U.S. markets were initially range-bound for most of the quarter until June, when the relative calm in global stock markets came to an abrupt end. Upending most forecasts and taking world financial markets by surprise, the United Kingdom voted to leave the European Union on June 23. In the wake of the vote, British pound sterling fell 11% overnight against the U.S. dollar, its lowest level since 1985. The euro fell 2.4% to 1.10 versus the dollar. Global equities plummeted.

 Then in the week following Britain’s historic vote, global equities rallied despite significant uncertainty regarding the economic, political, and financial market implications of Brexit.When the dust had settled, developed international and European stocks remained in the red, while U.S. stocks edged into positive territory. The big winners in the quarter were emerging-markets stocks, which gained 2.6% and are now up 6.6% year to date.

As the second quarter ended, investors could be forgiven for feeling both bruised and battered. In the aftermath of the Brexit vote, global financial markets initially hit the panic button. Following the vote, stocks fell, bond yields dove, and both the British pound and the euro swooned. The markets demonstrated the typical flight to safety, with U.S. Treasurys, the U.S. dollar, Japanese yen, Swiss franc, and gold all rising sharply.

Here are the broad index returns through the Second Quarter of 2016:

There are a number of positives in the U.S. economy. Historically low oil prices and high domestic production have lowered the cost of doing business and the cost of living in the United States. Both are a boon to the economy, which is on track to grow at a 2.0% rate this year. Although hardly dramatic, this growth rate is sustainable and not likely to overheat the different sectors of the economy which could lead to a recession. Manufacturing activity is expected to grow 2.6% for the year based on the numbers so far, and the unemployment rate has fallen to 4.7%, below the Federal Reserve target. The unemployment statistics are almost certainly somewhat misleading in the sense that many people are underemployed, and a sizable number of working-age men are no longer participating in the labor force. But for many Americans, the employment picture is much better now than a few years ago. By a number of measures, the U.S. economy seems to be comfortably plodding along.

Uncertainty remains in the Eurozone. A recent report by Thomas Friedman of Geopolitical Futures suggests that the EU, at the very least, is going to have to reform itself and the vote in Britain could be the wake-up call it needs to make structural changes.  The Eurozone has been struggling economically since the common currency was adopted.  It is still dealing with the Greek sovereign debt crisis, a potential banking crisis in Italy, economic troubles in Finland, political issues in Poland and a wealth disparity between its northern and southern members. Nevertheless, Friedman thinks the UK will be just fine, because Europe needs it to be a strong trading partner.  Britain is Germany’s third-largest export market and France’s fifth largest.  Would it be wise for those countries to stop selling to Britain or impose tariffs on British exports?  Cooler heads are likely to prevail.

The quarter’s market upheaval was yet another reminder that successful investing requires patience. Investing is part of a process, not a one-off decision, toward achieving your long-term financial goals. On the first day of July, the Dow, S&P 500 and Nasdaq indices were all higher than they were before the Brexit vote took investors by surprise. This suggests, yet again, that the people who let panic make their decisions lost money while those who kept their heads sailed through.  There will be plenty of other opportunities for panic in a future where terrorism, a continuing mess in the Middle East, a refugee crisis in Europe and premature announcements of the demise of the European Union will deflect attention away from what is actually a decent economic story in the U.S. There will be inevitable and unpredictable shorter-term market ups and downs along the way, and through these periods, it is our job to remain focused on the long-term objectives of our clients, maintaining a consistent investment discipline to guide our decisions over time.

It was a tale of two halves in the first quarter of the year for global financial markets. Stock markets plunged early on, but then sharply reversed, staging a furious rally into the quarter-end. Emerging-markets stocks led the charge, gaining 5.8% for the quarter. Larger-cap U.S. stocks also finished in the black, up 1.3%, though domestic small-cap stocks trailed, down 1.5%. The 10-year Treasury yield fell .49% year to date and core bonds gained 3.0%.

As is often the case, there was no single obvious catalyst for the turnaround that began on February 12. There was speculation in the news that major oil producers might be ready to cooperate to cut oil output. At the same time, the head of the Federal Reserve Bank of New York dismissed the likelihood the Fed would need to adopt a “negative interest rate policy,” lowering the interest rates to below zero in order to encourage lending and investments, given the U.S. economy’s strength and momentum. Then, over the following weekend, the head of the Chinese central bank stated it saw no basis for further yuan depreciation. Amidst other positive data points, these would ultimately lead to additional investor optimism.

