Despite finishing the quarter with modest gains of approximately 1%, the market was quite volatile to begin the year. The S&P 500 fell by over 10% through the middle of February before rebounding strongly in recent weeks to finish the quarter in positive territory. Investors initially appeared to be fixated with slowing international economies, plummeting oil and other commodity prices, and the potential for a U.S. recession, all with the Federal Reserve having just begun its tightening campaign. In our view, improved U.S. economic data, rebounding oil prices, and a more dovish tone out of several major central banks all conspired to boost sentiment, enabling stocks to close out the quarter on a positive note.
As has been the case for much of the past several years, central banks continued to loom large in the minds of investors during the first quarter. In the U.S., the Federal Reserve lowered its expectation for the number of interest rate hikes for the year. The Fed now expects to hike rates only two times, down from its earlier projection for four rate increases. Fed Chair Janet Yellen noted that while domestic employment remains healthy, she is increasingly concerned with the state of the global economy and this was part of the rationale for reducing the bank’s interest rate forecast. In response, the two-year Treasury bond yield saw its sharpest one-day decline since September, the dollar dropped, and stocks moved higher, indicating that investors view the more dovish policy stance as appropriate for current conditions.
The European Central Bank (ECB) also made headlines in recent weeks by expanding its monetary stimulus. In addition to a further reduction in interest rates, the ECB increased its asset purchase program by an additional 20 billion euros per month, and introduced another round of ultra-cheap loans to banks in order to further ease borrowing conditions. This latter measure is noteworthy in that certain of these loans will carry a negative interest rate, meaning that in some cases the ECB will actually be paying banks to borrow. Unlike the market’s reaction to the Federal Reserve’s latest meeting, European stocks dropped on the day of these announcements. While we believe that the new measures exceeded market expectations, we think that stocks were reacting to Mario Draghi’s comments that he does not expect to lower rates further from current levels. In our view, however, this pronouncement may be a positive for stocks. We interpreted Draghi’s comments to imply that any further stimulative measures are likely to be in the form of additional quantitative easing (QE), as opposed to further rate cuts. We believe that QE is a stronger form of monetary stimulus as it is more directly impactful to economic activity and it also lessens the likelihood of competitive currency devaluations. Moreover, it is far better for banks whose stocks were battered earlier in the year amid fears that negative interest rates could be a significant drag on their profits.
Investors continued to keep a close watch on oil prices during the quarter. While lower prices are typically beneficial for countries which are net importers of the commodity, the type of precipitous decline which has ensued has been devastating for much of the energy sector, and has also negatively impacted stocks and fixed income securities more broadly. In our view, the rebound in oil prices which began during February was a major inflection point for the stock market, particularly given that the correlation between the two assets had approached record levels during the quarter. A meeting between major energy producers scheduled for later this month may be a catalyst for energy prices moving forward. However, given the different agendas among oil producing nations, we are skeptical that any significant agreements will be reached. Moreover, oil supplies remain at very high levels, and it is unclear whether the recent pace of appreciation will be sustained. One reason for optimism, however, is that the number of rigs in operation has declined dramatically, and at some point this should begin to help bring supply and demand into better balance.
We currently hold a balanced outlook for equities. Several measures of the risk environment which we have been monitoring have improved or stabilized in recent months. These would include oil prices, high yield bond spreads, the VIX (CBOE volatility index), and China’s currency the yuan. We are also encouraged that the dollar has pulled back meaningfully, as its earlier appreciation had negatively impacted corporate earnings as well as exports.
With the dollar headwind having somewhat subsided, and the U.S. labor market continuing to improve, we see little reason to call for a domestic recession in the near to intermediate term. In fact, we maintain a positive view on the consumer, a key component of the U.S. economy. While we have yet to see much in the way of increased discretionary spending from the drop in energy prices, we continue to believe that at some point lower pump prices will boost consumption. We note that historically there have been meaningful lags between energy price drops and pickups in spending. Moreover, with the unemployment rate falling towards healthy levels, we would expect wages to firm over the coming months which could be another catalyst for consumption. Finally, we maintain our view that the global monetary landscape in aggregate is quite stimulative. In addition to the aforementioned actions taken by the Fed and the ECB, China too has taken measures to boost its economy, both via fiscal and monetary policies--the most significant of which may have been the country’s recent pledge to significantly boost its budget deficit to 3% of GDP, up from 2.3% last year.
Despite these positives, our view on the market is balanced by several factors, both economic and political in nature. China’s economic health remains a key concern, as the country’s GDP growth continues to decelerate, and overcapacity remains a critical issue in many industries. While scaling back capacity in these sectors would be beneficial in the long run, it would also likely lead to greater unemployment. We therefore question the government’s appetite for instituting these types of structural reforms. In the U.S., we have written about our concerns pertaining to the election and the extent to which rhetoric may impact stocks. We continue to believe that this will be a headwind for stocks over the next several months, particularly in the healthcare space. Elsewhere, we view the potential for the United Kingdom to leave the European Union as a significant risk factor. We note that polls on this issue have been very close, and London’s mayor Boris Johnson recently came out in favor of exiting. Finally, while Greece has been out of the headlines for some time, the country does need to refinance its debt this summer, and this could be another source of market volatility moving forward. As always, we maintain our risk-conscious approach to seeking long-term growth.
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