Quarterly Market Update
As the Quarter Goes, So Too May the Year
We anticipate global equity performance should closely mirror the return pattern of the first quarter.
The first quarter was a record-breaking one for financial markets, thanks to the efforts of major central banks to keep short-term interest rates exceptionally low, coupled with encouraging indications that global economies, particularly in Europe and Japan, may be stabilizing. Globally, seventeen stock market indexes set new highs, the U.S. dollar surged to an 11-year high relative to major currencies, and U.S. Treasury bonds rallied for the fifth-straight quarter.
Led by European stocks, the big winner was international developed market equities as measured by the MSCI EAFE. Major Eurozone stock market indexes, including Portugal, Germany, Italy, France, and Spain, posted double-digit returns. Improving economic data, supported by lower oil prices that boosted consumer confidence and weakness in the euro that benefited European exporters, set the stage for European stocks to bounce back from the weak second half of 2014. The ECB’s new bond-buying program aims to weaken the currency and stimulate the sluggish Eurozone economy. The combination of improving economic data and strong monetary stimulus was enthusiastically received. Investors in U.S.-based mutual funds pulled $1.1 billion out of stock funds in the week ended March 25, according to data from the Investment Company Institute. Meanwhile, foreign-focused stock funds attracted $3.3 billion in the 12th straight week of inflows.
The stocks of larger U.S. companies were challenged by declining oil prices and a stronger dollar which threatened profits in the energy sector and at U.S.-based multinational companies whose revenues are highly dependent upon exports. Although the S&P 500 and the Dow Jones Industrial Average reached a number of intra-quarter highs, the rally stalled near the quarter end as concerns mounted about the strengthening dollar. While the S&P 500 managed its ninth-consecutive quarter in the black, posting a somewhat anemic 0.95% return, the Dow ended the quarter in the red. In comparison, the quarter’s second best performing asset class was U.S. small-cap stocks, as measured by the Russell 2000 Index. Those companies only receive roughly 18% of their revenues from international sources and are much more geared towards the U.S., arguably the best performing economy among developed markets.
Figure 1. Broad stock market indexes post double-digit returns for the one- and five-year periods.
Earnings Stumble under Strong Dollar and Lower Oil
Because the fourth quarter was the first one to bear the full brunt of the twin drags of falling oil prices and a stronger dollar, earnings were particularly closely scrutinized. As expected, energy was the weakest performing sector with a number of companies suffering a margin contraction. The impact of the strong dollar was felt across a broad range of industries from beverages to computers, and the fourth-quarter earnings season ended with a whimper. Revenue growth was anemic at 1.5% and earnings-per-share (EPS) growth was 5.2% – better than estimates going into the quarter, but not nearly as improved as was earlier anticipated.
U.S. stock returns must become less dependent upon multiple expansion and much more earnings-driven.
The impact of oil prices and a stronger dollar will continue to influence stock market returns for the balance of the year. The dollar will likely continue to strengthen as the Fed executes its first interest rate hike since 2006, and credit tightens. Although oil prices have yet to establish a floor, perhaps the larger question is at what point we might expect lower prices at the pump to influence consumer spending patterns.
The consumer has received the equivalent of a “tax cut” in the form of cheaper fuel and energy prices, but they have chosen thus far to save, rather than spend, the windfall. Indeed, personal savings rates have gone up. But, in our opinion, there is pent up demand building and we should see consumers spending again in a more meaningful fashion, which will translate into improved earnings for U.S.- focused companies.
Figure 2. A comparison of price-to-earnings ratios and earnings-per-share across capitalizations for developed and emerging markets.
The first-quarter earnings season will begin shortly after the close of this BBVA Compass Market Outlook’s reporting period. In addition to the impact of the dollar and oil prices, it is unclear how badly this winter’s big weather events in the Northeast and the Midwest, although not the polar vortex of 2014, will affect earnings. Earnings estimates are currently back-ended toward the balance of the year, placing a great deal of weight and expectation on the third- and fourth-quarter earnings. Those numbers are already threatened by the lower commodity prices and the strong dollar, which puts a great deal of pressure on those numbers coming through, given where current estimates stand.
This year, U.S. stock returns must necessarily be less dependent upon multiple expansion and much more earnings-driven. Stock returns have been driven mainly by multiple expansion since the market bottomed in March 2009. After the financial crisis, earnings growth was irrelevant because companies were coming off negative numbers. Now we are back to the point where earnings must once again drive returns.
This increased focus on earnings will be a challenge for U.S.-centric companies as they are faced with the headwind of rising interest rates while the Eurozone benefits from the tailwind of a falling interest rate cycle. Eurozone economic data is also improving and, although the absolute level of Eurozone growth rates is still fairly low, the rate of change is accelerating significantly. The original boost to international equity returns occurred when the ECB announced its bond-buying program, but now we are beginning to see important follow through from improving economic data.
Figure 3. On March 31, 2015, the euro fell to a 12-year low of $1.07, down from as much as $1.39 in April 2014, nearly a 25% drop.
The financial markets are obsessed with attempting to predict the timing of the first fed funds rate increase. With history as our guide, we expect the hike will have a short-term impact on financial markets. During a typical cycle, the Fed executes several closely-spaced, consecutive interest rate hikes until rates have normalized. However, consensus is that this cycle will be different because the economy is still not strong enough to handle a steady series of increases. While the Fed desperately wants to get off the 0% target rate, it is mindful that the economy is still recovering, and at a slower pace than from previous recessions. Expectations for the fed funds target rate for 2016 have also been lowered. Under this scenario of a gradually implemented rate hike cycle, equities theoretically should have an opportunity to digest the initial increase, have a shorter-term pull back, and then move forward, albeit at a more modest pace than we have seen in the previous six years of the U.S. bull market.
Looking forward, we believe developed international market stocks and U.S. small- and mid-cap stocks should continue to lead returns, and that the S&P 500 will continue to lag the former. In summary, in terms of returns, what did well and what lagged in the first quarter will likely continue to do so for the remainder of the year.
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).