Since the 2008 financial crisis, asset allocation has played an important role for portfolio returns with both equity and fixed income generally delivering good returns driven by steady economic growth, low inflation and a loose monetary policy. However, last year, equity and fixed income markets bucked the trend. In fact, the U.S. stock markets had their worst yearly performance since 2008 with the Dow losing 2.2%, while the S&P 500 fell 0.7%. This is arguably a significant difference when compared to the previous seven years’ annualized return of 10.3% for the Dow and 12.4% for the S&P 500. Post-1939, no third year of a Presidential cycle has delivered a negative return for the stock market as it did in 2015. The iShares iBoxx High Grade Corporate Bond Exchange Traded Fund (ETF) was down 4.5% for the year, while its High Yield version, the largest junk-bond ETF by assets, fell 10%. Please note that returns mentioned in this paragraph do not include any dividend reinvestments.
This market performance was driven mainly by two very significant factors. On the one hand, the developed world saw the divergence between the Federal Reserve (Fed) increasing rates while Europe and Japan were continuing their easy monetary policies; on the other hand, the developing world suffered from a severe commodity downtrend. Concurrent with a deceleration in the Chinese economy, the aforementioned rate divergence surprised many long-term global investors and resulted in negative yield levels on hundreds of billions of dollars of European debt. With its need to deleverage, China will not be able to invest in its domestic economy as in the recent past, and their growth rate will likely decelerate further. The People’s Bank of China (PBOC) will remain under pressure to stimulate and further develop the consumption and services sectors of the Chinese economy.
According to an article published by Bloomberg in early 2015, approximately 2/3 of the traders on Wall Street have never been through an interest rate hike cycle, and with the Fed signaling multiple rate increases in 2016, the US dollar has been appreciating considerably. Many critics to the Fed’s increase in rates argue that a stronger dollar can hurt corporate earnings in America, and thus, undermine the arguably subdued growth of the economy. This can be problematic since publicly traded stocks constituting the S&P 500 generate 40% of their profits from abroad.
As we write this piece in early 2016, global markets are clearly in a risk-off mode due to the fear of a hard-landing in China as well as subdued economic growth across the globe. Oil prices are down nearly 20% already and the S&P is approaching a decline of 10%. Caution is clearly warranted as the last year that began with a severe first day drop was 2008. Furthermore, since WWII, only two bull markets have lasted seven years or longer. Although, the valuation in stock markets does not look cheap, credit spreads are indeed wide, and offer potentially a good opportunity. At this stage, volatility is the only certainty we can expect in 2016.