Global markets exhibited significant volatility during the first quarter of 2016. Concerns over economic prospects caused markets to correct through the first six weeks of the year. Thereafter, markets recovered. Catalysts for the recovery in equity prices included indications by the Federal Reserve that it would go more slowly in raising short term interest rates than appeared to be the case earlier in the year. The resultant weakening in the U.S. dollar had a favorable impact on commodities, and in particular, oil, as well as emerging markets. Evidence that the Chinese economy was at least stabilizing also reduced concerns that global economic growth would weaken significantly during 2016 as a whole.
Emerging markets as measured by the MSCI Emerging Markets Index led the recovery with a total return of 5.7%, while the U.S. as measured by the Standard and Poor’s 500 Index increased by 1.4% on a total return basis. Developed markets outside the U.S. declined by 3.0% during the first quarter. Global equities as measured by the MSCI All Country World Index ended the first quarter on a slightly positive note, with a total return of 0.2%.
The U.S. economy remains in relatively good shape, with growth in inflation adjusted Gross Domestic Product expected to continue at a 2% pace during the remainder of 2016 and beyond. Labor markets continue to provide steady employment growth at an average gain of 200,000 in the monthly payroll reports. Wages are finally starting to accelerate, with average hourly earnings increasing by 2.3% for the year ended March 31, 2016. The risk that the Federal Reserve will raise interest rates too rapidly seems to have receded in recent weeks. Chair Yellen’s recent statements reflect a focus on global economic conditions. While interest rates are likely to rise, the pace of increase will be more gradual than anticipated last December so the risk to U.S. economic growth from tighter monetary policy seems to have been reduced.
The economic outlook outside of the U.S. is more uncertain. In Europe, the June 23rd vote in the U.K. on whether to leave the European Union creates an element of risk. A “yes” vote would create risks for the entire European project as trade relationships between the U.K. and the EU will have to be renegotiated, a process which would take several years. On the positive side, the European Central Bank is becoming more aggressive in quantitative easing in an attempt to get their moribund economies moving and offset deflationary pressure. The Bank of Japan’s implementation of negative interest rates appears to have backfired, with the yen strengthening after the announcement and creating even more deflationary pressure on the Japanese economy. In the long run, the implementation of economic reforms remains essential for the Japanese economy to break the multi-decade stagnation.
Emerging market prospects remain closely tied to those of China. In recent weeks, concerns over a so- called hard landing for China have abated. Capital outflows have slowed, reducing downward pressure on the Chinese currency. The transition from manufacturing to consumption seems to be ongoing, with consumer spending holding up as reflected in a 10% increase in auto sales for March. The improved sentiment for China is reflected in a recovery in commodity prices. How sustained a recovery will be from here is uncertain but it appears likely that the lows may have been seen in commodity prices. For example, the supply/demand relationship for oil appears to be improving. Oil production in the U.S. as reported by the Department of Energy has declined from a peak of 9.6 million barrels per day to a recent level of 9.0 million. Major oil producers are expected to meet on April 17 and a freeze in production is possible. Growth in demand is less robust than previously estimated, with the IMF outlook for 2016 global growth being reduced from 3.4% to 3.2%. Improving prospects for China, a stabilization in commodity prices and recent weakness in the U.S. dollar have led to a recovery in emerging market equities. At a minimum the lows in emerging market prices of early 2016 seem increasingly unlikely to be breached.
Our global equity strategy responded to these trends by increasing representation in the energy sector. We still hold higher than average cash reserves and are looking for further opportunities to commit these to equities. Our areas of focus remain energy, attractively valued European and Japanese equities, and a highly selective approach to emerging markets. Our current expectation is to reduce cash and initiate additional equity positions on a highly gradual basis.
As of March 31, 2016, our equity asset allocation is as follows:
North America (Including U.S.) 61%
Developed Markets (Including Europe and Japan) 30%
Emerging Markets 7%
In fixed income markets, increasingly aggressive easing by the Bank of Japan and European Central Bank combined with an increasingly dovish Federal Reserve to produce across-the-board interest rate declines during the first quarter of 2016. Two year U.S. Treasury yields declined from 1.05% to 0.72% while yields on five year Treasuries dropped from 1.76% to 1.21%. The yields on ten year Treasury obligations declined from 2.3% to 1.8%. Ten year German obligations showed a yield decline from 0.63% to 0.15% while the yield on ten year Japanese obligations declined from 0.26% to a negative 0.3%.
The slowing pace of interest rate increases by the Federal Reserve, coupled with negative short term interest rates in Germany and Japan, will cause longer term rates in the U.S. to remain lower for longer. Nevertheless, it seems inevitable that U.S. interest rates will eventually rise as inflation in the U.S. is allowed to increase, most likely beyond the stated target of 2%. With this outlook in mind, the average maturity of our taxable and tax exempt fixed income portfolios remains shorter than average. We continue to pursue a selective approach to new obligations, focusing on attractive relative values which appear to offer better risk/return charactistics than the average.
This report is for informational purposes only, and contains data based on information derived from sources Princeton Global Asset Management (PGAM) believed to be accurate. However, PGAM cannot assure the accuracy of the data. Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities transactions or holdings that may be cited were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities cited.