The first quarter of 2016 was volatile – politically, economically and in the stock market.  The year began with fears of a U.S. recession linked to sagging oil prices and economic volatility in China which led to the worst start to a year for the S&P 500 on record.  Through the first 10 days of 2016 the market was down 7% and by February 11th the market was firmly in correction territory, down over 11% for the year.  In the midst of all this negativity it became clear from economic data that we were not headed into a recession.  As “earnings season” got underway, fact overcame emotion and the market rallied 12% from the low to finish the quarter slightly positive.  This is why we often echo the Warren Buffet quote that “in the short term the market is a voting machine and in the long term it is a weighing machine.”

Since the middle of February, U.S. economic data has had a number of positive surprises.  While there has been plenty of bad news, reports that are better than economists’ expectations are a significant measure of sentiment versus reality.  Looking at the Citi Economic Surprise Index the shift is evident:

q1 2016 1These positive economic surprises have seemed to assuage market fears of a U.S. recession but they haven’t changed our expectation of only modest growth in Q1.

In March, the U.S. economy added another 215,000 jobs, many of which were in the construction, retail and healthcare industries.  The job market continues to demonstrate healthy growth which is good for our consumption-based economy.  The rate of participation in the labor force hit a two-year high but more importantly, wages rose at a respectable 2.3% year-over-year pace.

The ISM manufacturing index indicated expansion in March after five months of contraction. The PMI was at 51.8% in March, up from 49.5% in February. The employment index was at 48.1%, down slightly from 48.5% in February, and the new orders index was at 58.3%, up sharply from February.  Without getting into the significance of each of these metrics, they all confirm that the manufacturing sector expanded in March for the first time in 6 months – a very encouraging fact!

On the negative side, consumer spending has disappointed so far this year.  Auto sales, a good proxy of consumer spending, came in below expectations for March.  Oil prices have moderated and are not nearly as volatile as they were last year.  Historically, lower gasoline prices manifest in higher consumer spending. Our impression is that healthcare expenses – primarily deductibles and premiums – have increased substantively (especially for the working poor).  This may have “eaten” some of the gains in lower fuel costs.  We also know there is typically a lag in GDP growth of about a year before you see the effects of a fall in oil prices.  This could bode well for potential upside surprises in 2016, but we are not counting on it.  Overall it appears once again to confirm that we are in a “muddle through” economy and the U.S. continues to be the best house in a bad neighborhood. The Federal Reserve seemed to agree with this assessment when Chairwoman Janet Yellen said last month that the “Committee continues to feel that we are on a course where the economy is improving and inflation is moving back up.”

Finally, the ramped up rhetoric from both political parties due to the November Presidential election will undoubtedly continue to fuel volatility. While it may be discouraging at times, we must resist the urge to think all is lost or believe those who say it’s never been this bad. According to the Republican National Convention, there have been two contested contests in recent history, neither of which resulted in the dissolution of the party.  The Democrats managed to survive their very turbulent 1968 convention that at least partially contributed to riots in the streets of Chicago. And just when things seem like they can’t get any worse, remember 1804 (and the subject of the hottest show on Broadway) when a simmering political rivalry, which featured much insult hurling (sound familiar?) resulted in a duel (yes, with guns) that saw a sitting Vice President shoot and kill a former secretary of the Treasury.

After a shaky start, the equity market posted a strong rebound and finished the quarter in positive territory.  For the first quarter of 2016, the S&P 500 posted a positive 1.35% return, after being down as much as 11% during the quarter.  According to S&P Global Market Intelligence, it was its deepest first quarter slide ever in a year where it staged a complete reversal by the end of March.  As mentioned earlier, economic growth concerns and stock market volatility peaked in mid-February but subsequently eased throughout the balance of the quarter.

For Q1, eight of the ten economic sectors posted positive results.  Financials (down 5.1%) and Healthcare (down 5.5%) were the two worst performing sectors for the quarter.  Both a flattening yield curve and concerns around loans to oil companies pressured Financial stocks during the quarter.  Healthcare stocks are currently being impacted by political discussion of containing drug prices and medical costs.  Two of the smallest sectors, Utilities (up 15.6%) and Telecommunications (up 16.6%), were the best performers in the quarter.  Given the investor angst during the quarter coupled with the Fed potentially slowing down its path of interest rate increases, investors warmed to these two defensive and higher-yielding sectors.  All other sectors were also positive during the quarter, notably the beleaguered Energy sector (up 4.0%).  As seen in the chart below, oil posted a strong rebound from its lows, helped by production declines in the U.S. and talks of OPEC freezing output at current levels.q1 2016 2

For 2016, analysts project earnings will rise by 2.2% and revenues will grow by 1.6%. According to FactSet Research, the 12-month forward P/E Ratio is 16.6x, which is just above long term averages.  With subdued earnings growth and a fairly valued market, we continue to have tepid expectations for the broad equity market over the short term.  But, as longer term investors, we continue to seek out and find high quality companies selling at a discount to our estimate of fair value.

