“What does that mean? Huh? ‘China is here.’”
- Kurt Russell as Jack Burton from the 1986 film “Big Trouble in Little China”
Markets whipsawed between gains and losses throughout the first quarter. Continued global growth concerns, renewed stress in Chinese markets, US political drama and divergent central bank policies all impacted markets in the first three months of 2016.
The US economy maintained some positive momentum. Based on the latest revised data, fourth quarter GDP increased at an annual rate of 1.4% following a 2.0% increase in the third quarter. This March 25th data point marked a positive revision from the originally lower estimate of +0.7% GDP growth. As discussed in our Q4 market commentary, inventory build-up represented an expected drag on fourth quarter growth. Nevertheless, consumption and residential investment continued to show signs of strength. As discussed in Massey Quick’s 2016 Market Outlook, we maintain our position that the consumer will continue to represent a positive growth driver. The labor markets continued to show signs of relative health. The February nonfarm payrolls figure released in March showed that employers added 242,000 jobs for the month while the overall unemployment rate posted further declines to 4.9%. Both December and January payrolls experienced positive revisions; however, critical wage inflation statistics appeared to take a step backwards.
The US Federal Reserve’s March meeting largely met expectations with the central bank opting not to increase interest rates. The Fed’s statement (and Chair Janet Yellen’s press conference) cited heightened global growth concerns and potential downside in inflation as key reasons behind the decision. The FOMC shifted its “dot plot” for future interest rates lower while further signaling that there would likely be only two rate hikes in 2016. These generally dovish indicators were further enforced by additional dovish commentary from Chair Yellen in a speech on March 29th. An accommodative Federal Reserve likely contributed to the first quarter reversal in the US Dollar’s uptrend. After rising in both Q3 and Q4 of 2015, the dollar fell approximately -4% to start 2016.
On the micro front, earnings results continued to be mixed. According to data from JP Morgan, 74% of S&P 500 companies beat earnings estimates in the fourth quarter. However, earnings growth continued to paint a worrisome picture with Q4 EPS growth clocking it at -7%. The embattled energy sector represented a meaningful drag on Q4 earnings; nevertheless, even if one excludes said sector, EPS growth was still negative for the first time since 2009 (data as of 3/2/16). The trend of recent lackluster fundamental results continues to raise questions about the future return potential of domestic equities following a multi-year rally from the depths of the recession. Expectations for Q1 2016 earnings remain largely pessimistic.
The 2016 Presidential election gained some clarity as the field of candidates narrowed meaningfully following a number of major caucuses. Nevertheless, there is still much ground to be covered between now and Election Day and there are concerns that the extreme views of certain candidates on both sides of the aisle pose risks to the US economy.
China was once again a source of meaningful volatility as signals of tighter liquidity and slowing growth weighed heavily on market sentiment early in the quarter. According to data released in January, China’s economy grew at 6.9% in 2015, the slowest rate of growth in 25 years. A common debate throughout the first quarter centered on whether the People’s Bank of China would engage in a devaluation of the yuan as a means to combat systemic leverage issues and slumping growth. While China concerns somewhat abated by quarter end amidst signs that capital outflows were slowing, questions will likely continue to dominate headlines in 2016.
Both the Bank of Japan and the European Central Bank featured prominently among the headlines in the first quarter. In the case of the former, a surprise move to negative interest rates in late January caught markets off guard as Japanese policy makers sought to combat lackluster inflation / growth data. The BoJ further reiterated its pledge to spur spending and inflation at a policy meeting in March. ECB President Mario Draghi followed suit at the ECB’s own much-anticipated March policy meeting: Europe’s central bank cut the already-negative deposit rates by an additional 10 basis points and boosted bond purchases from €60B to €80B. Additionally, Draghi noted that corporate bonds would now be eligible for asset purchases. Perhaps somewhat surprisingly, the market response to each of these accommodative actions was more muted than in previous instances as negative interest rates engendered banking sector stress and concerns about the reduced efficacy of quantitative easing.
Geopolitical tensions remained high as another tragic terrorist attack in Europe (this time at a Brussels airport in March) produced uncertainty. The European migrant crisis also showed no signs of slowing down. Additionally, the specter of a British exit (i.e. “Brexit”) from the European Union loomed large as the Mayor of London publicly supported a UK departure.
After meaningful declines in 2015, the price of WTI oil actually rose from $37.04/barrel to $38.34/barrel in the first quarter amidst signs of continued production cuts and (ultimately unfounded) rumors that Saudi Arabia would be willing to make a deal on production. Nevertheless, this slight rebound in prices belies the significant volatility that the commodity demonstrated in Q1: WTI’s route to this gain included a stop at $26 on February 11th and a high of $41 on March 22nd.
