Global equity markets got off to a rocky start in 2016, while yields on long duration U.S. government bonds fell sharply, as markets began pricing in a possible U.S. recession and a deeper slowdown in global growth. Our Global Allocation strategy was well-positioned for this turbulence, having been significantly underweight equities and overweight bonds since the beginning of August 2015.
The S&P 500 started the year off with a 9% drawdown before rallying in the last few trading days of the month to finish January down only 5% after Japan’s central bank instituted a negative interest rate policy (NIRP). Developed markets (EFA) finished the month down 6% (after having been down 11%), while emerging markets (EEM) finished the month down 5.5% (after having been down 13%).
The bounce in the equity markets coincided with a bounce in the price of crude oil, which rebounded from a 13-year low of $26 to finish the month near $33 a barrel. Small-cap stocks suffered even deeper losses as IWM was down as much as 13% before finishing the month down 9%. China, perhaps the epicenter of the slowdown in global growth as its credit bubble bursts, finished down 13% after having been down 17% mid-month.
Notably, the mega-cap FANG stocks (Facebook +7% in January, but -10% prior to its earnings announcement; Amazon, -15% in January; Netflix,-20%; and Google, -3%), which had held the S&P 500 afloat in 2015, masking broad-based weakness throughout the market, finally showed signs of vulnerability.
Long-duration U.S. bonds (TLT) rose 5.4% in January as the 30-year yield fell from 3% to 2.75%. 10-year yields fell from 2.26% to 1.93%. Emerging market bonds finished flat on the month after being down 2% prior to NIRP.
Gold and mining stocks while up only modestly in January, at 5% and 3%, respectively, have started off February at a torrid pace. Gold was up 10% through February 5th, while mining stocks were up 22%, in what may be the first signs of investors beginning to question the credibility and “omnipotence” of central bankers. Significantly, the NIRP equity bounce has all but evaporated as of this writing. In December, the raising of interest rates by the Federal Reserve along with the S&P 500 just shy of its all-time high was widely acclaimed by the financial press as evidence of a U.S. recovery and that the Fed could justifiably say “mission accomplished.” Now the consensus has shifted to viewing the rate hike as a policy error, with the market now not pricing in another rate hike until November 2017 at the earliest (when multiple rate hikes for 2016 had been priced in just a month ago).
With 63% of the companies in the S&P 500 having reported earnings as of February 5th, the year-over-year earnings decline for the index is 3.8%. Q4 2015 marks the first time since Q1-Q3 2009 that the S&P 500 has seen three consecutive quarters of year-over-year earnings declines.
The profits recession coupled with the ongoing manufacturing recession, equity market selloff, ongoing hard landing in China, and flattening of the U.S. yield curve has brought to the forefront the possibility that the U.S. may be headed for, if not already in, a recession. Various studies have been trotted out on both sides of the argument to bolster or refute the notion. Q4 2015 GDP appears to be tracking in the 0.0% to 0.4% range, while Q1 2016 GDP is currently forecasted at 2.4%
Other macro developments include a continued loss in foreign reserves for China as it sells dollars to defend the yuan from speculators who envision China having to devalue its currency to help stabilize the fallout from the bursting of its credit bubble. And in both the U.S. and Europe, financial stocks are suffering deep losses as poor earnings combine with fears of a global growth slowdown and the effects of NIRP to scare away investors.
In light of the turmoil across the global financial landscape, we are suggesting that clients use the inevitable short-term rallies in equities to continue to reduce overall global equity exposure and increase long-duration U.S. government bond exposure. With earnings decreasing, U.S. equities are still significantly overvalued relative to history despite the recent selloff. Further, the slowdown in global growth and the exceedingly low (or negative) bond yields across developed markets should bolster the attractiveness of long-duration U.S. government bonds.
Our positioning in our Global Allocation strategy remains significantly defensive. We continue to have a substantial underweight to global equities and a substantial overweight to long-duration U.S. bonds. This positioning has only intensified (less equities, more bonds/cash) in recent months as equity market momentum turned negative and we anticipate it will remain that way until equity market momentum stabilizes or turns positive.
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