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After Seven Fat Years…

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Jeff-PantagesAfter seven fat years…

In the Old Testament, the Pharaoh had a dream about withering cows and grains and asked Joseph to interpret it for him. Joseph said it was a warning that after seven bountiful years they would need to prepare for seven years of hardship. He ordered the granaries filled during the good harvests so people wouldn’t starve when the tough times appeared. Even way back then they knew the good times couldn’t go on forever and that the economy was cyclical.

And so it is with the financial markets. The economic expansion following the Panic of 2008 completed its seventh year of slow and steady growth. The U.S. stock market is up a cumulative 200% (it has tripled) from its March 2009 low to March 2016. It has been a good run.

The silver lining of “slow and steady” may be that “imbalances” have been kept in check and there is no recession in sight. But both the domestic equity and bond markets are fairly, maybe fully, valued and are offering much more modest returns over the next seven years.

First quarter roundup

After a harrowing “panic attack” through mid-February which saw stocks in the U.S. and abroad lose over 10%, a rebound in oil prices, better economic data, and soothing words and actions from central bankers steadied the ship. By the end of the quarter, we were practically right back where we started the year.

For the record, the S&P 500 gained 1.4% this quarter. The issue for the U.S. equity markets going forward is earnings, which have declined two quarters in a row. Analysts expect this trend to continue when first quarter earnings are reported in April. Certainly weak earnings out of the energy sector are a drag (that may dissipate later in the year), but it’s tough when economic growth is slow, margins are already fat, and wage costs are starting to rise. These are headwinds for most sectors.

Overseas markets were hit harder, but have snapped back more sharply, especially the emerging equity markets. The MSCI Emerging Market Index was down 13.3% in late January before rallying back to end the quarter with a 5.7% return! Weak commodity prices and high corporate debt levels which accumulated over the past seven years (much of it issued in dollars) have made these economies vulnerable to a global slowdown and strength in the U.S. dollar.

The MSCI EAFE Index of developed countries (dominated by companies in Europe, Britain, and Japan) lost 3.0% over the quarter. In the EU, immigration concerns and the upcoming Brexit vote in June created uncertainty.

Meanwhile, U.S. Treasuries had their best quarter in four years. The 10 year U.S. Treasury bond declined almost 50 basis points (bps) in yield to 1.77%. High yield “junk” bonds had a roller coaster ride. They sold off sharply as energy credits got slaughtered early on, pushing yields on many such bonds into the high teens. The Barclays High Yield Index declined in price to yield 10% early in the quarter before rallying all the way back to yield 8% at quarter end.

Commodity prices finally stabilized. Oil sold off and then rallied, ending the quarter right where it started the year at $38 a barrel. Gold had a blistering run, up 16% this quarter to $1,233 an ounce.

Oil has probably bottomed at $26 a barrel. Inventories are high, but supply is being taken off the market (the rig count has dropped from 2,000 active rigs to 500) and demand continues to expand. Still, the American frackers are probably profitable at $50 a barrel, which can limit the upside, and OPEC is not yet united on controlling production. The NYMEX futures market has oil under $50 through 2020.

Going forward, we expect more of the same. Tough sledding. Slow growth. Markets (investors too!) climbing the proverbial “wall of worry.” More volatility as unexpected events unfold, only to play out as temporary setbacks. So focus on the long term, stay invested, and be diversified.

Jeff Pantages, CFA®
Chief Investment Officer

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