Beyond the Benchmark: Market Commentary

Despite a poor handoff from the third quarter and a sluggish close to the year, equities posted solid returns in the fourth quarter. This might come as a surprise given the negative tone which seemed to dominate the market narrative. The S&P 500 Index advanced 7.0% during the period, which exceeded the 4.7% return for international developed equities and 0.7% for emerging market equities. In one of the most anticipated moves in central banking history, the Yellen-led Federal Reserve Bank (Fed) announced its first interest rate hike in nearly a decade, raising the federal funds by 0.25%. Citing confidence in the U.S. economy, reinforced by positive employment and growth data, the Fed reassured markets that future rate hikes would be gradual. Despite the Fed’s positive outlook, equity markets declined in December after oil prices resumed their downward trend and concerns over slower growth in China resurfaced.

The S&P 500 Index, a broad measure of the U.S. equity market, advanced for the eleventh time in twelve quarters with a 7.0% return. Despite the move higher, the S&P 500 put an end to three consecutive years of double-digit gains with a modest 1.4% total return in 2015. The U.S. dollar strengthened slightly during the quarter and remains a formidable headwind for companies generating revenue from international markets. A stronger U.S. dollar dampens foreign-generated earnings and reduces profit margins. Large cap stocks outperformed small cap stocks as investors showed a preference for large-cap Technology and healthcare stocks. Both sectors were up over 9.0% in the quarter and 5.0% for the year. Each of the 10 underlying sectors of the S&P 500 Index posted gains for the quarter. However, growth-oriented segments of the market bested their value brethren as the Energy and Utilities sectors posted only modest gains.

International developed market equities, measured by the MSCI EAFE Index, advanced 4.7% in the quarter. International stocks lagged domestic markets in both the quarter and the calendar year despite continued improvements in financial conditions and more pronounced earnings momentum. That said, the European region’s growth trajectory and inflation levels remain below expectations. In December, European Central Bank (ECB) President Mario Draghi reaffirmed the bank’s accommodative stance by cutting the deposit rate deeper into negative territory and extending the existing monthly bond buying program an additional six months. However, the market was anticipating an increase in the size of purchases and the announcement failed to lend support to Eurozone stock markets. Equity valuations are attractive relative to their longer-term averages and their U.S. counterparts, but slower growth with trading partner China, geopolitical uncertainty, and the threat of deflation have tempered investor enthusiasm.

Emerging market returns, measured by the MSCI Emerging Markets Index, increased a mere 0.7% during the quarter and produced a painful 14.9% decline for the year. The retreat marked the third consecutive calendar year decline. Performance across countries and regions remained disparate during the period as Asia produced positive results while Europe and Latin America continued to move lower. The deterioration of energy and commodity prices provided noteworthy headwinds for Brazil and Russia and concerns of moderating growth in China elevated investor anxiety. Cheaper oil is like a tax cut for consumers, but for oil producers, it represents a pay cut. The massive geopolitical and economic consequences of persistently cheaper oil will likely be an ongoing source of volatility as markets digest the implications and gain a better understanding of the winners and losers.

In December, Fed policymakers raised the Federal Fund rate by 0.25% citing a healthy job market and the prospect of rising inflation levels. Fixed income indices recorded negative results for the quarter as interest rates generally moved higher. Bond prices adjust lower in response to rising interest rates. The Barclays Aggregate Bond Index declined 0.6% as investors began to price in future rate hikes after the hike in December. In response, the yield on the 10-year U.S. Treasury bond pushed higher during the quarter from 2.06% to 2.27%.

The global bond market, measured by the Barclays Global Aggregate Index, declined 0.9% for the quarter as interest rates generally remained flat. The U.S. dollar gained over 2.0% against the Euro and the Yen also declined modestly. Currency weakness primarily contributed to the negative return for the global bond index.

The high yield and bank loan holdings provided the worst results among the fixed income categories. The yield on high yield bonds increased to roughly 9.0%, reaching its highest level in over five years. The closure and subsequent liquidation of one high yield mutual fund highlighted that the lack of buyers caused large discrepancies between estimated and actual bond prices, particularly among the riskiest unrated bonds. Concerns over a potential increase in defaults from Energy and Materials sector companies were the primary reason yields moved higher.

Municipal bonds outperformed Treasuries and corporates in the quarter and emerged as the best performing fixed income asset class of 2015. The municipal bond market has benefited from favorable supply and demand dynamics as issuance has fallen. Issuer credit ratings have also generally improved as tax receipts have increased while expenditures have remained stable.

The confluence of a falling unemployment rate and rising core inflation allowed the Federal Reserve to raise short-term interest rates as they perceive the U.S. economy is gaining strength and can withstand higher borrowing costs. Wage inflation appears to be picking up in a sign that labor markets may be approaching full employment. Consumer sentiment reached the highest level since July as consumers felt encouraged about the current economic backdrop. Although there are pockets of weakness within the Energy sector and manufacturing has slowed, consumer spending, which accounts for about 70% of economic growth, remains on solid footing.

The Eurozone grew at a 0.3% rate in the third quarter after a 0.4% expansion in the previous quarter. The bloc’s recovery has been led by its largest member, Germany, which has benefited from both reduced financing costs and the lower euro. Among the member states, Germany has the lowest unemployment rate of 4.5%. Unsurprisingly, the Eurozone trade surplus (exports minus imports) reached another record high during the period, boosted by increased exports generated from a weaker euro. High unemployment and modest growth remain challenging headwinds for the region, but targeted monetary policies have begun to move the needle in the right direction as borrowing is increasing and the unemployment rate is dropping.