Island Light Quarterly Commentary (December 2015)
2015 year-end review
“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” William Arthur Ward
For the last 50 years, the S&P 500 has returned an average of 9.7% (total return) per year, fueled primarily by economic growth, corporate earnings and dividend payments. The stock index has been positive for the last seven years and in twelve of the last thirteen calendar years. In 2015, the S&P 500 returned 1.4%, including dividends, masking a decline in the raw index of 0.8%. While this total return was below the long term averages, and below market expectations at the beginning of the year, it accurately mirrored the lack of growth in corporate earnings for the year. In other words, the market performed in line with corporate earnings growth.
On the other hand, over the last 25 years, the S&P 500 index has suffered an average inter-year loss of 14.2%, measuring the largest market drop from a peak to a trough during the year. The three worst losses of the S&P 500, peak to trough, were 49% (2008) and 34% (2002, 1987). In 2015 the peak to trough loss was 12%, the worst loss in five years, but below the 25 year average. Changes in market sentiment drive most of these market losses.
Reviewing long term history reinforces the optimist’s view that over the very long term, stocks tend to outperform inflation and every other major asset class. On the other hand, history also reminds the pessimist that in the short run, stocks can lose more than every other major asset class. In other words, long term equity returns often come at the expense of jarring inter-period loss and considering history, 2015 market behavior was little different than prior history.
After losing 5.3% in the first three quarters of the year, the S&P 500 grew 7.0% in the fourth quarter, ending the year up a modest 1.4%. October was the best month of the year (up 8.4%), recovering all of the losses of August and September, but the index was off 1.6% in December, limiting year end gains.
One of the biggest themes of the year was the narrowing leadership among stocks. A very small group of names posted outsized gains, which helped keep the index slightly positive. Meanwhile, the median stock in the Russell 3000 had a rough year, down more than 5%. The biggest leaders in the market (Facebook, Amazon, Netflix and Google, otherwise known as FANG) returned an average 83.2%, which contributed about 3.7% to the overall market return. Absent FANG, the S&P 500 would have lost 2.3% for the year. Narrowing leadership is often a bear market indicator of potentially poor future performance.
Growth-oriented large cap stocks (7.9% for quarter, 5.5% for 2015) outperformed value-oriented stocks (6.1% for the quarter and minus 3.1% for the year) by 1.8% in the fourth quarter and 8.7% for the year. For the year, growth oriented sectors, consumer discretionary (up 9.9%), healthcare (up 6.8%) and technology (up 5.5%) out-performed value-oriented sectors with energy (off 21.5%) and materials (minus 8.7%) the worst performers.
Although large cap stocks eked out a small gain because of dividends in 2015, the same cannot be said for mid-cap and small cap stocks. Mid-cap stocks, as measured by the Russell 800, while returning 3.6% for the fourth quarter, lost 2.5% for the year. Midcap growth stocks (-0.2%) outperformed midcap value stocks (-4.8%) by 4.6% for the year. In the small cap space, while the Russell 2000 won back 3.6% in the fourth quarter, small stocks lost 4.4% for the year. Small growth stocks outperformed small value stocks by 6.1%.
Looking forward to 2016, market consensus is for a modest, high single-digit return for the S&P 500. Most analysts expect earnings growth to be low, ranging from 3 to 7%, contributions from dividends to be 2% and share buybacks to account for another 2% or so. Thus, we might expect to see S&P returns to range between 7.0% and 11.0%. However, this assumes that no material change in investor sentiment or relative valuation (price to earnings ratio) occurs. Investor sentiment is the most important factor on short term volatility and a drop in investor sentiment is quite likely, given current market risk and uncertainty related to energy production, commodities pricing, overseas growth, debt levels in emerging economies, including China, and the upcoming US presidential election. Therefore we are somewhat less optimistic than market consensus, and it more likely-than-not that US equities will outperform fixed income in 2016 by 4% to 6% with at least one market correction of more than 10% in 2016.
Non-US Equity Markets
Globally, central banks had divergent monetary policies in 2015. While the US was tightening from very accommodative policy, raising the Fed funds rate by 0.25% in December, the European Central Bank (ECB), Bank of Japan (BOJ) and Peoples Bank of China (PBC) pursued accommodative policies. This divergence of policy, in addition to different rates of economic growth, caused the dollar to strengthen 9.3% against a basket of currencies, making it more difficult for a US investor to earn money in an unhedged foreign investment.
