The big stories in 2015 were the plunge in commodity prices to a 16-year low, turbulence in China, and coming monetary policy “divergence” which contributed to strength in the U.S. dollar. These factors took their toll on various asset classes (global stocks saw their first annual decline since 2011) and market sectors (especially energy).
The S&P 500 posted a 1.4 percent total return in 2015. Corporate earnings were flat to down slightly for the year and P/E valuations remained unchanged at elevated levels. Smaller company stocks as measured by the S&P 600 were down 2 percent while REITs, a reasonable proxy for commercial property, gained 2.5 percent.
Many foreign stocks did well in their own currencies, but the gains were given back when translated to dollars. The EAFE developed country stock index was up 5.3 percent in local currency but off 0.8 percent in dollars. Emerging market stocks took it on the chin posting a negative 14.9 percent dollar return in 2015.
With bond yields very low, coupon income was not much protection against the modest increase in interest rates last year. The yield curve flattened with two-year Treasury yields up 0.38 percent to 1.05 percent, while 10-year yields rose 0.10 percent to close the year at 2.27 percent. Most high quality bond market returns were flattish, while the high-yield “junk” bond market was down 5.5 percent mainly because of worries over energy and market liquidity.
Commodities were trounced across the board. Oil lost $30 a barrel ending the year at $35. The broad based Bloomberg Commodity Index fell 24.7 percent and is at levels last seen in the late 1990s.
The bottom line was that most diversified portfolios, whether tilted to bonds or stocks provided a return of around +/-2 percent in 2015. This year will likely be better, but challenges remain. Our long-term return expectations remain subdued in the 7 to 9 percent range for stocks and around 2 to 3 percent for bonds.
Economic growth in the U.S. remains modest and is running just north of 2 percent. There has been pretty good news on the jobs front with the unemployment rate now at a low 5 percent and decent numbers on the services side of the economy (88 percent of GDP), but frankly poor data from the manufacturing side (12 percent of GDP).
We will get a nudge from fiscal stimulus in 2016. The recent federal budget deal turned previous temporary tax benefits permanent and provided for more spending to the tune of 0.6 percent of GDP. It’s positive for growth.
The Wall Street Journal reports that the current expansion is longer than 29 of the 33 dating back to 1854. Slow but sure may be frustrating but it means few imbalances have built up. There is no recession in sight.
Overseas, both Europe and Japan are rebounding from anemic growth. Economic growth will no doubt lag the U.S., but it is improving and supported by continued monetary easing and low oil prices.
China grew at 10 percent from 1980-2010, then downshifted to 8 percent in 2011-2014, and is now coming in just under 7 percent. That’s still strong and on a much bigger base. Still, China and the emerging markets in general are a wild card in the outlook.
Inflation is MIA throughout the globe, due mainly to weakness in commodities, sluggish growth and global competition. In the U.S. we may be seeing signs of wages perking up and while headline inflation is just above zero, the core CPI inflation rate is approaching the Feds 2 percent target.
Low inflation has allowed central banks to be ultra-easy and keep interest rates at rock bottom levels. In fact, rates in Europe are negative for many government bonds out to five years.
At yearend, the Federal Reserve finally began to raise short term rates — the first time in nine years. They have promised to go slow and caution that they are “data dependent.”
With many other central banks (Europe and Japan, in particular) keeping rates near zero for several more years and the Fed hiking rates, some believe the dollar will continue to appreciate. We aren’t so sure. Certainly some of this is “in the market” and in fact the dollar is maybe 10-15 percent overvalued on a purchasing power parity basis.
What to Expect in 2016
Keeping in mind the late Yogi Berra’s famous admonition that “forecasting is difficult especially when it’s about the future,” here are our thoughts:
It’s a slow and low world. Slow economic growth. Low inflation. Low interest rates. Probably low returns on financial assets. Seven years after the Panic of 2008 and Great Recession we are still suffering from the aftereffects of too much debt and challenging demographics.
After a seven-year bull market, U.S. stocks are fully valued, so future gains will hinge on earnings growth. Sales and earnings in 2015 were flat to down for S&P 500 companies, but are set to rise 5 to 10 percent according to the consensus. That might be aggressive, as profit margins may narrow owing to nascent wage pressures. Still, we expect modest gains in stocks.
We expect developed equity markets outside the U.S., (Europe, for example) to do better. Easy money, more fiscal stimulus, an expanding economy, and weaker currencies should give corporate profits a boost. And valuations are better than in the U.S.
While it’s a much tougher call, hope springs eternal with respect to the emerging equity markets. They have been trashed, but perhaps not enough to jump in yet. Valuations are better of course, but there is still considerable uncertainty.
The plunge in commodities is worrisome because it is so broad based. It not just oil and gas, which we might chalk up to a supply glut, it’s everything! It is suggestive of weak global demand. We will maintain our underweight to this asset class and not try and catch the proverbial falling knife.
It’s hard for us to get excited about foreign government debt boasting negative yields. In general we view bonds as expensive insurance in diversified portfolios. They will probably remain so given a dearth of safe haven assets.
Within separately managed bond portfolios we remain underweight corporate bonds but are watching for an entry point as spreads have widened making these bonds more attractive. While non-financial leverage has increased (fueled in part by stock buybacks), the banks have shored up their balance sheets and are quite healthy.
We expect the yield curve to flatten as the year progresses although don’t expect much of a sell-off in the intermediate and long end of the market. The Federal Reserve will be cautious and likely hike rates only twice this year keeping the federal funds rate below 1 percent.
Jeff Pantages, CFA, is the chief investment officer for Alaska Permanent Capital Management, a $3.5 billion investment management and advisory firm located Anchorage.