Markets bounce back . . .
After a dismal start to the year, financial markets bounced back in March. For the month, the Dow Jones Industrial Average was up 7.22 percent, the S&P 500 Index gained 6.78 percent, and the Nasdaq was up 6.94 percent. For the quarter, the Dow moved into positive territory for the first time this year, gaining 2.20 percent, as did the S&P 500, gaining 1.35 percent. The Nasdaq is still down for the year, having lost 2.43 percent for the quarter.
A return of investor confidence was responsible for the March recovery. Major fears that had driven markets down earlier in the year began to ease. For example, the dollar started to pull back from its gains and the price of oil started to rise, suggesting that the global economy was not headed for a crash. With prospects for the future on the rise, investors reentered the market and bid prices back up.
Fundamentals, however, remain weak, though there are signs that they may be improving. Corporate earnings for the first quarter of 2016 have been revised down substantially, from an expected gain of 0.8 percent to a decline of 8.5 percent, according to FactSet. If this forecast becomes a reality, it would be the first time since 2009 that earnings have been down four quarters in a row. Revenues are also expected to decline, for the fifth quarter in a row, which would be the worst performance since 2008. All ten sectors are expected to show declining earnings. In short, expectations for the first quarter are very low across the board.
On the other hand, although it is quite early, 13 of 15 S&P 500 companies that have reported earnings for the first quarter have beaten expectations. During periods of low confidence such as the past couple of months, expectations often drop so low that they can be easily beaten, and that may be happening here. If so, it could well continue to be a positive for U.S. markets.
From a technical standpoint, things are on the upswing. All three U.S. indices have moved back above their 200-day moving-average trend lines, often a sign of continued strong performance. Moreover, the improvement over the first two months of 2016 has been substantial.
Developed international markets also performed strongly in March. The MSCI EAFE Index rose 6.51 percent, slightly below the results for U.S. indices but still a good result. Although risks remain in Europe—notably the possible exit of the U.K. from the European Union (EU)—strong action by the European Central Bank (ECB) helped ease financial and economic fears.
Meanwhile, the MSCI Emerging Markets Index recovered from previous poor results in a spectacular fashion, gaining 13.26 percent, based largely on a weakening dollar, which greatly reduced perceived systemic risks in those markets. For the quarter, the EAFE stayed in the red, losing 3.01 percent. Emerging markets, however, climbed back into positive territory, up 5.75 percent, making this the best-performing category.
Technically, the EAFE remains well below its long-term moving average, so risk is still there. The emerging markets index, however, moved just above its long-term trend line, suggesting that the outlook may be changing to positive for those markets.
Stock market gains did not prevent the fixed income sector from also doing well. The Barclays Capital Aggregate Bond Index was up 0.92 percent in March, spurred by improvements in credit spreads, as buyers became more confident and interest rates remained relatively unchanged. High-yield bond returns were evidence of this, as reflected in the Barclays Capital U.S. Corporate High Yield Index, which posted a substantial 4.44-percent uptick. For the quarter, however, returns for the aggregate bond and high-yield indices were comparable, up 3.03 percent and 3.35 percent, respectively. This reflected the decline and recovery of the high-yield market, which moved much as the stock market did.
. . . While the economy slowly improves
Despite the more dramatic recovery in the financial markets, the real economy continued to show signs of only slow growth. Even though job growth remained strong, averaging gains of more than 200,000 per month for the quarter, details were less supportive. Wage growth data has been mixed, and labor demand in hours worked per week has ticked down. Consumer confidence has therefore not grown at the same rates as employment during the quarter, and spending growth has suffered.
This differential was clearly reflected in personal income and spending releases. Personal income growth dropped to 0.2 percent, and spending growth was even weaker at 0.1 percent. These pullbacks after a strong previous month suggest that sustained growth in spending remains elusive. This situation matters because other sectors have also been in a slowdown.
