DWM 2015 Year-end Market Commentary

Uncertainty imageIf you had to summarize the markets in 2015 with one word, it would be “uncertainty”. Much of the reason for the poor performance of stocks, fixed income, and alternatives can be chalked up to uncertainty…uncertainty of what the Fed was going to do with interest rates, uncertainty to when oil supply and demand will come into balance, and uncertainty surrounding China’s economy. In last quarter’s market commentary, we wrote about having just finished an awful August/September stock market drubbing, only to see equity benchmarks almost fully recover in October. Unfortunately, the good vibes didn’t last long as another sell-off commenced in December after the Fed raised interest rates for the first time in over nine years. The end result: 2015 going down as the first losing year since 2008 for many investors.

Here’s how the major asset classes fared in 2015:

Equities: The MSCI AC World Equity Index registered -2.4%. Emerging markets really took it on the chin, losing 14.9%, as represented by the MSCI Emerging Markets Index as falling commodity prices and the strengthening US dollar hurt these countries’ economies. On paper, the big cap US market benchmarks appeared to do better with the S&P500 only down 0.7% before reinvested dividends, but that is skewed by the outperformance of some of the largest capitalized names like Facebook, Amazon, Netflix, and Alphabet (formerly Google). Remove those names and the S&P500 would have similar figures to the Russell 2000 Small Cap Index (-4.4%) or the Russell Mid Cap (-2.4%).

Fixed Income: Fixed income investors aren’t jumping for joy at this year’s end. The Barclays US Aggregate Bond Index was up just a tiny bit, +0.6%; but the Barclays Global Aggregate Bond Index declined 3.2%. It was worse off in the high yield aka “junk” market which finished the year -4.5%. This index was weighed down by energy companies where long term solvency has come into question given these extremely low oil prices.

Alternatives: In theory, asset allocation using a diversified approach helps investors over the long run. This was a very untypical year in that the three major asset classes (equities, fixed income, and alternatives) finished the year with very similar small negative results, with the Credit Suisse Liquid Alternative Index down -1.0% for the year. We wouldn’t expect that trend to continue for 2016. For more detailed info on alternatives, please see our blog from last month at http://www.dwmgmt.com/why-alts/ .

At the time of this writing, the stock market is not off to a good start in 2016, with the Dow tumbling more than 1000 points in the first week, as the uncertainty of the Fed, China, and oil continues. But let’s chat about those three items.

  1. The Fed and interest rates: The Fed has indicated that it wants to keep raising, but at a very gradual rate. The last thing they want to do is harm the economy or US or global growth. In fact, Fed officials expect that rates will still be below 3.5% in late 2018. So this is not the same thing as slamming down on the brakes when going 80mph.
  2. China’s slow-down: This is not a one-time 2015/2016 event. China is undergoing a necessary and positive adjustment, shifting from an economy based on heavy manufacturing towards one based on service. This will take years to convert so investors should simply expect these type of headlines and not fear them.
  3. Oil prices: Consumers are loving these lower prices at the gas pump, but it’s creating havoc in the global markets. There’s a disequilibrium: demand is up, but supply is up more, way more! Many energy companies are suffering. Imagine if your paycheck got cut in half or more. It’s very hard to live on severely reduced income. You still have the same fixed costs. So what do you do? You can borrow money and hope for prices to recover, but they may not and you may go bankrupt. This ballgame is only in the middle innings and could get uglier. Fortunately, for the US consumer, these lower oil prices means extra money in our pocket which most likely leads to spending and boosting our economy even more.

2016 isn’t another 2008 in the making. Major market declines typically occur when the economy is heading south. That’s not the case as the US economy is one of the world’s healthiest right now: there’s strong job growth, solid inflation-adjusted wage growth, and cheap gas prices. For diversified investors, there are opportunities in areas where selling has been overdone and market cycles start to reverse. It’s been a rough start in 2016, but a long-term investor remembers to stay the course, be disciplined, and be rewarded in the end.

Uncertainty is the one thing that is certain about financial markets.  Expect it, but don’t fear it.

Brett M. Detterbeck, CFA, CFP®

DETTERBECK WEALTH MANAGEMENT

Ask DWM: What Does the Fed’s Decision Last Week Mean?

FED logoThat’s a very important and good question.

Last week the Federal Reserve decided to hold rates steady. The uncertainty as to when they will raise rates has been extended to at least October and, if not then, to December or beyond. A Fed rate hike has been in the air since March when the Fed removed the word “patient” from its press release, signaling it could increase rates for the first time in nine years. Rates were reduced to zero in 2008 during the financial crisis and haven’t moved since.

This uncertainty has made markets very skittish. After a January and February when all asset classes were up, March through July was flat overall. Since the week after July 4th, the S&P 500 has alternated between weekly declines and gains for 11 consecutive weeks. China’s devaluation of the yuan in August (see the DWM blog) and the related concerns about its growth and that of emerging markets, caused a 6-7% pullback in stocks in August.

As we have pointed out previously, investors hate uncertainty. It’s interesting though. History shows us that equities typically do well during the tightening cycle (raising of rates by the Fed) and a year after the initial rate rise. (This is based on results in seven different time periods from 1983 to 2004). Hence, the uncertainty may be more disruptive to the markets than the actual tightening (raising of rates).

It’s valuable to look at the Fed’s decision and related statements in greater detail. They did acknowledge the U.S. economy is expanding at a “moderate pace” with “solid job gains and declining unemployment.” There is concern, however, about global growth. China, which has been growing at double digits, is now expected to be 6.8%. And other emerging market countries are struggling, particularly those whose income comes from oil and commodities. A decade ago, China accounted for 9% of the world GDP, now it’s 16%. Emerging markets overall now account for 57% of world GDP, up from 46% in 2004. We’re all interconnected, so lower worldwide economic growth impacts business earnings and stock valuations.

The other key factor is that inflation has failed to reach the 2% Fed target the last three years. Furthermore, the Fed doesn’t expect it to get there until 2018. What the Fed is trying to do is gradually raise rates at just the right time(s) before inflation hits 2% such that there will be a nice “soft landing” near 2% without the economy heating up and pushing inflation up too much and too quickly. At the same time, if the Fed raises rates too quickly and causes the economy to cool down, inflation could decline or even move to deflation, which we want to avoid.

Based upon the statements from the Fed officials last week and other recent data, it appears likely we may have lower worldwide economic growth and low inflation for at least a few years. Plus we will need to continue to endure the uncertainty of when the Fed will raise rates. October? December? Next year? What does all of this likely mean for investment returns?

First, nominal investment returns are likely continue to be lower than historical values. Historically, since 1970, stocks have grown at an annual rate of almost 9% while inflation has been a little more than 4% per year. Hence, there has been a 5% real return earned by risking money and investing in stocks. For the same time period, bonds returned 6%, or a 2% real return.

Mathematically, therefore, if inflation is 2%, it is very likely that a diversified all-equity portfolio might earn 7% and returns on a diversified bond portfolio might be 4%. And, if economic growth is low or stagnant, that pushes valuations down and lowers returns as well.

Nominal returns for all of us are under pressure from three sources; low inflation, slowing global growth and Fed uncertainty. We can’t control any of those. What we need to do is focus on real returns, not nominal returns. And, we need to make sure our financial planning and investment return expectations for the next few years are based on lower inflation and lower nominal returns.

We’re happy to chat about this important topic at any time. Give us a call.

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