The U.S. stock market got off to a rocky start in 2016, and the first quarter went into the history books as “a tale of two halves”. The first half started off terribly with renewed economic concerns, worries over the state of China’s economy, a 30% decline in the price of oil and an immediate market correction of 10.30% for the S&P 500 Index. Then, about halfway through the quarter, thanks to improving economic data and market-friendly central banks’ actions, the market turned around and the S&P 500 Index posted a 1.35% positive return. The Dow Jones Industrial Index exhibited its best quarterly comeback in decades, ending the first three months of the year with a 2.20% advance. Despite a strong month of March, the Nasdaq Composite Index and the Russell 2000 Index of small capitalization companies remained in negative territory, falling by -2.39% and -1.53% respectively.
The international markets posted mixed results. The MSCI Emerging Markets Index, last year’s worst performer, suffered further steep losses in the first six weeks of 2016 before rebounding and finishing the quarter with a 5.37% gain. A strengthening dollar, falling commodity prices and fears of deflation created headwinds for many developed countries, and the MSCI EAFE Index ended the quarter with a 3.74% loss.
Through all the ups and downs it was a strong quarter for fixed income assets. The Barclay’s Capital Aggregate Bond Index advanced by 3.03%. On the flip side, interest rates dropped sharply during the first quarter, and the decline in the 10-year Treasury yield over the first six weeks of 2016 was one of the steepest for such a short time period.
Economic growth was stronger in the fourth quarter of 2015 than was initially reported, with real GDP growth being revised upward to a 1.40% annualized pace from the previously released value of only 0.70%. Upward revisions to the services component of personal consumption and a smaller drag from trade were largely responsible for the improvement, while inventory investment was a slightly larger strain than previously reported. Another solid gain in personal consumption services is encouraging and highlights the strength of the domestic economy.
Also encouraging was the fact that the manufacturing sector appeared to be stabilizing and even showed some signs of returning to growth. Regional and national surveys posted nice increases during the quarter, reaching the highest levels since 2010.
More importantly, almost 2.7 million net new jobs were added across sectors last year, and the average pace has remained in excess of 200,000 jobs per month through March of this year. Unemployment inched up to 5.00% recently but only due to the increase in labor force participation. Hourly earnings for American workers increased by 2.50%. Leading indicators of further job growth such as initial jobless claims show no real sign of a slowdown.
The U.S. consumer, the cornerstone of the economy, continued to benefit from low energy prices, low unemployment, higher wages and reduced debt loads. Housing, the sector that has been a strong point through the entire recovery, has recently shown signs of cooling off a bit as existing home sales fell 7.10% in February while new homes rose by 2.00%. However, the data shows that millennials are increasingly looking to settle down and buy their own homes, which should continue to provide an upward push to housing, especially with mortgage rates remaining historically low.
The Federal Reserve appeared ready to embark on a series of interest rate increases in the beginning of 2016 after determining during its last meeting of 2015 that the economy was strong enough to handle it. Yet big losses in the stock market early this year, slowing U.S. growth and fresh worries about the global economy spurred the Fed to back off. The Federal Reserve also signaled that it will lift rates more slowly than previously indicated.
After a churning and volatile beginning of the year, it looks like now we have entered a relatively calm investment world, admittedly of uncertain duration, marked by reduced fears yet moderated expectations. We recognize that increased volatility could reemerge at any time – markets are jittery, and investors are still swinging between fear of recession, relief when it does not happen, and anxiety when good economic news brings U.S. Federal Reserve back onto the radar.
While the Federal Reserve is not in the process of lifting short-term rates, which some see as a threat to the economy, we, to the contrary, think that current rates, which are near historic lows, still should be viewed as very accommodative. Also, the Fed has calmed investors’ fears by indicating its sensitivity to the U.S. and international economies and the financial markets. The Fed will probably raise rates modestly in June, but this is not likely to derail the economy or severely disrupt markets.
We agree that from a pure valuation perspective the U.S. looks relatively more expensive than other developed equity markets. It is important to note, however, that the U.S. looks more attractive from a recessionary risk perspective as well. Moreover, equities still look attractive versus government debt, offering dividend yields above current yields on the 10-year U.S. Treasury bond.
In our view, the near-term U.S. stock market gains for the rest of 2016 will likely continue to be modest and limited by expected scanty profit advances reflecting a year-over-year rise in the dollar and low energy prices.
Dumont & Blake Investment Advisors, LLC
March 31, 2016