Even as consumers continued to stagnate, there were signs of improvement in the business sectors. The ISM Manufacturing survey returned to positive territory at March-end, and regional manufacturing surveys also showed substantial improvement. With industry stabilizing as the dollar weakens, a major headwind for the economy is fading. Housing continued to show price increases, helping consumer net worth, and both housing starts and sales were well above the levels of a year ago.
Overall, in the first quarter, the economy continued to suffer from the same headwinds—a strong dollar and low oil prices—that had previously pulled the stock market down. In many respects, the damage has been deeper, as it has affected consumer confidence. We did, however, see positive signs as of March-end; for example, both major consumer surveys beat expectations, showing rising confidence levels for the period. So there appears to be a real chance for improvement into the spring.
Global recovery risks remain
Economic reports for the quarter for the rest of the world were mixed, but sentiment improved on continued governmental policy support. China’s lower economic growth became less of a concern, as its government continued to increase policy stimulus, which should decrease short-term risks there. In Europe, ECB action was broader than expected, as it increased bond purchases by one-third, which should support the real economy there, although the effects on the stock markets were mixed. A sour note came from Japan, as it continued to disappoint during the quarter, with extended policy stimulus having had no apparent effect on real growth.
Despite the general improvement in the international economic picture, political risks remain—primarily in Europe. With Britain committing to an “in-or-out” referendum on EU membership, the risk of an EU breakup rose to unprecedented levels. With the continuing refugee crisis eroding the continent’s open-border policy and anti-EU parties gaining strength in France, Germany, and other countries, the EU’s ability to survive politically looked even more difficult.
In the short term, Europe’s economic situation continued to stabilize, with Germany and other major countries still evidencing signs of growth. Smaller countries also showed general signs of progress. Nevertheless, although an EU breakup still remains unlikely, for the first time in a generation it has become a possibility worth discussing—and that continues to worry financial markets.
Oil turns around
A major factor rocking markets has been the price of oil. Prices dropped in the first quarter to levels below those in the financial crisis, but a sustained recovery to levels perceived as more normal in March suggested that, rather than signaling a global collapse, oil was merely experiencing a normal price adjustment. Although prices were down again at March-end, they remain well above the lows that sparked concern earlier this year. Oil’s decline and subsequent recovery are clearly illustrated in Figure 1.
Figure 1. WTI Crude Spot Prices, First-Quarter 2016 (Source: Bloomberg)
Even as the price of oil has normalized, however, it is low enough to continue to stimulate spending. U.S. car sales, for example, remain at high levels, largely driven by low gasoline prices, and other areas of the world are benefiting from low oil prices even more than the U.S. Moreover, higher prices and industry adjustment mean that the economic damage will continue to abate. With prices moving up to more normal levels, and little apparent risk of an unhealthy spike, the potential for the gains to outweigh the pain continues to grow.
One big step forward after two steps back
The substantial market recovery in March was a very encouraging end to a sometimes frightening first quarter. Nevertheless, it is important to remember that, although we have largely recovered from the spike in uncertainty earlier in the year, risks remain. Even as the U.S. economy grows, the recovery is somewhat uncertain.
Politics, too, are a substantial factor. Depending on the course of the election campaign, confidence may still be at risk. Outside the U.S., a rising concern, as previously noted, is the pending U.K. in-or-out referendum. If the British vote to leave the EU, the political shock waves could be severe.
Although we expect the U.S. economy to keep growing, the continuation of last year’s weak fourth quarter into the first quarter of 2016 shows that this is by no means guaranteed. In short, although markets have largely recovered from the collapse in confidence at the start of the year, uncertainty remains.
Therefore, despite the strong March market results, we believe that it is important to maintain an in-for-the-long-haul perspective. As we have seen this quarter, the markets will have good and bad months. Over time, however, a diversified portfolio focused on the long term can help investors achieve their goals.
All information according to Bloomberg, unless stated otherwise.
Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
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Authored by Brad McMillan, senior vice president, chief investment officer, at Commonwealth Financial Network.
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