U.S. stocks ended the quarter with modest gains as the S&P 500 Index rose 1.35%. The modest gain, however, masked a good deal of volatility within the quarter. The year began with sharp declines as concerns about slowing global growth increased. Chinese authorities took steps to aggressively devalue their currency which led many investors to believe economic growth in China was falling faster than previously expected. At the same time, fears of a recession in the U.S. increased as corporate earnings growth was negative for the third quarter in a row. The S&P 500 was down 11.4% by February 11th only to reverse course over the next seven weeks. A series of positive economic reports in the U.S. and a rally in oil prices drove the reversal in U.S. stocks.
Developed market foreign stocks, as measured by the MSCI EAFE Index, dropped 3.01% during the quarter despite additional easing of monetary policy in Europe and Japan. The European Central Bank and the Bank of Japan both now have their key overnight lending rates below zero, meaning banks have to pay interest to keep reserves with their respective central banks. Uncertainty over the impacts of negative rates and mixed economic data led to the declines in foreign stocks. The terrorist attack in Brussels and an upcoming referendum on whether the United Kingdom should leave the European Union added to the uncertainty. Emerging market stocks, on the other hand, rallied strongly. The MSCI Emerging Markets Index gained 5.71% for the quarter as higher oil prices and a weaker dollar provided support.
Yields on U.S. bonds dropped sharply in the first quarter as volatility in risky assets drove investors to purchase safe havens. The yield on the 10-Year Treasury dropped to 1.77%, roughly 0.50% lower than the yield at the beginning of the year. At its March meeting, the Fed left rates unchanged and lowered their expectations for growth and future rate rises. The Fed cited low inflation and global economic weakness as reasons for the revisions. The Barclays Aggregate Bond Index ended the quarter up 3.03%. Treasury Inflation Protected Securities (TIPS) also rallied (+4.46%) as inflation expectations increased, primarily due to higher oil prices and an uptick in the Consumer Price Index.
Despite the pickup in volatility, returns in the U.S. stock market (as measured by the S&P 500 Index) have been relatively flat over the recent past. Since December 31, 2014, the S&P 500 has returned just 2.75% and most of that return has been earned through dividends, not from price appreciation. When some investors see results like this, they begin to think that the risk of owning U.S. stocks is higher than the potential reward and start thinking that maybe a change in allocation is in order.
One popular response to the current situation is to seek higher yields. The thinking goes like this: if a majority of the return one receives is from dividends, one might as well buy assets with higher yields. The search for yield has contributed to rallies in areas of the market that pay high dividends like utilities and consumer staples stocks. The utilities sector was the best performing sector in the first quarter (+15.6%) and the search for yield was one of the reasons why. This strategy, however, can be very dangerous. As investors pile into utility stocks, they get more expensive from a valuation standpoint. As of March 31st, utilities were trading well above their 20-year averages for both forward and trailing price/earnings ratios. As the valuation of utilities stocks rises, risk increases and investors could lose significantly more than they gained in yield.
Energy Master Limited Partnerships (MLPs) are an excellent example of how the reach for higher- yielding assets can backfire. For several years through 2014, investors poured money into MLPs, attracted by the seemingly stable dividend stream and 6-9% yields that MLPs offered. As the price of oil dropped, the prices of MLPs dropped as well. The Alerian MLP Index (a broad index of MLPs) dropped 33% in 2015 and many dividends have been cut or suspended.
The same reach for yield is occurring in bond markets as well. Bond investors who depend on their portfolios for income are looking for ways to earn more than the 1-3% yields generated from high- quality bonds. It is tempting to consider segments of the bond market that have higher yields such as corporate high yield (junk) bonds which are yielding almost 6%. But, investors need to remember that there is no free lunch. Higher yields means higher risk. The performance of high yield bonds is highly dependent on the performance of the issuing corporations. High yield bond performance is also highly correlated to the performance of the stock market which reduces the benefits of diversification that bonds offer.
Considering a change in portfolio allocation is a serious decision. That decision should be driven primarily by the investor’s long-term goals and risk tolerance rather than the current conditions of the market. No one knows how long this period of lower-than-average returns will persist. Given that, we believe it is best to remain broadly diversified and patient.
Written by Jeffrey L Blanchard, CFA, Investment Analyst; [email protected]
|Index||Market||Year-to-Date as of 3/31/16|
|Standard & Poor’s 500||Large Co. U.S. Stocks||1.35%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||1.64%|
|Russell 2000||Small Co. U.S. Stocks||-1.52%|
|MSCI All-Country World ex US (ACWI)1||Foreign Stocks||-0.38%|
|Barclays 1-5 Year Gov’t/Credit||U.S. Shorter-Term Taxable Bonds||1.61%|
|Barclays Aggregate Bond||U.S. Taxable Bonds (Broad-based)||3.03%|
|Barclays 1-5 Year Muni Bond||U.S. Shorter-Term Tax-Exempt Bonds||0.71%|
|JPMorgan Global Ex-U.S. Bonds||Hedged Foreign Bonds||9.08%|
Written by Jeffrey L Blanchard, CFA, Investment Analyst; [email protected]
Data Sources: Morningstar; Econoday; Bloomberg.com
(1) Source: MSCI. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties or originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.
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