Last year marked the end of a multi-year winning streak for most major equity indices and a divergence in the fixed income markets. 2015 broke a string of three straight years of double digit gains in stocks and it was the weakest showing since 2011 for the S&P 500. This last quarter was also historic in that the Federal Reserve, after years of zero interest rate policy, finally raised short term rates by 0.25%. The final results do not tell the full story for 2015 where many sectors experienced dramatic moves. Energy prices continued to freefall in the fourth quarter and High Yield bonds fell, led by issuers in the commodity sector. We also finished a year where the threat of terrorism once again reared its ugly head.
The recent U.S. economic news has been inconsistent. Manufacturing, whose renaissance helped lead the U.S. recovery since the financial crisis, has shown signs of weakness. The December ISM Manufacturing Index fell to 48.2 (a reading below 50 indicates contraction), which is the first time the index has fallen below 50 since 2012. It is our view that much of the weakness can be attributed to Energy related industries as well as weak exports (due to the strong dollar). Wholesale inventories have also been increasing, a sign that manufacturing could slow further in the short term. Conversely, the much larger services sector as represented by the ISM Non-Manufacturing Index, was reported as 55.3 in December. While expansionary, this is the lowest reading since the first quarter of 2014. This type of “choppy” data will be common in 2016 as the economy adjusts to the change in monetary policy and resulting currency fluctuations that effect global competitiveness.
Surprisingly, employment growth continued to be stable as the economy added over 200,000 jobs a month on average during the course of 2015. Average hourly earnings are expected to have increased at a 2.8% annualized rate for December. Construction contributed 46,000 jobs in November, so there are pockets of strength. With job losses in the energy sector (more below), it is good to see the construction sector taking up some of that slack. In December 2014, economists expected home prices to increase 3.7% for 2015. Instead, we are very likely to close the year above 6% which is a pleasant surprise given the fact that this is most Americans’ largest investment. However, declining supply of existing homes coupled with consistent demand is putting upward pressure on prices and is subsequently slowing pending home sales.
Given the Fed’s view that economic growth is now self-sustaining and extraordinary monetary policy measures are no longer needed, the Federal Reserve raised interest rates in December. We wonder if they are indeed hoping to create breathing room down the road to lower rates when we enter the next inevitable recession. The Fed’s position has been based in part on their belief that the U.S. economy has improved enough to handle a rate increase. The Fed will want to continue to raise rates in 2016 if economic data provides justification. However, weak U.S. inflation, a slowing Chinese economy, a strengthening dollar and a presidential election will all serve as strong headwinds.
One of the biggest stories of 2015 was the continued decline in oil prices. During the year oil declined as much as 38% to $36 per barrel from a peak of $106 in 2014 (and a pre-crisis high of $147). OPEC has made the decision not to cut production in order to “starve out” the marginal oil producers, i.e. “maintain market share.” The combination of increased production in Iraq, OPEC’s persistence and the Iranian sanctions being lifted have weighed heavily on prices by drowning the market in supply. Oil production and demand both grew in 2015 but a decline in production is on the horizon as oil projects are being canceled around the world. In fact, the U.S. oil rig count has fallen from 1482 at the end of 2014 to 536 rigs at the end of 2015. The dramatic drop has caused several of the “marginal” oil exploration companies, which tend to be highly leveraged, to take extraordinary measures to avoid filing for bankruptcy. This has caused shock waves in the junk bond or “high yield” market. The decline in working rigs along with the major oil producers cancelling projects are in affect eliminating future production. This means that at some point we will reach a supply/demand imbalance again where oil prices will rise potentially with as much velocity as they have fallen. Commodities have a tendency to move too far in either direction past fundamentals. The question is how long will OPEC-nations run budget deficits to fund their desire to “maintain” market share.
The decline in oil prices and subsequent decline in gasoline prices have not had the expected impact on consumer spending. Recent data shows the vast majority of gasoline savings was offset by dramatic increases in health insurance premiums, consumers paying down debt and increase personal savings. While increasing personal savings is encouraging, it does not bode well for an economy looking for the next “boost”. It appears that low gas prices will not be the economic stimulus we were hoping for. Given these conflicting signals and the tightening stance from the Fed, we may well be resigned to 2% GDP growth or lower for the foreseeable future.
After the market correction in the third quarter, equities rebounded in the fourth quarter. For the quarter, the S&P 500 posted a positive 7.0% return, and was up 1.4% for the full year. With the Fed rate increase, a major source of uncertainty was removed for investors but global economic growth concerns remain.
All ten economic sectors posted positive results for the fourth quarter. Energy was the worst performing sector with a 0.2% gain. The Energy sector continues to be hampered by low commodity prices and elevated oil output from OPEC members. For the full year, five of the ten sectors posted positive results while the remaining five posted negative returns. Sectors exposed to sluggish global growth and negatively impacted by a strong U.S. dollar were the worst performing sectors for the year. Conversely, those sectors positively impacted by the relative strength of the U.S. economy and beneficiaries of lower commodity costs outperformed for the year. Energy (down 21.1%), Materials (down 8.4%), Utilities (down 4.9%) & the Industrials (down 2.5%) sectors were the four worst performing sectors for the year. Consumer Discretionary (up 10.1%), Healthcare (up 6.9%), Consumer Staples (up 6.6%), and Technology (up 5.9%) were the four best performing sectors for the year.
The 1.4% annual performance for the S&P 500 masks some of the underlying weakness in the overall market. During the year, traders flocked to the largest and more growth oriented (and higher P/E multiple) companies in the index. The divergence between growth companies and value companies continued in 2015 and widened as the year progressed. For the year, the S&P 500 Growth Index was up 5.5%, while the S&P 500 Value Index was down 3.1%, for a total spread of 8.6%. In addition, the S&P 500 Equal Weight Index, where all 500 companies have the same weight versus being weighted by size, was down 2.2% for the year. This shows how the very largest and those classified as “Growth” companies carried the performance for the entire market. In fact, “market breadth”, a measurement of how many companies are contributing to the market’s overall performance is near record lows (see chart below).
