2016 Half-Time Report
Economic risks this past decade have tended to be magnified because of the low-growth, low-inflation landscape in which we have been beset. Even moderate growth slowdowns trigger recession scares because the U.S. economy has been growing at a historically low rate, particularly in nominal terms. Investors have reacted strongly to every economic bump.
Fear took over the U.S. Equity market to begin this calendar year, and the results were not pretty at all. January got off on a terrible note, with panic about the slowdown in China and crashing oil prices sending the Dow to its worst 10-day start to a year on record going back to 1897. Chinese GDP growth declined to 6.9% in 2015, marking the slowest pace of growth in 25 years, and uncertainty about future growth triggered panic selling in stocks worldwide at the start of 2016. Although the Chinese 6.9% growth is more than double that seen in the U.S., it pales in comparison to the double-digit growth of the Chinese economy before the 2008 financial crisis.
The S&P 500 tumbled from around 2040 in January to a low at 1810 in February, marking out a solid 10% correction in the index. But the S&P stabilized and began to recover, reaching a high of 2120 in early June. Then Brexit hit and knocked down the S&P by about 5% in just two trading days, leaving the Index close to where it started the year.
The crude oil market also played a starring role in global market action in early 2016 with an extremely high correlation with the S&P 500. Stocks and crude oil formed bottoms at roughly the same time in February, and as crude oil climbed, U.S. stocks gained as well. The price of West Texas Intermediate (WTI) crude oil hit its lowest level in 13 years in February. Nearby New York crude futures touched the $26 per barrel area, marking the continuation of the multi-year slide in oil prices from over $100 per barrel back in 2013.
Massive global overproduction—stemming in large part from the U.S. shale industry along with overproduction from OPEC nations—and slowing demand for crude contributed to the price slide. The low level of crude oil prices decreased profitability for U.S. oil drillers and ultimately triggered a slowdown in U.S. production. That, along with weakness in the U.S. dollar and expectations that OPEC could freeze production, helped support a rising trend in crude oil. Crude oil futures climbed from a low at $26.05 per barrel in February to a high in early June above $50 per barrel.
Yields on the 10-year Treasury note remain historically low. A key theme driving the direction of bond prices and interest rates (which move inversely) this year, of course, has been the U.S. Federal Reserve and monetary policy expectations. Since the start of 2016, expectations on when the Fed could pull the trigger on another rate hike have fluctuated wildly.
The Fed ended its zero interest rate policy in December 2015 with a small rate hike of 0.25%, the first hike in nearly 10 years. That brought the Federal funds rate to its current 0.25% to 0.5% level. Shifting views on the strength of the U.S. economy and whether inflation is picking up enough to hit the Fed's 2% target have knocked expectations of Fed policy back and forth throughout the year.
Global investors have continued to favor the safe-haven appeal of U.S. Treasuries in light of early-year concerns about Chinese growth and, most recently, fears about what Brexit could mean for the global economy. The yield on the 10-year Treasury fell to 1.45% immediately following the Brexit vote as investors piled into bonds pursuing safety.
Gold has been a big gainer throughout 2016, posting a 24% gain year-to-date through late June. Gold, like Treasury bonds, has been viewed as a safe-haven asset and received a fresh jolt of buying interest post-Brexit. Throughout 2016, gold also gained support from investors worldwide amid concerns about the move to negative interest rate policies by a number of global central banks, including the European Central Bank and the Bank of Japan. Gold futures spiked to a high at $1,355 per ounce immediately after the Brexit vote, hitting its highest level since March 2014.
Last but not least, the U.S. Dollar Index has been buffeted back and forth by conflicting themes in 2016. Early in the year, the dollar came under pressure as traders began to lower expectations for the number of Fed rate hikes in 2016. At the start of the year, many economists expected as many as three or four rate increases. Now, some question whether the central bank will be able to hike at all this year.
The U.S. dollar index slid from a high around 100 at the start of the year into a low near 92 in early May. Bargain hunting emerged around that zone, and shifting expectations about future Fed monetary policy boosted a rebound. In late June, the dollar soared higher, boosted by global safe-haven demand in the wake of the Brexit vote.
Our short-term view is cautious to guard against a meaningful U.K.-induced shock to the euro area economy, and by extension, to the U.S. We are waiting to see if the hit to business and consumer confidence in Europe is significant in terms of determining if we should adopt a more defensive investment strategy. It is also possible that November’s U.S. election could increase economic risks by unnerving the business sector and hiring plans beyond the near run. So far there are no such signs, but we will continue to monitor the situation closely.
On the plus side, both the U.S. and euro area economies had positive momentum heading into Brexit, and have shown impressive resilience in recent years. Activity was mildly accelerating in the U.S. and the euro area, and China had stabilized (with its foreign exchange reserves actually rising). The ISM and PMI surveys in recent months were positive despite the political uncertainty around the globe and weakness in the U.K. It is prudent to be cautious in terms of investment policy in the near run. However, the repeated resilience of the U.S. economy since 2009, and the euro area economy since 2012, holds out the prospect of a more positive outcome.