January 18, 2016

Market Summary – Year-End 2015

2015 was a weak year for most major financial market indices. There were four key drivers of the financial market moves during the year.  These factors were: 1) the strengthening U.S. dollar, 2) the considerable slowdown in China and the ripple effects, 3) the sharp drop in oil prices and the ripple effects, and 4) significant monetary policy and stimulus actions around the world.

The U.S. dollar index appreciated about 10% in 2015 and is near its highest level since 2003. The dollar appreciated because of the higher economic growth rate and higher interest rates in the U.S. than most other major countries.  For example, interest rates on short-term German bonds are negative.  One of the most significant impacts of the stronger dollar is that U.S. goods and services become more expensive to foreign buyers, resulting in a decline in U.S. exports.  In addition, a stronger dollar makes imports into the U.S. less expensive which makes goods and services produced in the U.S. less competitive.  Both these impacts are a negative for corporate earnings and in their earnings releases and outlooks numerous companies commented on the dollar impact which caused their stock prices to drop.  In addition, since most commodities are traded in U.S. dollars, a stronger dollar tends to lower commodity prices.  This impact exacerbated the pressure on commodity markets and producers already suffering from slowing demand and oversupply.

Major Market Indices –2015

2015 Chart of Returns

Throughout the year, data from China showed a significant slowdown in major areas of that economy. For example, the first quarter gross domestic product (GDP) report showed 7% year-over-year growth, which was the worst reading in six years. GDP growth declined to 6.9% in the third quarter.  The China Caixin manufacturing PMI index fell below 50 in March and stayed below that level for the entire year.  The index reached a low of 47.2 in September.  (A reading under 50 represents a contraction and a reading above 50 represents expansion.)  The China Services PMI dropped to 50.2 in December, which was the second lowest report in survey history.  A key number was the August report that showed that China’s exports fell almost 8% from the prior year.  Immediately after that report China made a surprise move to allow the yuan to devalue by 1.9%.  That move set-off a major sell-off in global equity markets.  The slowdown in economic activity in China had substantial ripple effects because China is the world’s biggest importer of raw materials, so reduced demand from that economy negatively impacts commodity prices and commodity producers, many of which are in emerging market countries. The reduction of imports into China is not limited to commodities and hurt providers of other goods as well, especially in Asia and Europe.

Oil prices continued the decline that started late in 2014 as production remained high and supply outstripped demand. The price of a barrel of West Texas Intermediate crude oil fell 31% in 2015.  Brent crude fell below $40 in December for the first time since 2009 after the decision by OPEC to maintain production at current levels.  The steep drop in prices is a benefit for oil consumers which has kept inflation low and has reduced the cost of filling car gas tanks.  AAA reported in December, that gas prices in 2015 averaged about 94 cents per gallon less than in 2014.  The national average price of gas in 2015 was $2.40 and was the second lowest annual average price during the last ten years.  However, the price drop has had substantial negative impacts.  Among the most significant impacts is the loss of jobs in the energy sector.  Reports indicate that the amount of energy sector job cuts globally was almost 200,000.  Much of the reason for the job cuts is that energy related capital investment has been slashed.  Having less capital investment hurts suppliers of materials and equipment.  The stubbornly robust production of oil worldwide and the corresponding falling oil prices also affected the corporate bond markets causing yield spreads to widen.  Weak prices for producers and less business for service and equipment providers have led to less cash available to repay debt and even some bankruptcies.  This has increased the risk of owning energy company bonds and resulted in lower bond prices.

Countries around the world took numerous policy actions aimed at making their currency more competitive and stimulating domestic economic activity. There were almost 80 central bank interest rate cuts during the year.  There were 29 cuts in the first quarter alone.  The first major policy action of the year was the surprise move by the Swiss National Bank to remove the franc to euro peg which set off global currency volatility.  Then several countries cut interest rates.  Another important move during the first quarter was the European Central Bank (ECB) announcement of a quantitative easing program including buying 60 billion euro of bonds each month through September 2016.  Initially stocks in many international markets advanced in reaction to these policy moves.  Also, bond yields fell in many parts of the globe, including the major European countries, which made U.S. bonds more attractive and drove bond prices higher and yields lower in the U.S.  In December, the ECB announced the program would be extended into 2017 which disappointed European markets that the amount of bonds the ECB intends to buy was not increased and equities sold off.  For most of the year, market participants were focused on economic data releases and comments by Federal Reserve (Fed) officials for clues as to when the first hike in the fed funds rate was likely to occur.  Equity and bond markets in the U.S. and other regions vacillated up and down depending on the tone of the data or comments.  The guessing finally ended on December 16 when the Fed made the decision to raise the fed funds rate target by 0.25% to 0.25% to 0.50%.  This move ended seven years of near zero interest rate policy in the U.S.

