VOLATILE FIRST HALF CAPPED BY RATE DROP AND STOCK RALLY
While most diversified investors earned decent returns in the first half of the year, wild market swings along the way fed our collective uncertainty. What does volatility tell us about future returns? We’ll look at what’s been roiling the markets and a new DFA study, then review the numbers.
The first half of 2016 wasn’t easy on investors, despite the gains. We were reminded once again that stocks prices are unpredictable, vulnerable to the risk of a profit contraction. And bond prices are temperamental and highly sensitive to extraordinary central bank support (we saw plenty of that).
Each time pundits say that bond yields can’t go any lower, the markets seem to prove them wrong. After Britain’s surprise decision to leave the European Union, yields dropped again. The interest rate on ten-year Treasury bonds reached a record low. German and Japanese rates headed deeper into negative territory, leaving bond investors little protection against the threat of higher inflation and a strengthening economy.
Where do we go next? Policymakers face difficult choices, and no one wants to get it wrong. On the one hand, there’s the long-accepted argument that low interest rates have been necessary to counterbalance faltering economic growth. On the other, the Fed has repeatedly signaled that it would like to raise rates to stay ahead of inflation in the aftermath of quantitative easing, and to rein in speculative excess in a weak economy. Many believe that raising rates could push the U.S. back into a recession. Is it worth the risk? The jury is still out. Following the release of mixed economic data and the Brexit vote, the Fed is in a holding pattern heading into its July policy meeting.
Historically low interest rates aren’t the only problem. Over the last 7 years, we’ve seen a surge in asset valuations that far outpaces growth in wages and incomes. As a result, measures of inequality and the health of the US economy have worsened, while the surge in valuations may have masked problems of faltering growth and economic sluggishness. Market bears are growling that US financial markets will soon face a day of reckoning absent an increase in government spending and thoughtful tax reform to boost the economy, or from a different perspective, once the Fed ceases its policy of bolstering asset price levels by way of artificially low interest rates. We’ve seen this movie before, others say, when the inflationary crisis of the 1970's led to the appointment of Paul Volcker and a revolution in monetary policy known as the supply-side revolution. Modern day supply-siders argue that the way to growth is through sweeping deregulation and incentives for vital sectors of the economy rather than deficit spending and tax reform.
Bottom line, policymakers are grappling with economic problems for which quick remedies are not readily apparent. So where should an investor look for guidance? Many have traditionally considered gross domestic product (GDP) an indicator of future equity returns. GDP has been revised downward a number of times in recent months; it’s now predicted to hold steady at approximately 2.5% for the foreseeable future.
But data collected in a new DFA study suggests there is little evidence that low quarterly GDP growth is associated with short-term stock returns above or below returns in other periods. According to the study, the average quarterly return for the S&P 500 Index was 3% from 1948 to 2016. When quarterly GDP growth was in the lowest quartile of historical observations, the average S&P 500 return in the subsequent quarter was 3.2%, very similar to the historical average for all quarters. In short, GDP may not be a very reliable predictor of what comes next.
Because we don’t know how the global pendulum will swing, diversification is still the investor’s best long-term ally. Our advice is to be sure your asset allocation is aligned with personal goals and to maintain a long-term perspective. And remember, even at today’s low yields, appropriate bonds remain a powerful hedge against declines in the stock market. Don’t fret about market swings. Turn off the news and take a walk or read a book instead.
As always, please call us if you have questions or concerns. We are here to help.
SECOND QUARTER 2016 AT A GLANCE
World Asset Classes: Looking at broad market indices, the US outperformed developed markets outside the US and emerging markets. US REITs recorded the highest returns at 5.42% for the quarter, outperforming the broad equity market. The value effect was positive in the US but negative in developed and emerging markets. Small caps outperformed large caps in the US, but slightly underperformed in the developed and emerging markets.
US Stocks: The broad US equity market recorded positive absolute performance for the quarter. Value indices outperformed growth indices across all size ranges. Small caps outperformed large caps (3.79% vs. 2.46%).
International Developed Stocks: Developed markets outside the US lagged both the US equity market and emerging markets indices during the quarter. Small caps slightly underperformed large caps in non-US developed markets (-1.28% vs. -1.05%). Large-cap growth performed the best of all at 0.57% for the quarter. The value effect was negative across all size ranges.
Emerging Markets Stocks: Emerging markets underperformed the US but outperformed developed markets outside the US. The value effect was negative in emerging markets. Large cap value indices underperformed large cap growth indices (-0.35% vs. 1.71%). The opposite was true among small caps, where value indices outperformed growth indices. Small cap indices slightly underperformed large cap indices in emerging markets (0.40% vs. 0.66%).
Select Country Performance: New Zealand recorded the highest country performance in developed markets (5.30%) followed by Canada (4.72%). Italy (-10.99%) and Ireland (-10.67%) posted the lowest performance for the quarter. In emerging markets, Peru (18.19%) and Brazil (14.44%) posted the highest country returns, while Poland (-17%) and Greece (-12.01%) had the lowest performance.
Real Estate Investment Trusts: US REITs had very strong positive returns for the quarter (5.42%), outperforming the broad equity market. REITs in developed ex-US markets recorded positive returns (1.31%), also outperforming broad ex-US developed equity markets.
Commodities: Commodities were broadly positive during the quarter. The Bloomberg Commodity Index Total Return gained 12.78%. Energy turned positive with natural gas gaining 30.88%, Brent crude oil 19.51%, and WTI crude oil 18.64%. Precious metals performed well, with silver posting a solid 19.51% gain, followed by zinc at 15.47% and gold at 6.77%%. Sugar gained 29.84%, coffee 10.90%, and cotton 10.29%. Grains were mixed: soybeans returned 27.68%, while wheat declined 9.28%.
Fixed Income: Interest rates across the US markets generally decreased during the quarter. The yield on the 5-year Treasury note fell 20 basis points (bps) to end at 1.01%. The yield on the 10-year T-note decreased 29 bps to 1.49%. The 30-year Treasury bond declined 31 bps to finish with a yield of 2.30%.
The 1-year T-bill ended the quarter yielding 0.45%, and the 2-year T-note finished at 0.58%, for declines of 14 and 15 bps, respectively. The 3-month T-bill increased 5 bps to yield 0.26%, while the 6-month T-bill dipped 3 bps to 0.36%.
Short-term corporate bonds gained 1.05%. Intermediate-term corporates returned 2.24%, while long-term corporate bonds returned 6.64%. Short-term municipal bonds returned 0.66%, while intermediate-term municipal bonds gained 1.84%. Revenue bonds slightly outperformed general obligation bonds.