When a US investor invests in foreign markets, total return is valued in US dollars. Therefore, one of the largest components of foreign market total return is dollar strength. A strong dollar hurts a US investor’s return while a weak dollar helps. The 9.3% change in the dollar was a major headwind to most foreign market returns, especially in the first half of the year. The strong dollar and weak commodities prices were also major factors in a very poor year for emerging markets.
Foreign markets lost -5.7% in dollar terms for 2015 and earned 3.2% in the fourth quarter, as measured by the MSCI All Country World Index ex US (ACWI xUS). If we ignore the impact of the strong dollar, or hedge the foreign currencies, the same index in local terms earned 1.6% and 4.8% for the year and quarter, respectively. Developed non-US markets (MSCI EAFE) lost 0.8% for the year and earned 4.7% for the quarter when measured in dollars. In local terms the index earned 5.5% for the year and 6.3% for the quarter. Developing markets (MSCI Emerging) lost 14.9% in 2015 and gained 0.7% in the fourth quarter. In local terms, the carnage was not so bad, with the local index losing 5.8% for the year and gaining 1.5% for the quarter. In other words, in 2015, as in 2014, hedging against currency loss in foreign investments paid major dividends for the US investor.
Returning to our investment themes, and not to belabor the point, very accommodating monetary policy in Europe and Japan contributed to the major gains in Germany (DAX up 10%) and Japan (Nikkei up 9%). Weaker currencies and low commodity prices provided positive support to both economies, both of which rely heavily on foreign exports for economic growth. On the other hand, growth in China decelerated and the yuan depreciated, reducing demand for foreign goods and making Chinese exports more attractive. Emerging markets currencies also fell victim to poor technicals that fueled price volatility.
We anticipate that developed markets in the Euro zone and parts of the Asian markets will outperform the US in local terms in 2016, fueled by the same trends that fueled growth in 2015 – monetary easing, weak currencies, low commodity prices and accelerating economic growth. Whether this translates to US investor gain will depend upon the direction of the US dollar. Valuations in foreign developed markets are, for the most part, at more attractive levels than in the US. We believe that the dollar will continue to strengthen because of policy differentials, but the trend may not continue for much longer.
Absent a major exogenous shock or other geo-political events in the Middle East, dollar weakening in the last half of 2016 should be a positive development for emerging markets, which now trade at attractive valuation levels. However, emerging markets experiencing slower growth (China), or those with internal problems (Brazil) or those subject to low oil prices (Russia, Nigeria), may continue to experience poor relative performance. We are neutral or underweight in our emerging markets exposure at this writing and maintain a modest currency hedge in our developed market exposures.
US fixed income and interest rates
Changes in US interest rates and widening credit spreads dominated the fixed income headlines in 2015. The ten-year US treasury yield began 2015 at 2.2% and ended the year at 2.3%, and traded between 1.7% and 2.5% throughout. Credit spreads relative to treasuries, as measured by the BAML credit option spread, began the year at 1.4% and ended the year at 1.7% and traded between 1.3% and 1.8% during the year. Spreads at the lower credit ratings were more volatile and contributed to poor high yield performance for the fourth quarter and year.
The Barclays US Aggregate bond index lost 0.6% for the quarter but was modestly positive for the year, returning 0.6% for the year. Shorter duration bonds also returned 0.6% for the year but with less volatility. TIPS were negative for the year and quarter. High yield bonds lost 1.5% for the quarter and lost 5.0% for the year. High yield bonds have a higher proportion of energy exposure than higher quality bonds and were therefore particularly hard hit by the low price of oil during the year.
Looking forward to 2016, we anticipate four major themes to impact fixed income. First, we expect the divergence of central bank monetary policy to continue, even as global economies converge. Because the Euro-zone and Japanese economies are growing more slowly than the US economy, the ECB and BOJ will continue their loose monetary policy. In China, fears of slowing growth (from 7.0%, according to the Chinese authorities) and excess manufacturing capacity are providing the PBC with an excuse to further lower interest rates, thus putting downward pressure on the yuan. In contrast, the US economy, which will probably grow around 2.5% in 2016, with inflation around 1.5%, the Fed hopes to continue to raise interest rates through 2016. We expect that the ten year Treasury will end 2016 between 2.4% and 2.6%, and trading between 2.0% and 3.0% during the year.