 Asset Class Summaries

U.S. equity markets were choppy in 2015. Major indices recorded multiple new closing highs during the first half of the year.  Then stock prices fell sharply with the S&P 500 index experiencing its first correction in four years.  A correction is defined as a decline of 10% from a peak.  The year started out with a negative return in January as lower energy prices and the stronger dollar took a toll on corporate earnings.  However, equity prices rebounded in February and March with indices including the Russell 2000®, S&P 500, Dow Jones Industrial Average, and NASDAQ reaching several new record highs.  Therefore first quarter returns were mostly strong with mid and small-capitalization (cap) stocks outperforming large-cap stocks.  The moves higher continued through most of the second quarter with indices hitting more new record highs.  Then on June 29 after the breakdown of Greek debt negotiations, the equity market had a sharp sell-off.  For example, the S&P 500 index fell -2.1% – the biggest one day decline since April 2014.  But within days, a Greek deal was reached and equity markets rebounded.  Markets turned sharply again in August in reaction to the surprise move by China to devalue the yuan.  The downward move was severe enough to push the S&P 500 index into correction territory.  By the last week in August the S&P 500 had declined 12% from its prior high.  Also, the Dow Jones Industrial Average had its largest ever intraday point drop when the Chinese currency was devalued.  Each of the major U.S. equity indices ended the third quarter with a sizeable negative return with large-cap stocks declining less than mid and small-cap stocks.  Also noteworthy during the third quarter was the double-digit sell-off in the healthcare sector which had for most of the year been the strongest performing sector.  The decline was due mostly to developments related to biotechnology stocks.  Biotechnology stock prices sank after Presidential candidate Hillary Clinton sent a tweet proposing a plan to counteract price gouging by drug manufacturers after an article was published about a price increase of over 5000% for a specialty drug.  Equities rebounded in October with the S&P 500 gaining over 8% due to the Fed decision to keep the fed funds rate near zero and some better economic and corporate earnings news.  In November and December equities trended mostly lower on mixed earnings news and anticipation of a hike in the fed funds rate in December.

There was a wide dispersion of returns for industry sectors in the U.S. equity market indices in 2015. Sectors with more exposure to consumer consumption had the better returns.  Sectors most exposed to exports and commodities had the weakest returns.  The best performing sector was consumer discretionary with a return of 10.1% and the poorest return was -21.1% for the energy sector.  Five of the ten sectors had a positive return – consumer discretionary, healthcare, consumer staples, information technology, and telecom.  Growth stocks outperformed value stocks for the year largely because of the weakness in exports and commodities.  For example, the S&P 500 Growth index had a return of 5.5% compared to the S&P 500 Value index return of -3.1%.

Returns for 2015 for both the MSCI EAFE index of developed international equities and the MSCI Emerging Markets (EM) index were higher on a local currency basis than on a U.S. dollar basis due to the negative currency impact to U.S. investors from the strengthening dollar. The currency impact was significant.  For example, the EAFE return on a dollar basis was -0.8% but on a local basis was 5.3%.  The EM return on a dollar basis was -14.9% but on a local currency basis was -5.8%.

Despite bouts of volatility, many international equity markets, particularly in Europe and Japan, moved higher on optimism about the impact of central bank stimulus measures and initial signs of better economic activity in at least some countries. The EM index had a mostly downward trend during 2015 due to the impact of the slowdown in China and the weakness in commodities.  On a local currency basis equity indices in various regions including Germany and the United Kingdom reached multi-year highs in the first half of the year.  Japan was also a top performer early in the year boosted by stock purchases by the government pension plan and improving corporate earnings.  However, conditions changed in the third quarter and the EAFE and EM indices posted double-digit negative returns.  Just as in the U.S., stocks fell sharply in reaction to China’s weak import and industrial production reports because China is a significant export market for many European and Asian countries.  International equities rebounded strongly in October.  Market participants reacted positively to comments by ECB President Draghi that suggested there may be additional easing measures taken as early as December to spur economic growth.  Certain indictors in Europe, such as the unemployment rate declining to an almost three year low, also provided a boost to stocks in the region.  Furthermore, markets reacted positively to additional stimulus action by China.  Stimulus measures taken by China early in the year helped the consumer side of that economy even though the industrial side continued to slow.  International equity returns were mixed in the last weeks of the year.  Some better news such as the euro area GDP increasing for the tenth consecutive quarter provided a boost.  However, in December market participants were disappointed and pushed stocks down again when ECB President Draghi announced that the ECB would extend the time period for is quantitative easing program but would not be increasing the amount of asset purchases.