A perfect illustration of the lack of breadth is the much discussed performance of “FANG” stocks; FANG being the acronym for Facebook, Amazon, Netflix, & Google. The average performance for these four stocks for the year was 83%. Just these four stocks contributed over 3.0% to the S&P 500’s overall performance and without them, the index would have been down around 1.5%. Again, the return calculation for the S&P 500 is such that larger companies have more impact. Last year was characterized by the average stock being negative but a handful of the top ten holdings almost doubling which mathematically resulted in a positive index return.
Last year also marked a record year for mergers and acquisition (M&A) activity. Companies looking to grow and realize cost synergies were able to take advantage of the market dislocations this year, to the tune of over $4 trillion in announced M&A activity. The chart here shows the historic value of global M&A activity along with 2015’s largest announced deals.
Volatility was not just a phenomenon in the equity markets during 2015. The 10-year Treasury note went for a ride of its own, with yields starting the year at 2.17%, falling as low as 1.64%, then rising to a high of 2.48%, only to settle back down to 2.27% at year end, virtually unchanged. Most of this volatility was a reaction to monetary policy changes at the Fed. Investors were primarily concerned with the size and pace of rate increases. When Chairwoman Yellen finally made the announcement of a 25 basis point increase in the overnight rate on December 16th and signaled that the pace of increases would be “data dependent” (and gradual), much of the uncertainty was lifted and bonds stabilized. One fear is what happens to interest rates for longer term bonds when the Fed Funds rate increases. Our view is that the Fed only controls the very short part of the yield curve and inflation expectations and economic growth forecasts of market participants determine the yield levels on longer term bonds. We find ourselves in a scenario when inflation is already low, the dollar is strengthening, global growth is slowing and nearly every commodity price is collapsing. In this environment we do not see upward pressure on inflation and therefore long term yields do not need to rise much to adjust for (non-existent) inflation. The U.S. Treasury market continues to be the benefactor of any “flight to safety” scenarios during times of market duress and our expectation is that we may see several of these episodes during the course of 2016.
The overall taxable bond market, as represented by the Barclays U.S. Aggregate Index, was up 0.55% for 2015 and was down 0.57% for the quarter. From a quality perspective higher credits performed better. The AAA sector of the index was up 1.1% for the year while the BBB sector was down 2.7%. The liquid high yield sector was off over 5% and the distressed sector saw double digit drops across the board. We have long believed that credit spreads did not reflect the risk inherent in the corporate bond market, particularly in the lowest rated credits. Spreads are widening out meaning lower rated corporate yields are rising relative to the Treasury market. This correction is likely to continue as long as economic uncertainties persist.
High yield bonds have often been called the proverbial “canary in the coal mine.” Several notable hedge funds have prevented investor redemptions (putting up “gates”) and/or closed down their high yield bond products after suffering double digit drops during 2015. Many of these products were in the distressed sector (CCC rated bonds), and many took the fatal approach of concentrating sector exposure. Commodity related issuers have become the major casualty as many small producers cannot sell oil/gas above their cost of production. With the bond market all but closed to this sector, companies have few choices in bridging the resulting liquidity gap. We view this as an unwinding of a high yield bubble and not a precursor to a larger financial crisis.
The municipal sector performed very well during 2015. The S&P Municipal Bond Index, a national non-state-specific index, advanced over 3% for the year, clearly one of the best asset classes overall. We believe this is based on the improving fiscal outlooks for many municipalities as well as a flight to quality. Default rates for municipal bonds are lower than corporate issuers of equal rating. While there are some issuers that either have current financial distress, or are getting very close, the majority of issuers appear strong. Puerto Rico (which is tax exempt at the Federal and State level) is deciding which bond holders to pay on time since the money is simply not there to pay all debts. Illinois is on borrowed time and other states that have not been prudent in managing debt levels and pension contributions will likely fall on hard times at some point. Like Detroit, most of these fiscal emergencies are slow motion train wrecks; these risks are widely discussed and should be easily avoided.
The final results of 2015, both domestically and internationally, surprised most market participants as the old adage has once again proved true: the only value of forecasters is to make fortune tellers look good. So what are our thoughts for 2016? Very simply said, we don’t have high expectations for stocks this year. That shouldn’t be a big surprise given a string of positive years back to back following the fall in 2008. It is unlikely that the market continues marching forward at these valuations and tightening monetary policy if earnings and revenues are not advancing. As we stated earlier, if you strip out four stocks (the FANG stocks) the S&P 500 was down last year. That lack of market breadth cannot sustain a rise in stock prices for very long. One of two things can happen. First, the high flying stocks with PE ratios 7 to 10 times that of the broader market can decline or the ~60% of stocks on market lows can broaden the breadth by rising. The easy bet here is that high flyers come back to earth.
The Federal Reserve created an unprecedented low rate environment for virtually a decade and as former Dallas Fed Chairman Richard Fisher said this week, “The purpose of zero interest rates engineered by the FOMC, together with the massive asset purchases of Treasuries and agency securities known as quantitative easing, was to create a wealth effect for the real economy by jump-starting the bond and equity markets.” Our thought is that the 2015 was the beginning of a pause that will allow asset prices to normalize and properly reflect risk premiums. As we mentioned in the bonds section, we have already witnessed this adjustment in certain junk bonds with corrections of up to 25% this past year. Our strategy remains to ensure we are diversified and that clients have the appropriate asset allocation between stocks and bonds and we will take advantage as opportunities arise.