Governmental policies helped to continue to fuel the rebound. The rally continued in March on the back of better economic news in the United States, dovish European Central Bank (ECB) and Fed actions during the month and monetary and fiscal stimulus in China. On March 10, the ECB went deeper into negative rates, cutting its policy rate to negative 0.4%—its third rate cut since adopting their negative interest rate policy in June 2014. The ECB also expanded quantitative easing bond purchases by €20 billion per month (to €80 billion) and will also now include investment-grade, non-bank corporates in the program, boosting prices for such bonds. Their actions are intended to add liquidity to the economy and boost growth.

Here are the broad index returns through the First Quarter of 2016:

Economic Outlook
In the United States, the Federal Open Market Committee held its mid-March meeting and did not raise the federal funds rate, stating that “global economic and financial developments continue to pose risks.” But it also highlighted solid U.S. economic fundamentals, lowered its projection of the number of rate hikes for the rest of the year (from four to two) and communicated both a slower pace and a lower trajectory of rate hikes than what it had projected in December. Financial markets responded positively to the Fed announcement, with stocks and oil/commodities continuing to rally and the dollar falling. After peaking in late January, the dollar (whose prior rise was likely driven in part by anticipated higher U.S. rates) ended the quarter down more than 4% for the year.

More generally, global monetary policy is moving deeper into uncharted, historically unprecedented territory, bringing with it unknown and unintended consequences. This continues to be a key uncertainty and risk as we construct and manage investment portfolios for a range of potential outcomes. How and when will the current extreme monetary policies be “normalized” and how will they impact the global economy and financial markets? No one knows.

The investment outlook—both in terms of potential return drivers and risks—has not materially changed over the past quarter. But in the context of the market’s recent gyrations, there are reasons for optimism that the relative performance trends (e.g., recent outperformance of foreign stocks versus U.S. stocks) may be sustained for a while. For example, last year marks the 6th of the last 8 years that the U.S. market has outperformed foreign stocks. This is the longest run of U.S. stock outperformance since the inception of the index in 1970. Unfortunately, much of the most recent appreciation in the U.S. stock market has been concentrated in growth stocks which have become expensive relative to historical benchmarks. In fact, lower cost “value” stocks have underperformed higher cost “growth” stocks for nearly the last 10 years. This has been the longest run of underperformance for value stocks on record going back to 1930. In contrast, developed international and emerging markets are almost a mirror image of the U.S market, with below-normal earnings and the potential for faster earnings growth from current levels. And valuation multiples have room to expand somewhat from current levels as earnings improve, thus increasing stock prices and enhancing portfolio returns.

As we look back on the financial markets in 2015, returns were poor across the globe and across asset classes (stocks, bonds, commodities, etc.). Among the major global stock markets, the United States was the best performer. Unfortunately, the S&P 500’s whopping 1.4% return was driven by a handful of large tech/Internet companies (e.g., Facebook, Amazon.com, Netflix, and Google) which generated huge gains and helped propel the index into positive territory. The equal-weighted S&P 500 index actually fell 2.2% for the year.

The difference in the U.S. economy and monetary policy versus other major global economies was one striking feature of last year’s investment environment. In December, the U.S. Federal Reserve was so comfortable with the outlook for economic growth and the potential for inflation to eventually normalize that it made its first increase in interest rates in nearly a decade. Outside the United States, regaining more normal economic growth and inflation has remained more challenging due to sharply lower commodity prices (most notably oil), Middle East tensions, and China’s slower economic growth. Year-end foreign stock prices ended lower, reflecting this bifurcation. As in 2014, the strength of the dollar exacerbated foreign markets’ underperformance for dollar-based investors, detracting 9% from emerging-markets stocks and 6% from developed international stocks Ccompared to their local-currency returns. Commodity indexes were down on the order of 25% as oil prices hit an 11-year low in December and fell 30% for the year.

Fixed-income offered little respite. The core bond index gained just 0.6%, high-yield bonds were down close to 5% and floating-rate loans lost 0.7%.

Here are the broad index returns through the Fourth Quarter of 2015:

Economic Outlook

The investment thesis for European and emerging-markets stocks has not changed materially over the last few months. Analysis suggests both markets are undervalued relative to their normalized earnings potential looking out five or so years. Those investments should benefit from stronger-than-expected earnings growth and the current allocations to European and emerging-markets stocks should yield outsized returns over a reasonable time frame.

Conversely, when it comes to U.S. stocks, the tactical outlook over the coming five years is much less positive compared to emerging-markets stocks and European stocks. Analysis suggests that U.S. valuations are still high and with U.S. corporate profit margins also well above normal, there is the potential for disappointing earnings growth and slow growth in stock prices over the next few years.

Effective portfolio allocation is based on a long-term view of the market. Financial market history is a history of cycles, like the swings of a pendulum, moving from one extreme to another. Market history teaches that undervalued assets can fall further and overvalued markets can overshoot on the upside. The tech bubble of the late 1990’s is one recent example of this. This type of volatility is simply the reality that comes with being a long-term equity investor.