Just as in the U.S. equity market, there was a wide dispersion among the 2015 returns for industry sectors in the international equity markets. Similar to the U.S., growth sectors outperformed value sectors with consumer related, healthcare, and technology sectors posting the best returns and energy, materials, and industrials having the weakest returns.

The volatility of mainland China’s equity indices was a major story of the year. China’s stock indices surged early in the year despite weakening economic activity particularly in the industrial and exports portions of that economy in large part due to the huge amount of margin used by retail investors to buy stocks.  The Shanghai index rose about 60% through early June.  Then the index dropped sharply falling 33% by early July and after a brief recovery took another leg down and declined 16% by the August 25 low after the surprise currency devaluation.  China attempted to control the extremes in stock market activity by putting in place various market controls during the year such as limits on margin, halting initial public offerings, and banning stock sales by major shareholders.

U.S. bond market returns were mostly positive for 2015 except for the corporate high yield sector which declined in part in reaction to the stress in energy related companies. Energy company bonds are about 14% of the high yield market.  The benchmark 10-year Treasury bond traded in a relatively tight range throughout the year despite the anticipation of the first increase in the fed funds rate in nearly a decade.  The 10-year Treasury bond yield was 2.27% on December 31, 2015, which was up only slightly from the yield on December 31, 2014 of 2.17%. During periods when better economic data, like strong jobs reports, supported the idea that the Fed could begin to raise its key interest rate and when the Fed finally did hike the rate, yields rose and prices fell.  The 10-year Treasury bond yield reached as high as 2.5% in June.  However, in periods when economic data looked weaker, yields declined and prices rose.  For example, the 10-year Treasury bond yield fell to under 2% for a brief period in August during the severe equity market sell-off after the Chinese currency devaluation.  Another factor kept yields from rising much during the year.  The rash of central bank policy moves around the world, particularly early in the year, drove bond yields down around most of the world.  The relatively higher yields available on U.S. bonds attracted cash into the U.S. bond market which drove prices higher and yields down.  The 10-year Treasury yield reached a low of 1.6% in late January.  Municipal bonds were the top performing sector for the year.  The Barclays Municipal Bond index had a return of 3.3% for 2015 compared to the broad investment grade credit index, the Barclays U.S. Aggregate Bond index, return of 0.6%.  Strong demand for tax-exempt income drove municipal bond prices higher during the year.

The Bloomberg Commodity index recorded its fifth consecutive year with a negative return. Commodity markets declined for most of the year.  The major sub-indices (industrial metals, precious metals, energy, and agriculture) each posted a double-digit negative return for the year.  Oversupply and the strong U.S. dollar were the main reasons for the steep declines.  Oil production continued to increase during the year.  North American production rose despite a significant reduction in the number of active drilling rigs and OPEC decided to maintain production and essentially removed production caps.  Because of the high level of production and inventories, crude oil prices continued the downward trend started in 2014 and dropped over 30% in 2015.  There were periods such as during the second quarter when oil prices moved higher, but these periods were brief and prices turned down again.  West Texas Intermediate crude price traded as low as $35 during the year but ended the year just above $37.  The slowdown in manufacturing and construction in China led to reduced demand for various commodities.  Therefore, prices for many industrial commodities fell to multi-year lows.  For example, the price of copper dropped over 20% in 2015.  Precious metals declined as well.  Gold fell 10% in 2015, which was the third consecutive annual decline.  Gold reached a five-year low in July.  The dollar rally and low inflation around the world reduced demand for the metal as an inflation hedge.  Most agricultural commodity prices declined again in 2015 as bountiful harvests boosted supply.

Because global economic growth is expected to be low and valuations are near or above historical averages to start the year, it is likely there will be bouts of heightened volatility in all sectors of global financial markets during 2016. Therefore, an adequately diversified portfolio including growth and risk reduction focused investments continues to be a prudent strategy.

The statistical information contained in this commentary has been compiled from publicly available sources and is presented to you for your review and for discussion purposes only. The information contained in this commentary represents the opinion of the author(s) as of its date and is subject to change at any time due to market or economic conditions. These comments do not constitute a recommendation to purchase, sell or hold any security, and should not be construed as investment advice or to predict future performance.  Past performance does not guarantee future results.

 The statistical information contained in this commentary was derived from sources that Vogel Consulting, LLC believes are reliable, and such information has not been independently verified by Vogel. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of the Russell Investment Group.  An index is not managed and is unavailable for direct investment.