2015: A blueprint for 2016?

Weekly Commentary Overview

  • Despite the Federal Reserve (Fed) playing to script and meeting market expectations with a 0.25% interest rate hike, U.S. stocks ended the week down. All three of the major averages surrendered their early-week gains.
  • The Fed’s 25-basis-point (bp) rate hike was what the market expected, provoking only a modest reaction in short-term interest rates and a yawn on the long end of the Treasury curve. Instead, investors were focused on what happens next.
  • U.S. equities continue to struggle with a familiar litany of problems: lack of organic earnings growth, mixed economic data and deteriorating conditions in the credit markets. Unfortunately, it appears next year may deliver more of the same.
  • We maintain our overweight to both European and Japanese currency-hedged equities. While neither market has had a stellar year, in local currency terms they have outperformed U.S. equities by roughly 550 and 1100 basis points, respectively, year-to-date. We believe that pattern could continue into the new year.

Markets Can’t Hold Gains

Despite the Federal Reserve (Fed) playing to script and meeting market expectations with a 0.25% interest rate hike, U.S. stocks ended the week down. All three of the major averages surrendered their early-week gains, with the Dow Jones Industrial Average dropping 0.79% to 17,128, the S&P 500 Index falling 0.35% to 2,005 and the tech-heavy Nasdaq Composite Index down 0.20% to close the week at 4,923. Meanwhile, the yield on the 10-year Treasury rose from 2.12% to 2.20%, as its price fell.

The mystery surrounding the Fed has finally been resolved, at least until the next meeting. But even with liftoff in the rearview mirror, U.S. equities continue to struggle with a familiar litany of problems: lack of organic earnings growth, mixed economic data and deteriorating conditions in the credit markets. Unfortunately, it appears next year may deliver more of the same.

Looking Beyond the Fed

The Fed’s 25-basis-point (bp) rate hike was what the market expected, provoking only a modest reaction in short-term interest rates and a yawn on the long end of the Treasury curve. Instead, investors were focused on what happens next.

Although the Fed maintained its implicit forecast for four hikes in 2016, which is more than the market expects, investors took comfort in the stated commitment to a gradual tightening cycle and the notion that the central bank will continue to reinvest its balance sheet until “normalization in the fed funds rate is well under way.” Consequently, long-term rates are largely unchanged from where they started the year, but the impact is being seen in shorter-term bonds and currency markets. Yields for two-year Treasuries climbed above 1% for the first time in 5½ years and the dollar rose more than 1% on the week.

While the Fed more or less delivered, several other factors are contributing to the decline in investor sentiment. Investors continue to struggle with the fallout from a strong dollar, collapsing oil prices and a tightening in financial market conditions. The latter issue has been a particular problem of late. Last Monday, high yield spreads—the difference between the yield of a high yield bond and that of a comparable-maturity Treasury—reached nearly 700 bps, a level not seen since June 2012. Not surprisingly, all of this has contributed to a turn in investor flows, with U.S. high yield exchange-traded funds experiencing $1.7 billion in outflows. Moreover, fears regarding high yield are increasingly leaking over into equity markets.

U.S. economic data also remain mixed, leading to questions about 2016 earnings. Core inflation is firming and the housing sector is doing well, evidenced by a surge in housing starts and permits in November. However, manufacturing continues to slide. U.S. industrial production is now down year-over-year, the first contraction since the end of 2009.

Markets outside the U.S. are proving more resilient. European stocks gained nearly 2% last week, with Germany leading the advance. Stocks were helped by a solid measure of German business confidence as well as strong manufacturers’ readings.

Markets can withstand a gentle tightening cycle. However, if the divergence in monetary policy between the Fed and the other central banks pushes the dollar still higher, this will continue to be a headwind for U.S. corporate earnings.

More of the Same in 2016?

U.S. stocks and bonds both appear likely to end the year close to unchanged. This has been a year of ample volatility with little to show for it. Unfortunately, many of the factors that have constrained U.S. equities in 2015 are likely to repeat next year.

Markets can withstand a gentle tightening cycle. However, if the divergence in monetary policy between the Fed and the other central banks pushes the dollar still higher, this will continue to be a headwind for U.S. corporate earnings.

In addition, the tightening of financial conditions, evidenced by wider credit spreads, is having the predictable effect on stocks. While we believe high yield (outside of issues from energy and other natural resources firms) can stabilize in 2016, the reality is that we’re getting late in the credit cycle. This suggests U.S. stocks and bonds may continue to struggle, unless we see a more meaningful acceleration in the global economy.

With that as a backdrop, we maintain our overweight to both European and Japanese currency-hedged equities. While neither market has had a stellar year, in local currency terms they have outperformed U.S. equities by roughly 550 and 1100 bps, respectively, year-to-date. We believe that pattern could continue into the new year.

Please note: This is the last commentary for 2015. We will resume publication on January 4, 2016.

© BlackRock

© BlackRock

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