Market & Economic Review - First Quarter 2016
2015 turned out to be a tepid year return wise, as all major asset classes were bunched together with the S&P 500 up only 1.38% for the year. Comparing stocks, bonds, and cash, it was one of the lowest return years in U.S. history, as one class is usually significantly positive for a given year. For most of the year, markets were anticipating an increase in rates by the Fed, which came much later than most had anticipated. China and the ongoing weakness in energy prices headlined most of the second half of the year. Most investors heading into 2015 were anticipating a Fed hike in late Summer/early Fall. Energy prices remained low, keeping a lid on inflation, while China weakness hit the radar screen just before the third quarter Fed meetings.
Asset Class Returns, 4Q 2015
It looked evident during the first half of the year that the Fed would raise rates in September or October. Energy prices looked to have bottomed out, and housing prices were moving higher. Believing that CPI would soon hit the 2% threshold and employment continuing to remain strong, the Fed would finally have cover to start the process of normalizing U.S. Monetary Policy. Oil prices were back up to $60/bbl in June, and the U.S. economy was growing (albeit slower than in the past). Then in August, oil was back down to $40/bbl, and China decided to devalue the Yuan, causing a sharp global sell-off in equities. From there the market focused on whether or not the Fed would raise rates by year end. In December, markets had recovered for the most part, and employment stayed strong. The Fed made its decision to raise the Fed Funds Target Rate, and more importantly gave a forecast on raising 4 additional times in 2016. Going into the New Year, the markets began to discount the likelihood of a trajectory of rate hikes and concerns of a slowing China and slower world growth mounted.
Our outlook is for rates to increase more slowly than the Fed has forecasted, with maybe one or two additional hikes in 2016. The Fed is likely to have a methodical approach due primarily to the global risks of a stronger dollar and its effects on emerging markets, which has provided for the most attribution to global growth. The link between the U.S. raising rates connects to other global economies, contributing to lower commodity prices (as they are priced in dollars) and more importantly it puts pressure on currencies that are pegged to the dollar. China and Saudi Arabia are two major players on the macro scene who have their currencies pegged to the dollar. The dollar has been appreciating since 2008, and as a result, the Yuan and Riyal have moved up as well and strengthened relative to most world currencies. In the case of China, a strong Yuan has had some economic effects. China has predominately been an export-oriented economy with cheap labor.
Since 2008, China’s competitiveness has eroded and they have been reliant on cheap global credit to grow internally. As the dollar has continued to strengthen, this has caused China to look at devaluing their currency. The announcement in August of devaluation caught markets by surprise, and led to a quick and sharp decline in global equity markets hitting emerging markets the most. There is still a growing possibility that China will devalue anywhere from 15%-30% if the dollar strengthens again. In the case of Saudi Arabia, there is the risk of social unrest with a strong dollar and weak oil prices. The kingdom is reliant on oil revenue to maintain social order through generous public sector jobs and price subsidies. Saudi Arabia has one of the highest youth unemployment rates in the world, at the same time they are dealing with radicals in neighboring countries. They are forced to spend more on defense while their revenues are declining. Their monetary policy is limited with the dollar peg, and there is very little room for fiscal cuts without major social uprisings. All this goes to say that the Fed has a lot to think about when determining how fast to raise rates. We feel the negatives of raising rates too fast outweigh the negatives of being more methodical.
When we look at the investment landscape, we see a challenging environment. Valuations in the U.S. are not cheap from an historical standpoint. Earnings growth has been propelled by financial engineering and easy credit with little top-line growth. The headwinds of a strong dollar and weak commodity prices make the risks of investing in emerging markets even higher. We start the year with a more defensive posture, which includes holding more cash, favoring quality dividend-paying stocks, and being underweight International and Emerging Markets. We believe there is value in alternative investments to help reduce volatility and prefer individual high-quality fixed income securities. There will likely be a point in the year where we will find an opportunity to add more risk through emerging markets and possibly energy. The divergence between value and growth stocks has moved toward historical wide spreads. We like value over the long-term, but it has not been a good time to be overweight in value. In 2016, we think that the environment will improve.
