February was a different experience for investors and a welcome departure from January. However, it didn’t start that way.
As we will discuss below, the month started with high volatility driven by many of the usual suspects that sent markets down in January. Concerns over slowing global growth, China and oil remain at the top of investors’ minds as we move further into Spring. However, despite ending the month down slightly, our domestic markets all rallied off their intra-month lows while international markets were mixed. We keep a very close eye on the markets but feel the areas below are worth highlighting.
Equities
The first two weeks of the month saw investors scrambling into gold, government bonds and cash as they fled equities. The latter half, however, saw domestic indices rally off their February lows as sentiment turned up, largely on higher oil prices. In fact, the S&P 500 Index was down nearly 6% intra-month while the NASDAQ Composite Index was down almost 7.5% before both rebounded to end the month -0.41% and -1.03% , respectively. Internationally, Japanese stocks fared the worst, falling as far as 14.65% on concerns over the Bank of Japan’s negative interest policy before popping up to close out February -8.51% in the red.
Source: Morningstar Direct
The selling during the first half of the month was largely driven by fears of slowing growth and its potential impact on the global markets. News came out that China’s foreign currency reserves had fallen to fresh three-year lows as the country expended vast sums of money propping up their currency. Investors have been trying to flee Chinese equities in fits and spurts since the beginning of 2016 over concerns that the country’s economy is losing steam. Indeed, Chinese equities, as measured by the Shanghai Composite Index, were down -1.81% for February and firmly in bear-market territory, down 24% year-to-date. This has driven the yuan, China’s currency, down further and this is one of the primary reasons the People’s Bank of China has been so aggressive in propping up the currency. With the lower reserves and a possible credit cycle slowdown on the horizon, China’s ability to purchase the yuan and increase its value may be dwindling. Investors are concerned about these developments for two primary reasons. First, investors may experience a negative feedback loop if China is less flexible with its foreign currency reserves. If the People’s Bank of China slowly loses its ability to prop up the yuan, more investors may take that as a sign and move their assets out of the country, lowering the yuan in the process. Other investors see the lower yuan as further proof of China’s weakness and the process repeats. The second reason is that there may be a competitive devaluation by other emerging markets countries in response to the yuan’s drop. The concern with this scenario is that, in a race to make their exports cheap relative to China’s, they are adding deflationary pressures to their economies and making other goods bought and sold in the stronger US dollar, such as oil, extremely expensive. Many of these emerging markets countries also issue debt in US dollars so their debt burden grows as well. In direct response to these concerns, China’s head central banker publicly stated the end of February that they do not intend to competitively devalue the yuan. While this is reassuring to many investors, only time will tell how China’s policy and that of other emerging market central banks actually manifests in the markets. We have mentioned these scenarios in one form or another in our past commentaries, but believe it’s important to keep a close watch on what may be the next market flashpoint.
Turning towards Europe, February turned out to be a rough month for financial companies and banks, in particular. As the European Central Bank maintains negative rates, banks are finding themselves under more and more pressure. How can a bank be profitable with interest rates so low? Many investors are asking themselves the same question, driving the share prices of European banks down as the decision to turn rates negative continues to weigh on the sector. To compound the situation, investors are becoming less willing to buy longer-term bank debt, drying up the banks’ credit and leaving them with fewer alternatives to fund their operations. While this loss of confidence was a large part of the drop in European banks since the beginning of the year, there is something else on the horizon that is sure to steal headlines in the European markets. On June 23rd, the UK will vote on whether to stay in the European Union. Should they leave, analysts estimate that up to 20% of value in UK banks and financial institutions could be wiped off their balance sheets as international capital flees and European banks move their London operations to Luxembourg, Frankfurt or another city still within the European Union. Those in favor of the “Brexit” believe that the country and its financial system would be better off unrestrained by the bureaucracy emanating from Brussels, the physical headquarters of the European Union. No matter which way the decision goes, we will definitely be monitoring the markets leading up to and after the vote.
