Market data for the quarter ended March 31, 2016:
• S&P 500 Stock Index: 2060, up 0.8%
• Ten-year Treasury Note Yield: 1.79%, down 0.48%
• Gold: $1,233 per ounce, up 16.3%
• Oil: $38 per barrel, up 2.7%
Stocks swung violently in the first quarter of 2016 but ended the quarter nearly unchanged from the end of 2015. The primary driver of the volatility was the price of oil. Oil plunged in the first six weeks of the quarter, trading as low as $25 per barrel. The collapse in the price of oil was seen as an indication of weak global economic growth, perhaps bordering on recession, while also wreaking havoc on the industrial and financial sectors of the economy. During the boom in the price of oil from 2009 to 2014, the petroleum industry ramped up its borrowing and became a prime driver of demand for industrial equipment. While lower prices are beneficial to consumers and non-energy related corporations, the resulting disruption in the financial and industrial sectors was seen as having the potential to tip the overall economy into recession. In mid-February, Saudi Arabia and Russia, the two leading producers of oil, began discussing the possibility of a freeze in the growth of oil production. This led to a sharp reversal higher in oil prices. Stocks followed oil upward, as the concerns cited above dissipated.
Going forward, risks remain in the global economy and financial markets. The Chinese economy is heavily reliant on debt financing, thus rendering it brittle and diminishing its ability to cope with stress. Since the turn of the 21st century, China invested heavily in industrial capacity, real estate, and physical infrastructure. This investment was financed largely through debt. As this investment cycle has run its course, China has been left with an unbalanced economy and substantial industrial overcapacity. The Chinese government knows that it must turn from an investment and manufacturing driven economy to one more balanced with consumption and services. This transition is fraught with risks made worse by the massive overhang of debt that was accumulated in the investment boom. Given the perilous economic position of China, a large depreciation in the Chinese currency, the yuan, is possible. This could unleash a chain reaction in the currencies of other emerging markets and lead to a broader economic and financial crisis, as money would stampede out of the emerging world economies. This would have serious consequences for the American stock market, as a significant portion of US corporate revenues are accrued overseas. Fortunately, recent economic data out of China has turned up, and the yuan, the Chinese currency, has strengthened. Nevertheless, the situation bears close monitoring.
While the Federal Reserve in its March monetary policy meeting moderated its projection for further increases in overnight interest rates, the risk of an overly aggressive Federal Reserve remains a risk to the economy and financial markets. The Federal Reserve raised its benchmark overnight interest rate a quarter point (.25%) in December of 2015 for the first time since June of 2006. Given the financial turmoil in the first six weeks of the year, this was increasingly seen as a mistake. The Federal Reserve responded at its March meeting by keeping overnight rates in a range of .25 to .50% and lowering its expectation of further quarter point rate increases in 2016 from four to two. As soon as financial markets stabilized, however, several Federal Reserve Bank presidents began making public statements that the tightening of monetary policy should be accelerated. Given subpar wage growth and persistently below trend growth in GDP and inflation, we feel this would be a major policy error that could sink the US stock market and economy. Fortunately, we believe Federal Reserve Board Chairwoman Janet Yellen does not share the opinions of these hawkish bank presidents and will not adopt an inappropriately aggressive policy.
Outside of economics, political risk factors are present. While we feel it is a distinct long shot, a President Trump could be an economic and financial disaster given his calls for draconian tariffs on foreign imports. This could result in a global trade war that would plunge an already fragile world economy into recession. While free trade is not the economic panacea that many claim it to be, Donald Trump’s position is reckless and destabilizing. There are more constructive methods of dealing with the negative impact of trade on American workers, such as increasing the earned income tax credit and infrastructure investment. On the other side of the Atlantic, the United Kingdom is voting in June on a referendum to leave the European Union, (commonly referred to as Brexit). Such a move would weaken the trade and financial systems of America’s largest trading partners and would be a distinct negative for both the global and American economies. The outcome of the referendum is highly uncertain, with the economic risks being weighed against perceived vulnerabilities to the refugee situation in Europe made worse by the recent terror attacks in Paris and Brussels.
While these risks are substantial, we by no means think they are inevitable. In the face of them, we will continue to execute our investment strategy of quality, value, diversification and patience. For the remainder of 2016, we expect the American stock market, as represented by the S&P Five-hundred stock index to trade in a range of 2150 to 1850. It ended the quarter at 2060. As always, please feel free to contact us with any questions or concerns.