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Quarterly Market Commentary: V is for Volatility – First Quarter 2016

  • The first quarter was characterized by a first-half selloff and second-half recovery, providing historical milestones for government bonds, oil prices and stock markets along the
  • Fixed-income markets had a positive quarter in S. dollar terms, with a high degree of return variability across market segments. Global equity markets rose slightly over the full quarter, masking significant volatility.
  • The bottom line: We continue to believe that global economic growth will grind its way higher, led by the advanced and commodity-consuming emerging economies.


Economic Backdrop

 The first quarter was a quarter of firsts: the first instance of negative-yielding 10-year government bonds by a major economy (in Japan), the first time WTI oil prices ― a key indicator of movements in the oil market ― fell back to their 2003 levels (in January, and then again in February), and the worst first ten trading days of the New Year in history (as measured by the performance of the S&P 500 and the S&P 90, its predecessor, since 1928). Of course, conditions improved dramatically starting in mid-February, propelling the S&P 500 and oil prices to small full-quarter gains.

The Bank of England’s Monetary Policy Committee (BOE) and the U.S. Federal Open Market Committee (FOMC) ― the less-dovish cohort of major central banks ― lowered their sights on tighter monetary policy during the quarter. The BOE registered two unanimous votes to hold benchmark rates firm, a departure from prior votes that typically featured hawkish dissenters favoring an immediate hike. The FOMC tentatively confirmed market expectations for fewer rate hikes this year than previously projected. The European Central Bank (ECB) and Bank of Japan (BOJ) ― the more-dovish set ― deepened their commitments to easy policy. The BOJ adopted a negative benchmark rate and continued asset purchases apace, while the ECB treaded further into negative rate territory and expanded its asset-purchase program. Both, however, confronted unenthusiastic market responses as their currencies firmed relative to the U.S. dollar following their announcements. Finally, the People’s Bank of China (PBOC) began the quarter by guiding the yuan-U.S. dollar exchange rate lower, and then making a significant capital commitment to its banking system. The PBOC also rebalanced its reserve requirement ratio during the quarter by ending preferential treatment for some banks and then lowering the broad ratio in an effort to stimulate bank lending. China’s securities regulator was also busy in early January, first introducing, and then quickly discontinuing, circuit breakers intended to limit large intraday swings on its mainland stock exchanges.

U.S. manufacturing growth claimed modest gains by quarter-end, propelled by a jump in export orders. Retail sales started the quarter on firm footing, before retreating in February; consumer confidence surveys for March, however, support expectations for retail-sector strength. The employment picture improved during the quarter, with notable earnings increases in January and March, large payroll additions in February and March, and a slow-but-steady increase in the participation rate (although the unemployment rate rose to 5.0% in March after falling to 4.9% in January). Core consumer prices began to approach the FOMC’s target, with core consumer prices increasing 2.3% in February year over year and core personal consumption expenditures measuring 1.7% in the years to January and February. Revised fourth-quarter economic growth registered an annualized 1.4%, an improvement due to increased consumer spending on services.

U.K. manufacturing muddled through the first quarter, with growth sliding to a 34-month low in February and recovering only marginally in March. Retail sales began the year with a jump in January, followed by a small slide in February; retail- sector surveys indicate February’s weakness could continue into March. Claimant count joblessness declined in both January and February, and coupled with a gain in average year-over-year earnings growth for the November-January period, implied a firming labor market. Weak inflation remained pervasive: core consumer prices registered a 1.2% year- over-year increase in January and February, while producer prices remained below their year-ago levels. Fourth-quarter economic growth was revised slightly higher, to 0.6%, and 2.1% year over year, due primarily to household consumption.

Eurozone services sector growth improved over the full quarter, weakening in February before gaining impressively in March. Manufacturing activity followed a similar, albeit more subdued path, with a more protracted growth slowdown during February and a March reacceleration that failed to overtake its January level. Consumer prices gave ground during the course of the quarter, starting in January with the highest year-over-year increase in seven months, before decreasing in February and March. Consumer sentiment slid to its lowest level during the quarter since late 2014, joined by flagging confidence in industry, services and construction. Fourth-quarter economic growth held at 0.3%, and 1.6% year over year.


Market Impact

 Fixed-income markets had a positive first quarter measured from start to finish, with a high degree of return variability due primarily to regional exposure, the impact of the U.S. dollar’s relative weakness, and the positive influence of rising oil prices on higher-risk market segments. Local-currency-denominated emerging-market debt was the top performer by a substantial margin, deriving the lion’s share of its gain from a March rally. Global sovereign securities also delivered an outsized return during the quarter, followed by strong performance from foreign-currency-denominated (external) emerging-market debt. Global non-government debt performed very well, trailed closely by U.S. investment-grade corporate fixed income, U.S. dollar-hedged (which seeks to reduce U.S. dollar-related volatility) global sovereign securities, and U.S. Treasury Inflation-Protected Securities. U.S. high-yield bonds performed well, after climbing back from losses through February, followed closely by U.S. Treasurys. Dollar-hedged global non-government debt also delivered respectable returns, trailed only by U.S. mortgage- and asset-backed securities, which were positive as well.