Source: Morningstar Direct
Central Bank(ing)
As we mentioned above, Japanese stocks suffered through a tough February. The impetus behind the rout in Japanese equities was largely the market’s reaction to the Bank of Japan’s negative interest rate policy. To reignite the sluggish Japanese economy, their central bank pushed rates into negative territory, joining the ranks of Switzerland, Denmark and the European Central Bank. Their hope was to devalue the Japanese yen and spark growth and inflation. However, the Bank of Japan’s move was overshadowed by other factors in the market, muting the surprise punch they were hoping for. Weak US service sector data and investor fear over Eurozone banks drove investors into high-quality government bonds, including Japanese bonds, as equities dropped earlier in the month. This caused the yen to spike to a 16-month high relative to the US dollar, making Japanese export goods more expensive to international markets and putting more pressure on the economy. While this didn’t go quite as planned, the central bank does have a few options. They can try monetary policy through stimulus actions and more interest rate changes, fiscally through taxation and government spending actions or more directly through currency intervention. Neither of these methods presents a straightforward path for the Bank of Japan and, as long as the yen and Japanese government bonds continue to be seen as a haven for investors, the path won’t be easy either.
Pivoting to the US, the Federal Reserve appears to be making progress towards its inflation target. In what was read as good news for the central bank, US inflation measures released the end of February indicated that prices are starting to tick upwards. The core measure of inflation that excludes more volatile food and fuel costs, was up 0.3% in January to settle at 2.2% for the past 12 months. This also happened to be the biggest 12-month gain since June 2012. While the Federal Reserve has publicly stated that its inflation target is 2%, the central bank uses its own measure which is likely running near 1.6% as of the end of January. It is important to note that the stronger US dollar is likely not fully reflected in these measures. In fact, the stronger US dollar will be a headwind for many core goods prices as those items produced outside the US will be more attractive to domestic purchasers. Indeed, according to the Labor Department, there was a distinct uptick in prices less affected by the stronger dollar. Core services prices were up nearly 3% for the year and include things such as child care and even funeral services.
Interest Rates
February saw high-grade government bond yields drop in response to the heavy selling the first half of the month. Interestingly, yields, as measured by the 10-year US Treasury bond, have not moved back up to their February starting point despite the rally in equities the second half of the month. In fact, interest rates are still hovering around 1.74%, only 11 basis points above the intra-month lows and still more than 20 basis points off February’s high. Generally, yields will fall when the price of bonds goes up. When the market is apprehensive about the future performance of stocks, bond yields typically fall as demand for fixed income pushes the prices upwards. Another relative measure of investor sentiment is the spread between US Treasury bond yields and corporate bond yields. As investors leave riskier bonds, such as corporate bonds, and move into Treasuries, the prices of the corporate bonds go down and the yields go up to reflect the higher perceived risk. As we discussed above, the greater demand for US Treasury bonds pushes those prices higher and the yields lower, thus widening the yield spread between the two types of bonds. The chart below illustrates this relationship using the difference, or spread, between corporate bond yields and US Treasury bond yields. Using the Barclays US Treasury Index and the Barclays US Corporate Index to represent the broad US Treasury and corporate bond markets, respectively, it is easy to see how the spread between the two yields has steadily risen since the beginning of the year. All else being equal, this indicated that investors perceived greater risk with corporate bonds over that time period. The yield spread peaked the middle of February just as the S&P 500 turned up from its intra-month low on February 11th and has fallen steadily since then. Generally, a narrower spread indicates that investors are willing to take more risk by moving back into corporate bonds, driving prices up and yields down.
Source: Morningstar Direct
Oil
Oil has been perpetually dominating the headlines as the impact of its low prices continues to be felt across the global markets. February was a volatile month for the commodity as a number of factors were pushing and pulling in different directions. Rumors of an agreement between the world’s largest producers and a quickly falling rig count provided price support while surprises on the supply level weighed on the commodity. Saudi Arabia, Qatar, Russia and Venezuela met and said they will agree to freeze production as long as Iran and Iraq agreed as well. However, comments from Saudi Arabia’s Oil Minister late February seemed to hint otherwise as he made an about-face, saying the country would not be capping output. It appears the markets will have to wait until March to get a clearer picture on whether an output freeze could actually materialize. Regarding rig counts, the number of oil rigs has actually fallen to its lowest level since December of 2009 in response to oil’s rock-bottom prices, providing some support while fears over China’s economic slowdown weigh on the commodity.
