An Average Quarter?

2Q 2016

It ended up being a pretty “average” quarter in the stock market after all. At least that’s what the final tally would have you believe. The S&P ended the first quarter of 2016 +1.3% (total return, including dividends). But the ride we took to get there was a bit more exciting than “average.”

Within the first six weeks of the New Year, US large cap stocks were down 10.5%. Mid and small cap stocks were down more, -12.6% and
-15.9%, respectively. Also hit hard were international stocks, particularly emerging markets (-13.3%). Much of the reason for the global worry related to two things: falling oil prices and the prospects of a strengthening US dollar.

By now, most know why oil prices fell beginning in the middle of 2014 down to $26.19 (West Texas Intermediate) on February 11th – because the North American oil shale boom was quickly becoming a sizeable new supplier of oil, while China’s need for oil was decelerating. So that explains part of the global concern. But why was the dollar so strong to start the year (peaking on January 22nd)?

A major contributor was The Federal Reserve’s decision in December to raise interest rates (1/4th of 1%) for the first time since June 2006. This contrasted with the more accommodative “easy money” stance taken by most of the world’s other central banks. Essentially the Fed was raising the rate that investors/depositors would receive on US deposits, while other central banks (like the European Central Bank and the Bank of Japan) were lowering their rates (even going negative in some cases – meaning they will charge interest, rather than pay interest on deposits). The anticipation of rising US rates (going back nearly two years) has played a large role in the strength of the dollar over the last couple of years. We would note that it is often less about where current rates are and more about where markets think they are going. Effectively, we’ve been borrowing trouble from tomorrow and tomorrow is taking longer to get here than expected.

Ironically, and completely opposite of consensus forecasts, the US dollar actually declined 4.9% on the quarter. To be clear, there remain important implications of a potentially stronger US dollar – some good, some not so good. Certainly it can degrade the net results of our foreign security returns but it also makes the price of our imports more attractive. It helps keep inflation down but it keeps alive the fear of deflation. With the markets assuming the Fed would simply continue hiking interest rates, (something Chairman Yellen indicated would be happening this year) many investors were concerned that the negative consequences of a stronger US dollar would trump the benefits. You may have heard the sentiment, “don’t fight the Fed.” This quarter, the Fed fought itself and began easing off of the planned four 2016 rate increases and now look more likely to stop at two. That change in plan/forecast resulted in a decline in the dollar, which created a surprising finish for Emerging Markets investments which led results for the quarter.

We’d offer simple conclusions to a normal quarter: It was wise to stay well allocated, rebalance through volatility and doubt the veracity of the Fed. Discipline smashed guessing more than normal this time. This was not a predictable quarter. Reminds me of Villanova and a quote from Peter Lynch, “The key to making money in stocks is not to get scared out of them.”