Global equity markets, as reflected by the components of the MSCI AC World Index (Net), rose slightly over the full first quarter, masking significant volatility. Latin America was the best-performing region, claiming the top three country-level advances (Brazil, followed by Peru and then Colombia). Eastern Europe also hosted several top-ten performers (Turkey, Hungary, Russia and Poland), while Southeast Asia had a high concentration of countries that delivered double-digit returns for the quarter (Thailand, Malaysia and Indonesia). The peripheral eurozone countries populated the ranks of the poorest performers, with Greece and Italy ranking worst and second worst, respectively. Israel also suffered a double-digit slide, while Japan, Egypt and Switzerland delivered notably negative performances as well. Finland, China, Ireland and Spain rounded out the bottom-ten performances for the quarter. Global sectors were mostly positive, led by traditionally defensive sectors but followed closely by their most cyclically-sensitive counterparts. Utilities had the best performance, followed by telecommunications, energy and materials. Consumer staples and industrials also delivered strong returns, and information technology was positive as well. Healthcare had the most deeply negative return, and  financials performed poorly, while consumer discretionary was down slightly.

Index Data for First Quarter 

  • The Dow Jones Industrial Average Index returned 20%.
  • The S&P 500 Index rose 35%.
  • The NASDAQ Composite Index declined 43%.
  • The MSCI AC World Index (Net), used to gauge global equity performance, rose by 0.24%.
  • The BarclaysGlobal Aggregate Index, which represents global bond markets, advanced by 5.90%.
  • The Chicago Board Options Exchange Volatility Index, a measure of implied volatility in the S&P 500 Index that is also known as the “fear index”, decreased in the quarter as a whole, moving from21 to 13.95, but peaked at 28.14 on 11 February.
  • WTI Cushing crude oil prices, a key indicator of movements in the oil market, moved from $37.04 a barrel at the end of December to $38.34 on the last day in March, falling to a 13-year low of $26.21 on 11 February.
  • The S. dollar strengthened against sterling during the quarter, but weakened against the euro and yen despite the accommodative monetary policy actions from the ECB and BOJ. The U.S. dollar ended March at $1.44 versus sterling, $1.14 against the euro, and at 112.4 yen.


Portfolio Review

 Global equity-market volatility did not spare U.S. stocks, although full-quarter performance was relatively subdued, with a modestly positive return for large U.S. companies and slightly larger loss for small companies. Large-cap positioning struggled, primarily due to sector allocation decisions. Underweights to traditional defensive sectors such as utilities and telecommunications, arising from our preference for deeper value managers, generated losses, as did overweights to pharmaceuticals and biotechnology. An under-allocation to lower-volatility stocks also detracted. Allocation to quality and profitability-based strategies was generally positive, but not by enough to overcome poor stock selection. Small-cap positioning produced results in line with the market; stock selection in healthcare was exceptionally strong, while technology detracted. An underweight to healthcare benefitted, while an underweight to utilities was challenged. Overseas, developed markets slid during the quarter, and positioning within international equities produced relatively attractive performance. Stock selection and an underweight to Japan were positive, while Europe produced overall neutral results despite a variety of intra-regional performances. At the sector level, selection in information technology and consumer discretionary was positive, and an underweight to the financial sector ― the first quarter’s weakest ― also contributed. An underweight and selection within consumer staples was challenged, along with holdings in the materials sector. Within emerging markets, performance was challenged by selection, but partially mitigated by allocation. Exposure to  Asia,  particularly  an  overweight  and  selection  within  India,  along  with  underweights  to  Thailand,  Malaysia  and

Indonesia, detracted; selection within Korea and Taiwan performed well. An underweight to South Africa also weighed on performance, while an overweight to Turkey contributed. Latin America was a source of strength due to an overweight to Brazil and sector-specific positioning in Colombia and Peru, although an overweight to Mexican banks detracted.

