Market Watch - April 2016
Written by Rick Welch on April 1, 2016
We are pleased to provide you with our quarterly newsletter featuring the status of our investment class weightings, our interpretation of recent data and our outlook for the future. If you have any questions about any topic, we hope you will not hesitate to contact us.
Status of our Investment Class Weightings
Changes from our January 2016 Market Watch are noted in italic.
US Large Cap Sectors –
Overweight – Financials, Health Care, and Technology
Neutral – Consumer Discretionary, Consumer Staples and Energy (↑)
Underweight – Industrials and Materials
No Weighting - Utilities
US Mid and Small Cap – Maintain all weightings.
International Developed Markets – Maintain all weightings.
Emerging Markets – Maintain all weightings.
Alternative Strategies – Maintain all weightings.
Multi-sector Bond Funds – Maintain all weightings.
Investment Grade US Corporate Bonds – Maintain all weightings.
High Yield US Corporate Bonds – Maintain reduced weightings in select accounts.
Investment Grade Municipal Bonds – Maintain all weightings.
Data – Q1 in 2016 was a turbulent one for investors. In January and into early February the markets corrected for the second time in 6 months. The major indices recovered nicely and in 2016 we see the following year-to-date results: US Large Cap – DJIA (+1.49%) and S&P 500 (+0.77%), US Small Cap - Russell 2000 (-1.92%) and International - ACWX (-0.32%). During the quarter the Dow Jones Transportation Index (often a predictor of domestic stock price movement) rose sharply on improving data on freight moving through ports, on airlines, by rail and trucks. Volatility (as measured by VIX) peaked on January 15th at 30.95, only to fall back to 14.02 at quarter end, well below the long run average of 20.0. Domestic economic data for Q1 was mixed, showing slight improvement during the quarter. GDP for Q4 came in at +1.4%, which followed a stronger, though below trend +2.0% in Q3. During Q1, the yield on the benchmark 10-year US Treasury fell from 2.27% to 1.79%. Job growth in Q1 was good (averaging 200,000 jobs/month) and the national unemployment rate remained at 5.0%, in line with the mandate of the Federal Reserve. New weekly unemployment claims averaged 273,900 in Q1 (compared to 268,000 in Q4) providing a positive outlook for the domestic job picture.
Consumer confidence, as measured by the Conference Board, declined slightly during the quarter due to increased concerns about the prospects for the economy as well as the expectation that gas prices could increase in the year ahead. The March Business Outlook Survey by the Federal Reserve Bank of Philadelphia showed improvement in business conditions, with significant gains in shipments and new orders. The diffusion index (current activity) in March rose to 12.4, the first such positive reading in 7 months. The diffusion index (future conditions 6 months out) also increased to 28.8, its highest reading in 4 months. Data from the housing sector was volatile in January and February with new home sales (-7.0% and +2.0%) and housing starts (-3.4% and +5.2%) showing some improvement as we moved through the generally difficult winter season quarter. CPI declined 0.2% in February and over the last 12 months, the all items index increased 1.0%, a level below the Fed target of 2.0%.
Outlook – In January we wrote “Now that the initial rate hike is behind us, we think the Fed will look for 2 or 3 more hikes, each of about 25 bps, during 2016.” That now appears unlikely. At its recently concluded March FOMC meeting the Fed cut its 2016 guidance to two rate increases from four, signaling it was prepared to let the economy and inflation run a bit, at least in the short term. At her March press conference, Fed Chair Yellen said “Caution is appropriate” as she made clear the central bank is juggling mixed economic signals: a strengthening job market but surprisingly weak wage growth, and a resilient US expansion amid global weakness. As of this writing, the federal-funds futures market is pricing in only one 25 bps hike this year, which hike will probably occur at the September, November or December FOMC meeting. Since the initial rate hike in December (2015), Ms. Yellen has emphasized that Fed monetary policy will remain accommodative in the early stages of the rate normalization process and that the longer term pace of rate increases will be gradual. We assume the pace of rate increases will depend on realized and expected economic conditions both here and abroad. Rate increase expectations can move markets in many ways, including, a strengthening US dollar, declining prices for crude oil and commodities and a flatter yield curve. If we learned anything from the market response to the March FOMC meeting, it is that though the path of monetary policy may be uncertain, a slow-to-tighten Fed may now share the same view (cautious) of the economy and rate outlook as many investors.
In 2016, we will continue to see a strong correlation between oil and stock prices which have moved in sync on about 80% of the trading days since the start of 2015. The rebound in oil prices in the second half of Q1 (WTI rose 46.36% from $26.12 to $38.23) calmed investors and allowed most stock indices to regain ground lost in the first month of 2016. The accompanying optimism may be tempered by the realization that abundant oil supplies and weak global growth will limit much further improvement in the energy sector in the short-term. Nonetheless, we think that the worst for oil could be over. The recent recovery in price has brought some much needed relief to the equity and credit markets. Should we see some real, constructive supply rebalancing this spring and summer, we think prices could move higher to about $50, though we must acknowledge the risk of a renewed drop below $30 is possible along the way.
For the current rally in equity prices to continue, we must see an earnings recovery from what is expected to be a disappointing Q1 earnings season for companies of the S&P 500. An early read predicts a drop of 8.7% from the year-ago quarter which would mark the first time the index has seen 4 consecutive quarters of year-over-year earnings declines since Q4 2008 through Q3 2009. While much of the earnings shortfall blame can be placed on the energy sector, only 3 of 10 S&P 500 sectors are expected to show earnings growth in Q1, they are consumer discretionary, telecom and health care. In our view, one headwind to earnings growth that has been downplayed is the strong dollar seen throughout 2015. Diverging monetary policies both here and abroad in 2016 should result in a weaker headwind, a condition which if combined with continued strong US employment growth and moderate inflation could create an environment for earnings growth to reaccelerate to a moderate pace over the near term.