Equities demonstrated meaningful volatility to start the new year. January actually saw the S&P 500 enter correction territory (defined as a decline of 10% or more from highs) as both micro and macro worries weighed on investor sentiment. However, markets experienced a furious bounce that began in mid-February and continued through the quarter end. This move, which saw the S&P 500 gain +6.8% in March allowed the index to yield an overall gain of +1.4% for the first quarter.
International markets were not immune to the swings in investor sentiment and generally experienced similar levels of volatility. Results were generally mixed across regions. Despite continued accommodation from the ECB and BoJ, European and Asian equities posted muted results. For reference, when measured in US Dollars, the MSCI AC Europe index shed approximately -1.9% while the MSCI AC Asia Index fared worse (down -2.2%). In a departure from recent trends, emerging markets were actually a standout positive performer as the aforementioned rally saw the region ratchet upwards by over 13% in March according to the MSCI EM index. This meaningful move allowed for the region to post an overall gain of +5.8% in the first quarter.
Sector dispersion was meaningful in the first quarter. In the US, more stable utilities and telecom companies returned a whopping +15% and +17%, respectively in the first quarter as investors likely sought perceived safe haven equities amidst a volatile trading environment. In contrast, the healthcare sector (-5.5%) struggled as political pressure on drug prices and the struggles of several high profile pharmaceutical companies likely weighed on results. The financial sector was also a noteworthy laggard in Q1, posting losses of -5%. This move was not isolated to the US: concerns over a low/negative interest weighed heavily on banks around the globe in the first quarter.
Bottom Line: We still continue to view equities as an attractive source of long-term growth in portfolios. We believe that volatility creates opportunities and are monitoring exposures closely. Opportunistic rebalancing activity may be appropriate in market segments that see significant selling activity.
Global bonds posted gains in the first quarter with the Barclays Global Aggregate index advancing +5.9%. Accommodative central banks and a bid for safe haven assets likely contributed to a rally in debt instruments around the world. High yield markets posted a meaningful rally alongside their equity counterparts in late February/March. For the quarter, the Barclays Global High Yield Index gained +4.1% though most of this move can be attributed to the month of March wherein the index rallied +5%. According to data from JP Morgan, the riskiest segment of the high yield market was a meaningful driver of returns with CCC-rated securities (+4.6%) meaningfully outpacing their BB counterparts (+2.8%).
On a fundamental basis, the first quarter saw default activity creep upward. Based on data from JP Morgan, 21 companies defaulted in Q1 with the total dollar volume of defaulted bonds representing the fifth highest quarterly default total on record. Furthermore, these defaults pushed the high yield default rate up to approximately 4.5%. As might be expected, the energy/mining complex represents a meaningful portion of this default activity. Many market participants expect the debt default rate to continue to increase as companies experience financing pressures.
Trading liquidity in fixed income markets remained poor as the absence of large bank dealer desks continued to result in non-fundamental price movements in debt instruments. These moves were perhaps most pronounced in structured credit markets in Q1. Both commercial and residential mortgage backed securities demonstrated meaningful spread volatility in sympathy with equities and high yield bonds, while illiquid trading conditions often engendered wide bid/offer spreads. Similarly, CLO markets also struggled as concerns about underlying credit spread risk caused dislocations.
Bottom Line: We continue to approach credit markets with caution. First quarter price action has continued to highlight the dangers inherent in a lower-liquidity trading environment.
Based on preliminary index results, hedge funds yielded mixed results in Q1 with the HFN Hedge Fund Aggregate Index shedding -0.5%. Most strategies struggled during the quarter. The HFN Equity Hedge benchmark fell -1.6% to start 2016. Many popular hedge fund long positions continued to see volatility in the early part of 2016 to the detriment of long/short strategies. Additionally, short positions generally suffered in the significant market bounce that began in mid February. According to HFN, Fixed Income strategies also yielded mixed results and more directional Distressed strategies (-1.9%) continued to struggle. Market liquidity likely weighed on alternative credit. As was the case in the previous quarter, exposure to “crowded” hedge fund positions once again represented a potential pain point for many funds as widespread portfolio de-risking may have facilitated price declines. Movements in the first quarter may have been exacerbated by the rumored unwinding of a number of portfolios at several large multi-manager platforms.
Bottom Line: We are sympathetic to investor frustration with hedge fund performance. However, we maintain our position that increasing levels of volatility and market inefficiencies in illiquid assets create attractive opportunities.
Conclusion and Outlook
Our focus remains grounded in a dedicated, disciplined asset allocation framework for each client portfolio. We continue to believe that portfolio diversification across asset classes facilitates a broad opportunity set for delivering returns in an environment of increasing uncertainty.
1Source: Bureau of Economic Analysis
2Source: Bureau of Labor Statistics
4Source: Wall Street Journal (http://www.wsj.com/articles/china-economic-growth-slows-to-6-9-on-year-in-2015-1453169398)