Core fixed income was challenged during the quarter primarily as a result of an overweight to banks. Long-term U.S. Treasury yields declined in a greater magnitude than short-term yields, supporting a yield- curve-flattening posture but detracting from a slightly shorter duration profile. An underweight to commodity producers detracted as the sector rallied sharply during March along with a rebound in oil prices. Overweights to commercial mortgage-backed and asset-back securities enhanced returns, and an underweight to agency mortgages contributed in relative terms, while an overweight to non-agency mortgages detracted. Within high yield, energy-sector swings drove the market to a rather positive full- quarter performance. From a sector perspective, selection within retail, an overweight and selection within leisure, and selection within healthcare enhanced returns, while an allocation to structured credit, and selection within basic industry and media detracted. A defensive posture and cash holdings hindered relative performance. Emerging-market debt had a positive quarter, with exposure to Mexico ― specifically its state-owned energy company ― serving as a key contributor. Indonesia, a significant overweight, also contributed on the strength of its currency, while an underweight and selection within Polish external debt benefitted relative performance as its political landscape deteriorated. Cash holdings underperformed as foreign currencies appreciated relative to the U.S. dollar, and an underweight to Brazilian local debt also detracted.

Manager Positioning and Opportunities

 We remain constructive on the U.S. equity market as we see pessimism far greater than is justified by fundamentals, but we expect the volatility to continue in the mature stages of this bull market. Stability and other forms of quality appear expensive versus recent history, while risk premium (deeper value) and other risk-based assets appear inexpensive and offer a compelling potential risk-adjusted return opportunity. We believe the rally will continue at a more muted pace over the next couple of quarters, with risk-based sectors continuing to outpace stability. The valuations within energy and deeper value names are coiled springs with considerable room to run if recent sentiment becomes more firmly established. Within small caps, we have also added to growth managers for valuation reasons as we have lowered core and stability manager allocations. Internationally, we retained pro-cyclical positioning with sensitivity to valuation and an overweight to the smaller-cap spectrum. We took the opportunity provided by strength in the materials sector to slightly reduce exposure, while we added to some energy holdings. Information technology remains the largest overweight, while financials and consumer staples remain the most significant underweights. Within emerging markets, we maintained an overweight to information technology, particularly Chinese hardware suppliers and social media names, as well as Taiwanese technology stocks based on attractive valuations. We also remain overweight to consumer discretionary in China and Hong Kong due to the burgeoning consumer-led economy. Consumer staples, healthcare and industrials also remain slight overweights. Our largest underweight remains financials, specifically Chinese banking stocks, on concerns about Chinese credit conditions. We also retain an underweight to telecommunications and utilities ― the more defensive segments of the market.

Core fixed income’s duration posture remains slightly short to neutral with a yield-curve flattening bias. Once the market focuses on fundamentals, yields are expected to trend modestly higher in tandem with a growing economy. Investment- grade credit spreads widened appreciably early in the quarter only to reverse course and end up close to where they began the year. The one notable exception would be the banking sector, where fears about the capital levels of European banks and the implications of a possible Brexit kept investors on the defensive. Bank capital positions are much stronger than they were pre-crisis, which puts them on firmer footing today, so we will likely add selective exposures. We remain slightly overweight to the industrial sector, but underweight to metals and mining issuers, and overweight to corporate credit. In high yield, we are overweight leisure, primarily within gaming, and media, as both sectors are generally less sensitive to changes in macroeconomic conditions. While the gaming sector is not very large, there is conviction that some credits are undervalued and offer strong total return potential. As for media, it is an asset-rich sector with strong cash-flow generation and reasonable amounts of leverage. We remain underweight the energy sector, as well as metals and mining (excluding steel), which is a subsector of basic industry. We maintain a defensive posture via bank loan and cash allocations, and will continue to assess bank loan opportunities especially when valuations appear attractive versus BB rated bonds. Within emerging markets, we remained near-equally underweight to external and local-currency debt, with a continued overweight to corporates and their higher yields. In currency terms, our largest overweights are to those standing to benefit from a rebound in commodity prices (Russia, Mexico and Colombia).

Our View

 One of our bedrock macroeconomic assumptions has been that the world will avoid a generalized recession, managing to continue muddling through. We believe a synchronized global recession that drags most countries into negative gross domestic product territory remains a low-probability event, and if our forecast holds, the rally in risk assets should be able to build on itself.

Certainly, there are good reasons to view the glass as half empty. Monetary policy appears to be losing effectiveness in Europe and Japan. Combined with an increasingly febrile political environment in the U.S. and other countries, as well as widespread sovereign and corporate over-indebtedness, it is easy to see why market strategists are still a cautious lot. But we think too much emphasis has been placed on the weaknesses of the global economy, while the brighter spots have been mostly ignored. Most major countries remain in an expansion phase despite sustaining a growth scare over the past year. The main areas of concern can be found in emerging markets, especially in commodity-producing countries.

