The markets began the year on a sour note mostly due to fears of the US and Chinese economies slowing. Fourth quarter US GDP growth came in lower than expected, and China’s growth continued to decelerate. The Federal Reserve had just raised rates in December and oil producers continued to overproduce, moving oil lower. As a result, volatility spiked and stock prices globally tanked, with the S&P 500 bottoming down roughly 9%. Investors with a healthy allocation to risk management strategies reaped the benefits and saw their declines muted.
By mid-February, however, sentiment had turned. The Fed’s dovish comments allayed fears of over tightening, and China announced additional stimulus. In addition, oil producers started talking about cooperating on production, and although no agreement has been reached, prices per barrel have risen from a low of $26 to end the quarter at nearly $40.
The effect was that the dollar dropped and oil prices climbed. These two areas had spelled trouble for stocks last year as manufacturing output was hurt by the dollar’s rise, making US goods less competitive. Energy sector earnings were crushed by low oil prices, distressing earnings for the entire S&P. Consequently, equities have had a strong negative correlation to the dollar and a strong positive correlation to oil. So, as these trends turned, so did stock prices. By quarter’s end the S&P had turned positive, closing the quarter up 1.35%.
Interesting to note is that the dollar’s decline came despite stimulus efforts in Europe and Japan. Both the Bank of Japan and the European Central Bank are pursuing stimulus policies, pushing interest rates into negative territory. The net result for US fixed income investors is that interest rates on bonds declined.
So, what began on a sour note ended positively, but we are cautious going forward. Geopolitical risks remain high. Terrorist bomb blasts have struck cities in Europe and the Middle East, the civil war in Syria persists, and ISIS remains a threat. Political instability in Brazil is growing and the potential of the UK leaving the European Union has increased. To make matters worse, the recent statements from the Fed have been contradictory—to say the least. Fed Chair Yellen’s recent statements hint at holding off on rate hikes, while Atlanta Fed President Dennis Lockhart, Philadelphia Fed President Patrick Harper, and San Francisco Fed President John Williams discuss raising rates as soon as possible. This doublespeak may keep a lid on stock prices. The Fed wants to raise rates to give it more tools should the economy fall, but the Fed is afraid to hurt asset prices which it has actively pushed higher.
As a result, we are guarded—not that we are predicting prices, but with volatility so low, spikes are more likely, which means market declines. The Fed’s contradictory statements have increased uncertainty, thereby raising risk, so hedging this risk is as important as ever.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Washington Trust Bank.