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:
|U.S. Large Cap Stocks||-1.3%||Emerging Market Stocks||5.8%|
|U.S. Small Cap Stocks||-1.5%||Commodities||0.4%|
|U.S. Real Estate||5.8%||U.S. Aggregate Bonds||3.0%|
|Overseas Stocks||-2.9%||International Bonds||7.7%|
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.