The S&P 500 ended the year up 1.38%, underperforming International markets for the first time since 2009. Japan was the winner among major developed countries, while Emerging Markets struggled with a stronger dollar and declining commodity prices. We have observed mounting distortions in the market, as fewer stocks have managed to provide positive attribution to the S&P 500 for the year. The gap has widened between Growth stocks and Value stocks, as Growth outperformed Value by 9.49%. If we look at the top 200 stocks, Growth beat Value by over 11.5% for 2015. The market created a new acronym, FANG (FB, AMZN, NFLX, and GOOG), which provided most of the positive performance for the S&P 500. Unfortunately most managers were underweight those stocks, which meant that 73% of fund managers within Large-Cap Core underperformed the S&P 500. This is slightly better than 2014 when 84% underperformed. According to a report issued by T. Rowe Price, stocks in the Russell 2000 with negative earnings have outperformed those with positive earnings by 800 bps. From 1995 to 2012, stocks with positive earnings outperformed those with negative earnings by 1200 bps. In a world awash with liquidity and optimism of future growth, we get distortions that make little fundamental sense.
Coming into 2016 we are cautious. Fundamentals have broken down, and equity performance is being driven by money flows. Profit margins look to be peaking and credit markets look to be tightening. It appears the Fed is the only major central bank looking to raise rates, which will continue to create some headwinds in the short- to intermediate-term. The divergence in policy is likely to keep commodity prices lower which will affect emerging markets. The emerging markets are an area of potential growth, and we want to be an investor long term, but the current environment of lower commodity prices and strong dollar keeps us on the sideline. The chart below shows a strong correlation between emerging markets and commodity prices and if anything, emerging markets have held up better than the major decline in commodities. We would like more stability in prices before making a major shift in allocation.
Municipal bonds were the bright spot in fixed income for the year, with the Barclays Municipal Bond Index up 3.3%. The Barclays U.S. Aggregate bond index was up 0.55% while High Yield was off about 4.5% for 2015. The U.S. 10-Year Treasury was slightly higher at year end than at the beginning of the year, peaking at just below 2.5% in the Summer. In the first half of the year there were rising expectations for a rate increase and then the second half of the year experienced yield declines as it became evident that the Fed was not going to raise rates until year end. Credit conditions deteriorated throughout the year, and Energy weighed heavily on spreads widening.
At this juncture in early 2016, we are in the camp of lower rates for a longer period of time. Outside of housing there are few indications of price increases within the CPI. There is weakness in manufacturing while the service industry is in decent shape. The level of the National Association of Purchasing Managers Index (PMI) is currently at a level where historically there has been a very flat yield curve. In the past a yield cuve that inverts has preceded a recession (indicated by red shade in chart below). While it is not apparent that a recession is imminent, the odds are significantly higher than what has been priced into the market. This being said, we expect a prolonged flattening of the yield curve while long-term rates hold steady, and short-term rates increase. We like individual municipal bonds although the tax equivalency yield has become less attractive. We are currently avoiding high yield, but there could be some opportunities during the year to dip our toes in.
The review of alternatives for 2015 is very similar to 2014. There was disappointing performance from hedge fund managers as value continued to underperform growth, and large cap outperformed small cap. Long/short and Event Driven managers also struggled, and fundamentally strong companies trailed behind stocks with negative earnings. The bright spots were those able to ride the trends of a strong dollar and weak commodity prices. Commodity Trading Advisors (CTA) had a strong year, and Global Macro managers were mostly positive. In private equity, we may be presented with some good opportunities to co-invest with other family offices and operating partners. We are attracted to smaller managers in the growth capital and small/mid buyout space. In energy there are compelling options, and we have started to commit a small amount of capital to the space with conservative managers. In 2016 we will build out our exposure to private equity and ramp up investing in co-invest/direct deals. We are finding some of the best distressed opportunities since 2010 and will likely take advantage of them.
Synovus Family Asset Management Investment Team
Michael S. Sluder, Chief Investment Officer & Sr. Portfolio Manger
Andrea R. Parker, Senior Portfolio Manager
Zachary D. Farmer, Senior Portfolio Manager
Catherine E. Hubbard, Reporting & Operations
Comments and questions can be directed to firstname.lastname@example.org