Second, we believe that low and volatile commodity prices will persist. While there is a low probability scenario where commodity prices increase,– monetary easing stimulates global growth, inflation and commodity demand, we think the more likely scenario is that global supplies will exceed global demand, and producers of energy and materials will barely maintain current earnings levels.
Third, we expect that credit spreads are more likely to stay at current levels than to either increase or decrease, although the energy sector will continue to be weak, particularly if the above scenario plays out. Defaults should remain low, except for energy-related and other very poor credit ranked bonds, so long as the economy chugs along. However, lower liquidity in corporate fixed income may also put upward pressure on credit spreads and increase volatility in fixed income.
Finally, the direction of the dollar and the potential weakening of the yuan bear watching. If the dollar remains strong, which we believe likely for the first half of 2016 given the monetary policies above, and the Chinese economy weakens more rapidly than expected (a hard landing), then inflation expectations and interest rates in the US will likely remain low. This will be good news for fixed income and some dollar-dependent emerging markets, but may be bad news for exporters and other manufacturers.
We have positioned our fixed income portfolios to have somewhat shorter duration than the aggregate market with a slight overweight to better quality high-yield bonds and some exposure to currency hedged non-US sovereign bonds. We look to fixed income allocations to provide an anchor to equity risk and to yield slightly more than an equivalent US Treasury allocation.
US inflation was 0.5% year over year in November, although core inflation, which excludes energy (minus 14.7%) and food (plus 1.3%), returned 2.0%, the highest level in 2015. Inflation remains low around the world, with deflationary pressures coming from the drop in commodity prices, slow demand in China, the world’s second largest economy, excess debt, low productivity and slow economic growth. This global “lowflation” persisted in 2015 despite improving labor markets in the US, Germany and the UK, tighter housing markets and now rising interest rates in the US. Looking forward to 2016, while the US and Europe should see somewhat higher inflation rates as oil prices stabilize and GDPs grow at moderate pace, emerging economies dependent on commodity prices (Brazil, Russia, Nigeria) or experiencing slower growth (China) may see their debt levels explode, resulting in weak currencies and exported deflation to the developed world.
Three major trends contribute to US inflation expectations in 2016; high oil production, foreign currency devaluation and US labor rates. Global oil production remains too high for current demand and prices are low at $36 per barrel, exacerbated by Saudi Arabia’s intent to drive out higher cost producers in the US. Low oil prices will keep US inflation in check and increase debt or lower reserves for oil exporters. Slower growth in China, burdened with excess manufacturing capacity and high debt levels, will put further downward pressure on the yuan relative to the dollar. US economic growth should continue to be modest but positive and combined with low US unemployment and low productivity growth should keep labor markets strong, and put upward pressure on inflation rates. While we expect lowflation to continue, changes in any of these trends could lead to higher inflation than in 2015 and therefore bear watching.
Looking forward, as realists, we are adjusting our sails. Last year, the US experienced lowflation, witnessed a policy-driven rate increase in treasury rates and suffered low, positive and volatile equity market returns. The US economy grew at a slightly better than 2.0% rate, unemployment dropped, and consumer sentiment was positive. Low oil prices helped the gas-guzzling consumer, wages inched upwards and a new generation of smart, labor saving devices helped to improve life styles and comfort. We expect much of the same in 2016, and anticipate being surprised by rapid changes in sentiment, both positive and negative. Overseas, we look for better growth in Europe and Japan, leading to good but not spectacular equity returns, slowing growth in China and yuan depreciation, and troubles in most emerging markets, at least in the first half of the year. Fixed income investors should see modest total return, mostly from yield and modest loss in fixed income principal as interest rates edge slightly higher. As realists, we know that we can’t expect to know the future, and therefore control for risk of loss through diversification, thoughtful shifts towards attractive assets in line with our investment thesis, and a hand on the tiller as we steer our portfolios through the shoals and channels ahead.
Matthew V. Pierce, President