Of the companies suffering from low oil prices, shale drillers have arguably been the hardest hit. A majority of these companies entered the market when oil was at or above $100 per barrel, but with excess supply and muted demand keeping oil low, their share prices have plummeted. Indeed, many believe these companies contributed to the oversupply that initially drove prices down in 2015. While investors have been expecting a rash of bankruptcies, the riskier shale drilling companies have proven to be more resilient than the markets had initially thought. Many of these companies have hedged their exposures to oil to alleviate the pressure lower prices would bring. Those hedges are just starting to unwind which means that many of those companies will be exposed to the full price swings of oil. Unfortunately, with the market’s current prices being where they are, the shale drillers have largely missed their chance to re-hedge at the higher prices that occasionally popped up over the last 12 months. While this doesn’t bode well for those drillers with unhealthy balance sheets and high debt, we continue to believe that the bankruptcies will clear the field for those companies with strong financials and solid prospects.
Concluding Thoughts
It has certainly been a volatile start to the first quarter of 2016. To add a little perspective, investors have experienced 23 days where the S&P 500 moved more than 1% up or down as of the end of February. That’s just over 60% of the trading days so far this year. Contrast that with 2015 where we experienced plus or minus 1% days roughly 30% of the time and it’s plain to see why 2016 already feels much more volatile. Markets like these can easily test the confidence of the most stalwart investor, causing them to rethink their portfolio allocations and making untimely or emotional decisions. This is why we feel a comprehensive wealth plan is prudent for everyone. Having a plan in place can help investors weather periods like this and focus instead on what really matters: their goals and financial well-being.
Investment advice offered through CWM, LLC, a Registered Investment Advisor. Securities offered through LPL Financial, Member FINRA/SIPC. LPL is under separate ownership from any other entity.
GENERAL DISCLOSURE
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
NASDAQ COMPOSITE
The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index.
S&P 500 INDEX
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
NIKKEI 225 AVERAGE INDEX
The Nikkei 225 Average Index is a Japanese index that tracks the top 225 companies listed on the Tokyo Stock Exchange. It includes the most liquid Japanese stocks listed in the first section of the Tokyo Stock Exchange. It is price-weighted and yen-denominated.
SHANGHAI COMPOSITE INDEX
The Shanghai Composite Index is a market index of all stocks (A shares and B shares) that are traded on the Shanghai Stock Exchange. It tracks the largest publicly traded companies in China.
MSCI EUROPE FINANCIALS INDEX
The MSCI Europe Financials Index captures large- and mid-cap companies across 15 developed markets countries in Europe. All securities in the index are classified in the Financial sector as per the Global Industry Classification Standard (GICS).
BARCLAYS US TREASURY INDEX
The Barclays US Treasury Index (Barclays US Treas Idx) measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. The index includes all public obligations of the US Treasury with at least one year until final maturity, regardless of optionality.
BARCLAYS US CORPORATE INDEX
The Barclays US Corporate Index (Barclays US Corp Idx) measures the investment grade, fixed-rate, taxable corporate bond market. The index includes senior and subordinated debt with at least one year until final maturity, regardless of optionality. It includes US dollar-denominated securities publicly issued by industrial, utility and financial issuers.
Sources:
Wall Street Journal, February 2016, http://www.wsj.com/articles/china-central-bank-chief-no-reason-for-yuan-to-fall-persistently-1456452515
Reuters, February 2016, http://www.reuters.com/article/us-usa-oil-hedging-idUSKBN0TX0F420151214
CNBC, February 2016, http://www.cnbc.com/2016/02/21/oil-prices-stay-weak-on-ongoing-overproduction-brimming-crude-stocks.html
Wall Street Journal, February 2016, http://www.wsj.com/articles/inflation-is-now-at-the-feds-service-1455903385
Financial Times, February 2016, http://www.ft.com/intl/cms/s/0/f8634526-d0b2-11e5-831d-09f7778e7377.html#axzz40R9tJ6mh
Financial Times, February 2016, http://www.ft.com/intl/cms/s/0/fb3c0ace-d618-11e5-8887-98e7feb46f27.html#axzz40voTrOar
Wall Street Journal, February 2016, http://www.wsj.com/articles/bank-of-japan-baffled-by-negative-reaction-to-negative-rate-policy-1455791343
Financial Times, February 2016, http://www.ft.com/intl/cms/s/0/4fe4726e-d3d0-11e5-829b-8564e7528e54.html#axzz411tQTGZa
Financial Times, February 2016, http://www.ft.com/intl/cms/s/0/570790ac-d94e-11e5-98fd-06d75973fe09.html#axzz411tQTGZa