced when compared to other assets. Corporate profits may continue to be pressured as they are still near historically high levels, however revenue growth is expected to continue growing which will be supportive for earnings. The headwinds of a higher dollar continue to have a negative effect on exporters and this has driven stock prices lower of those companies most effected. European stocks are more attractive from a valuation viewpoint and offer potentially higher upside as Europe has further ground to regain in its own recovery. The effect of a cheaper currency for European companies has a positive effect on those companies’ earnings and we still expect those stocks to perform better than U.S. stocks.
The continued fall in interest rates throughout the second half of the year has continued to surprise those investors expecting higher interest rates. Bonds have rallied over the past six months as investors return find appeal in the safety of high quality bonds. While we still expect interest rates to eventually rise to a more normal level, we do not expect this to occur for some time. Inflation expectations remain low, and slowing economic growth makes high quality fixed income investments attractive relative to stocks as the certainty of coupons relative to the more variable earnings of companies which drive stock valuations.
Our portfolio construction process is built around a statistically-driven long term allocation to assets that have over time shown the ability to provide investors with returns commensurate with their investment goals without holding excess risk. Over the short term we understand that risks can arise that may be prudent to avoid. Our investment committee may decide to lower our shorter term allocations to specific asset classes and categories. Currently we find European stocks to be more attractive than similar U.S. stocks as the higher valuations in the US, and monetary policy in Europe are expected to benefit European stocks. Because of this, we currently have a higher proportion allocated to European stocks versus U.S. stocks compared to the long-term allocation. We are also maintaining a higher proportion of high quality fixed income investments compared to high yield than would normally be the case. Financial markets may soon offer attractive buying opportunities for long term investors, but currently this is an environment that requires a defensive posture that can allow investors to capture the inevitable future opportunities.
These are the opinions of James Regitz and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Diversification and asset allocation strategies do not assure profit or protect against loss. Indices mentioned are unmanaged and cannot be invested into directly. Past performance is not a guarantee of future results.