Economic Growth & Inflation
The U.S. economy has been one the few bright spots across the globe, as most other developed and emerging market economies performed below expectations. In a repeat of 2014, U.S. Gross Domestic Product (GDP) growth slowed during the first quarter but rebounded during the second and third quarters. U.S. GDP for calendar year 2015 is forecasted to grow 2.2%, slightly below last year’s reading of 2.4%.
The employment picture in the U.S. remains on a steadily improving path, and the unemployment rate now standing at a post-crisis low of 5.0%. While the overall U.S. economic growth picture looks good relative to other economies, there are still mixed economic signals creating uncertainty for investors. For example, domestic vehicle sales are very strong and reached a post-crisis record 17.5 million units this year. On the other hand, retailers struggled during the second half of 2015 to attract customers, and holiday sales were simply average at best.
Fears about the sustainability (perhaps even the authenticity) of China’s economic growth and mounting deflationary pressures contributed to severe stress among commodity producing economies. China’s decision to devalue the Yuan during August caught the financial markets off guard and caused a spike in equity market volatility. European and Japanese economic growth has been subpar despite quantitative easing (QE) and negative rates in Europe.
Pricing pressures across the commodity complex kept investors and global central bankers more fearful of deflation than inflation. Longer-term inflation expectations in the U.S. moderated throughout the year. Ten year breakeven inflation (10 year nominal yields minus 10 year real yields) recently touched a five year low of 1.4%. The Personal Consumption Expenditure price index (PCE), the Federal Reserve’s preferred measure of inflation, has settled near 1.5% recently, below the Fed’s stated 2% inflation target. Wage growth, which has been lagging despite the falling unemployment rate, has begun to show signs of a recovery.
Monetary Policy
The Federal Reserve finally delivered liftoff from its zero interest rate policy in December. The rate increase occurred seven years to the day since the Federal Reserve lowered the Funds rate to zero. We expect a very slow pace for Federal Reserve rate increases in 2016. In contrast, easier monetary policies by most every other major central bank across the globe are set to continue well into 2016.
The European Central Bank (ECB), Bank of Japan (BOJ) and Peoples Bank of China (PBOC) all appear headed down the path of additional monetary stimulus to combat disappointing economic growth and deflationary pressures. Mario Draghi again appears ready to do “whatever it takes” to combat low inflation. The ECB moved the already negative deposit rate even lower at the December meeting. Japan recently surprised the financial markets by increasing the amount of its QE program with larger purchases of Japanese government bonds. China recently lowered interest rates for the sixth time in less than twelve months due to disappointing economic growth and muted consumer inflation.
The cross-currents created by easier monetary outside the U.S. with probable Federal Reserve tightening contributed to market volatility across every asset class during 2015. The Federal Reserve will be forced to walk a fine line as tightening too quickly could lead to even more pain for emerging market economies already stressed by the combination of lower commodity prices and substantial debts denominated in U.S. dollars.
Interest Rates and Credit
Exhibit 1: Bond Market Performance (One Year as of 12/31/15)
Source: Barclays Aggregate Index. Data from Factset.
For the one-year period, 30-year U.S. Treasury yields increased 26 basis points from 2.75% to 3.01%, while 2-year yields backed up 38 basis points from 0.67% to 1.05%. While the magnitude of overall year-to-year yield change may be small, long-term rates have been on a wild ride this year. 30-year yields reached a low of 2.22% on January 30 and quickly reversed course to make a high of 3.24% on June 26. Foreign central bank selling of U.S. Treasuries contributed to the back up in rates this year.
Corporate credit spreads had also been volatile last year due to a challenging environment for liquidity coupled with record new supply. During the past twelve months, spreads for investment grade corporate bonds widened to treasuries by 34 basis points. Valuations for most structured securities, especially the commercial mortgage backed securities (CMBS) sector, also cheapened in 2015 due to supply pressures.
Prices of European sovereign debt remain supported by accommodative monetary policy and ECB bond purchase activity. Germany recently issued 2-year notes at a record low level of negative 38 basis points. Even yields for European sovereign credits, which struggled to borrow at single digit interest rates four years ago, traded well below U.S. interest rates. Italian and Spanish 10-year yields traded near 1.75% and Portuguese 10-year yields were below 2.5%. Japanese yields appear destined to remain stuck near zero for the foreseeable future.
Equity Markets
For the second straight year, large capitalization U.S. stocks represent one of the best performing segments of the global equity markets. S&P 500 Index performance had been dominated last year by the stellar performance for mega-cap technology high flyers, including the names of Amazon, Netflix and Google. Equity market volatility spiked to near record highs during the August freefall, but stock prices recovered almost as quickly and produced a healthy 7.04% return for the fourth quarter of the year and finished up modestly at 1.38% for 2015.
Emerging market equities posted disappointing performance in 2015 under the weight of lower commodity prices and high debt burdens denominated in U.S. dollars. Equity returns in Europe were lackluster on a local currency basis but delivered nearly double digit returns hedged back into U.S. dollars.
Exhibit 2: Equity Market Performance (One Year as of 12/31/15)
Source: Factset.
Major Themes
2015 witnessed the return of financial market volatility. Periodic episodes of extreme volatility emerged across almost every asset class. The year started with a dramatic spike in rate volatility as 30-year yields fell sharply in January and then almost immediately gave back all the gains in February. Volatility also arose in the currency markets as the year started, due to the Swiss central bank surprising investors by removing its peg to the Euro. Equity market volatility re-emerged with a vengeance in August as China unexpectedly devalued the Yuan. U.S. equities went into freefall when the markets opened Monday morning following the announcement. Wild distortions in the pricing of the rapidly growing exchange-traded-funds (ETFs) market occurred as well. The turmoil was another sign of potential liquidity challenges facing investors today.
Volatility has been the norm this year across the commodity complex. Commodity prices declined in 2015 due to ample supplies and weak global demand, especially in China. The Iranian nuclear agreement and warmer temperatures due to El Niño also contributed to the selloff. The strain being placed on commodity-producing economies has grown more severe as the year progressed. Investors seeking higher yields in the junk bond market and Master Limited Partnerships (MLPs) also felt the pain from low energy prices during 2015.
Financial engineering in the form of share buybacks, higher dividends, and mergers and acquisition (M&A) activity reached post-crisis heights during 2015. As corporations are being challenged by worsening prospects for organic earnings growth, borrowing cheap money to finance shareholder-friendly activity has grown more popular. Corporate debt issuance set a record during 2015 at over $1.2 trillion and contributed to the widening in spreads.
With 2015 in the rearview mirror, what will 2016 hold for investors? Check out our 2016 Economic and Market Outlook which will be available soon!
Index Definitions: S&P 500 Index – An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. MSCI EAFE Index – An index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. Russell 2000 Index – An index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks.MSCI Emerging Markets Index - A free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
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Disclosures: The views expressed in this material are the views of PMAM through the year ending December 31, 2015, and are subject to change based on market and other conditions. This material contains certain views that may be deemed forward-looking statements. The inclusion of projections or forecasts should not be regarded as an indication that PMAM considers the forecasts to be reliable predictors of future events. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate. Actual results may differ significantly. Past performance is not indicative of future results. The views expressed do not constitute investment advice and should not be construed as a recommendation to purchase or sell securities. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed. There is no representation or warranty as to the accuracy of the information and PMAM shall have no liability for decisions based upon such information.