Nevertheless, sound investment philosophy is based on the belief that fundamentals ultimately drive investment returns. The value of an investment is generally determined by the cash flows the investment generates over time. This type of valuation is a very poor short-term market indicator. But over the longer term and over full market cycles (five to 10-plus years), history has shown that valuation is a powerful driver of returns. Simply enough, studies show that if you buy an investment when it is relatively expensive, your returns will likely be lower over time. Alternatively, if you buy an investment when it is relatively inexpensive, your returns will likely be higher. Buying undervalued assets pays off, but it may take a little while for the markets to turn in their favor. To be successful, one must be disciplined and patient.

Financial Planning (Not Investment Returns) Insures Retirement Success

After mediocre (or negative) returns like the markets have produced over the last couple of years, investors often begin to question the underlying assumptions and the expected returns for their portfolios. Retirees often begin to fret over the viability of their long-term goals, fearing that they will eventually run out of money.

It is the helplessness created by the seemingly random series of returns that creates worries. However, there is a solution: At the intersection of “What Matters” and “What You Can Control” is the area where you should spend your energy. We all know what matters: living comfortably through retirement, giving to those in need, having peace of mind, etc., but what can we control? We know that we cannot control when the market goes up or down or what our return will be in the next few years. However, there are a number of things you can control to insure you are able to achieve what matters:

1) minimizing income taxes

2) consistently rebalancing to insure you are buying when stocks are cheaper

3) maintaining a long-term perspective

4) controlling spending and the timing of expenses relative to the portfolio value

5) lowering portfolio costs

6) diversifying the portfolio to mitigate risk, etc.

Take the worry out of the portfolio volatility by allowing BFA to assist you in developing your financial plan and staying focused on the things you can control. This is how you can insure that you are successful in the long run.

The Third Quarter proved to be quite an eventful one this year. 

Increasing concern about China’s economy, accompanied by a surprise devaluation of the yuan currency, helped trigger a sharp drop in global equity markets.  In late August, the S&P 500 fell 12% from its high reached just a month earlier. It then bounced briefly from its August 25 low but dropped an additional 2.5% in September, ending the quarter down 6.5%. This marks the first negative quarterly return for the index since 2012. Developed international stocks, as measured by the Vanguard FTSE Developed Markets ETF, also dropped 12% intra-quarter, from high to low. For the quarter as a whole, they were down 9.7%. Emerging-markets stocks fared the worst, dropping 21% from their intra-quarter high in early July to their low on August 24. For the quarter, the emerging-markets stock index was down 18%. That return includes several percentage points of losses to dollar-based investors from the continued depreciation of emerging-markets currencies against the U.S. dollar.

In fixed-income markets, the core bond index gained about 1% during the U.S. stock market’s 12% intra-quarter drop. While this was strong relative outperformance versus most other (riskier) asset classes, with yields on core bonds so low (around 2.3%), their potential to generate strong absolute/positive returns over any meaningful time frame is very limited.

Here are the broad index returns through the Third Quarter of 2015:

Economic Outlook

The recent correction was not a surprise. Given the market’s historical pattern of corrections, there was no surprise in the volatility the market exhibited in the third quarter. That is not to say that we were predicting a correction would happen or what the triggers or catalyst might be. Short-term market predictions are a fool’s errand, and history doesn’t exactly repeat. Nevertheless, knowledge of the market’s history and its cycles are useful for putting the present moment into context and thinking through different potential scenarios, risks, and investment opportunities. Otherwise, fundamentally, the economic outlook has not significantly changed from earlier this year.

The big question looming for the markets over the quarter was whether the Federal Reserve was going to raise interest rates for the first time in more than six years. Ultimately, the Fed decided to hold off on a rate hike, citing that “recent global economic and financial developments may restrain economic activity somewhat…” Fed Chair Janet Yellen pointed specifically to the recent developments in China and emerging markets as factors that gave them pause. Nevertheless, thirteen out of the 17 Fed policymakers indicated they expect to raise rates at least once this year, with six of the 13 expressing a preference for two rate hikes. The next FOMC meeting is scheduled for October 28^th.

Declines create tax-loss opportunities. The reality of owning stocks is that, inevitably, the portfolio will experience bear market losses. In fact, just since 2010 the U.S. market has experienced 5%+ declines a total of 23 times!¹ Owning bonds and other “safe” assets help mitigate the declines, but this interim volatility also creates opportunities to capture tax losses. By selling off some of the positions that have declined and reinvesting in similar positions, a portfolio can capture losses to reduce overall tax liability while still participating in any market recovery. Essentially, it’s making lemonade out of the markets’ lemons.