On a sector basis, it’s obvious energy and materials have been the primary drag, but it’s a mistake to assume that a contraction in these industries will lead to a downturn in advanced, service-based economies. While it certainly looks as if the boom in U.S. shale oil production is turning into a bust, the rising number of associated layoffs has been nearly offset by the improving trend in the construction trades as housing activity comes back to life. Total non-farm payrolls, meanwhile, appear to be growing near the upper end of the historical range.

The bottom line: We continue to believe that global economic growth will grind its way higher, led by the advanced and commodity-consuming emerging economies (including China and India). Although China’s debt is a concern, the bulk is owed by state-owned enterprises to quasi-state-owned banks. Only a small fraction is held by foreign investors. The central government’s debt ratio is rather low, and households are not highly leveraged either.

Another bedrock assumption of ours has been the conviction  that central-bank monetary policy will remain highly expansionary on a global basis. Even in the U.S., where economic growth and inflation appear more entrenched than in most other countries, it is unlikely that interest rates will be pushed higher in an aggressive manner.

A more interesting question is whether central banks have reached the end of their policy effectiveness. This issue has come to the forefront in recent months as the BOJ, and then the ECB, implemented radical policy prescriptions only to see markets react negatively. In both Europe and Japan, government bond yields now are negative out to 9 and 10 years, respectively. If there is an overvalued asset in the world it is a negative-yielding government bond. And yet the yen and the euro have gained against the greenback on a year-over-year basis. This resiliency runs counter to our  own expectation that a widening interest-rate differential between the U.S. and those two countries would keep the greenback strong. If the dollar’s weakness is sustained, it would have far-reaching consequences for global assets. It would, for example, be positive for commodities as well as emerging-market debt and equity.


It’s hard to make a fundamental case for this dramatic turn in the fortunes of emerging-market equities. Earnings per share (EPS) for the constituents of the MSCI Emerging Markets Index have collapsed 30% since mid-2014 in U.S. dollar terms, a performance that correlates closely with the bear market in commodity prices. We need to see stronger global economic growth, improved trade flows and additional supply discipline from commodity producers. The sharp improvement in investor sentiment might be enough to keep the rally going in the short run, but it’s not enough for a sustained bull market.


At this point, we see better prospects for a durable earnings revival in the U.S. than elsewhere. The stalling of the dollar’s appreciation against other currencies in the past year suggests that U.S.–based multinational corporations and import- sensitive industries should see some relief from negative currency translations and declining import prices. In all, we see underlying U.S. earnings growth on a per-share basis in the 5-to-9% range over the next 12 months, and look for equity prices to appreciate in the same neighborhood.


Given the economic and political uncertainties, markets will remain difficult to navigate. We lean in a bullish direction, mainly because we are confident that the world economy will exhibit modest growth and that central banks around the world will do “whatever it takes” to coax their economies to grow and push inflation in an upward direction. Safety and stability still look expensive, as do government fixed-income securities. We like U.S. risk assets because the fundamentals seem better than most, although political dysfunction is becoming an increasing worry. Meanwhile, the sharp recovery in emerging-market debt and equity and high-yield securities underscores the fact that beaten-down areas can come roaring back with little advance warning. Under these circumstances, diversification seems a better strategy than concentrated positions as trends shift back and forth in almost random fashion.


Benchmark Descriptions


The Dow Jones Industrial Average is a widely followed market indicator based on a price-weighted average of 30 blue- chip New York Stock Exchange stocks that are selected by editors of The Wall Street Journal.


The S&P 500 Index is a capitalization-weighted index made up of 500 widely held U.S. large-cap companies.


The NASDAQ Composite Index is a market value-weighted index of all common stocks listed on the National Association of Securities Dealers Automated Quotations (NASDAQ) system.


The MSCI All Country World Index is a market capitalization-weighted index composed of over 2,000 companies, representing the market structure of 48 developed and emerging-market countries in North and South America, Europe, Africa and the Pacific Rim. The Index is calculated with net dividends reinvested in U.S. dollars.


The Barclays Global Aggregate Bond Index is a market capitalization-weighted benchmark, tracks the performance of investment-grade fixed- income securities denominated in 13 currencies. The Index reflects reinvestment of all distributions and changes in market prices.


The Chicago Board Options Exchange Volatility Index (VIX) tracks the expected volatility in the S&P 500 Index over the next 30 days. A higher number indicates greater volatility.


The BofA Merrill Lynch US High Yield Constrained Index measures the performance of a representative basket of high-yield bonds.



Important Information
This information is provided for general information only, and is not intended as personalized investment advice. Reading the above is in no way intended to be a substitute for individualized investment advice, and no conclusions should be drawn from this information regarding any potential investment.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI). Neither SEI nor its subsidiaries are affiliated with your financial advisor.
Certain material in this work is proprietary to and copyrighted by SEI Investments Management Corporation and is used by Capital Trust & Associates, LLC with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.


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