While the stock market was bouncing around in a sea of uncertainty, the bond market was in tow.  The 10-year U.S. Treasury note began the year at a 2.27% yield, rallied to a cycle low of 1.66% on February 11th, (corresponding to the oil chart above), sold off to nearly 2.0% in mid-March, before falling again to 1.77% at quarter-end.  Many of the same factors causing the uncertainty in stocks impacted the bond market; uncertainty is generally good for bond prices.  What caught many by surprise is the direction of long term rates.  The Federal Reserve finally began the long awaited interest rate “normalization” process.  This is economist-speak for raising the Fed Funds rate (from zero) with the implication that a series of rate hikes are on the horizon.  This has a direct impact on short term rates, as can be seen in the yield curve chart below.  The surprise to many is what has happened to the long end of the curve.

q1 2016 3

This chart shows that over the last two years, rates have increased from the overnight rate out to two years, and yields on anything longer have fallen.  As we have discussed in previous letters, the long end of the yield curve is controlled by market participants’ expectations for inflation.  The Federal Reserve has begun to fight inflation in a low inflation environment, giving more confidence to investors that inflation is and will continue to be, contained.  Couple this with the outright deflation that is being deported from China via a weak currency, and the dismal outlook for the European Union (where many yield curves are negative, even out to 10 years in some cases), and our domestic bond market has some of the most attractive rates globally.  We believe that the combination of these factors will limit any steepening of the curve on the long end.  However, one can also see from this chart that investors pick up very little yield beyond the 10-year sector.  There is a 0.84% yield increase by moving from 10s to 30s.  While we have stated we do not believe longer bonds will face substantially higher yields, we are also aware of the risk embedded in this sector.  The duration of the 30-year U.S. Treasury is 21, meaning if the long bond yield increased from 2.61% to 3.61% (a 100 basis point move), the price of this bond will drop by over 20%.  This is not a risk/return profile that seems attractive in our opinion.

The overall taxable bond market, as represented by the Barclays U.S. Aggregate Index, was up over 3.0% for the quarter.  The longer and lower quality, the better.  The 1 to 3-year sector returned 1.0%, versus 7.0% for the 10+ year sector.  AAA rated credits advanced 2.66%, while BBB bonds returned 4.32%.  In many ways this was the reverse of how 2015 ended.  The abatement in recessionary fears reinforced lower-rated issuers while the more dovish tone from then Federal Reserve bolstered long bonds.  To begin the year Wall Street forecast 4 interest rate increases by the Fed this year; now many firms only predict 2 if any.  We are navigating this environment by managing duration and quality, with having less of the former and more of the latter.  In other words, we are positioning portfolios with a 4-5 duration (short to intermediate) and buying only the highest credit qualities.  We are finding yields in excess of 2% by building out portfolios with step-up Gov’t Agency callables and taxable municipal bullets.

While we do not make formal Fed Funds rate predictions, we do find it hard to believe the Fed will be overly aggressive in this normalization process.  With over $5 Trillion of bonds globally trading with negative yields we find it hard to envision inflation expectations warranting substantial tightening.

The tax free municipal market turned in a 1.6% return for the quarter, as represented by the S&P Municipal Bond Index.  The municipal market was less volatile than the taxable counterpart, as this sector generally is not as impacted by the flight to quality that results with stock market corrections.  Pension underfunding levels and Puerto Rico/Illinois/Detroit restructuring issues seem to dominate the news in this market.  We focus on credits that we believe are adequately funded, or have the ability to fund, their future pension obligations.  Some municipalities will have financial difficulty in the not too distant future.  Our average credit quality is being maintained at AA, and we are focusing on above market coupon bonds that have longer maturity dates with intermediate (5-10 year) call dates.

We realize the “roller coaster” analogy is probably played out but the first quarter was a perfect embodiment with stocks experiencing extreme volatility but ultimately ending up back where they started. We continue to believe U.S. stocks are in a secular bull market but in a more mature phase which will be dotted with volatility and pullbacks. Corporate earnings likely need to recover before stocks can move demonstrably higher. More clarity from the Fed and a better political environment would help, but both seem unlikely in the near term. We continue to stay disciplined and diversified as we watch to see if global growth can improve.