Russ Koesterich, global chief investment strategist at BlackRock, comments on the outlook for the new year.
An Upbeat End to a Lackluster Year
Global equity markets were able to close 2015 with a modest year-end rally, offering a somewhat positive coda to a lackluster year for stocks as well as other asset classes. Despite the gains in late December, the Dow Jones Industrial Average ended the year with a loss of 2.3%, closing at 17,425, while the S&P 500 Index declined 0.73% to 2,043. However, the Nasdaq Composite Index fared better, closing at 5,007, a 5.19% gain for the year. In fixed income, the yield on the benchmark 10-year US Treasury rose from 2.20% to 2.27% as its price fell over the course of the year.
As we begin the new year, investors face an unpleasant truth: 2016 will start with many of the same challenges we encountered in 2015.
Tech, Europe and Japan – A Few Bright Spots
Stocks managed to mostly advance toward year’s end, pushing large-cap US equity returns back toward flat for the year. Strength in the equity market continues to be concentrated in those parts of the market defined by secular growth themes, such as technology and health care. Gains have been disproportionately powered by a handful of mega-cap Nasdaq stocks, allowing that index to outperform other US benchmarks.
European and Japanese equities were able to outperform the US, at least on a currency-hedged basis, although 2015 will not be remembered as a brilliant year in these markets either. European stocks finished with mid-single-digit gains while Germany advanced close to 10%. European equities continue to be supported by more evidence of economic stabilization and improving credit growth.
In addition, investors remain hopeful for further monetary easing by the European Central Bank (ECB). While investors were disappointed by the ECB’s official announcement in early December, they were heartened later in the month by comments from ECB official Yves Mersch that the bank has “by no means used up all our ammunition.” This was interpreted as a sign that the ECB deposit rate, already in negative territory, can move even lower.
Bond markets also finished the year close to flat. US long-term rates ended the year a bit higher than they started, with yields rising following a weak auction of five-year Treasuries and a strong US consumer confidence report. Still, long-term yields remain constrained by mixed economic data, including more evidence of weakness in the manufacturing sector in the form of a poor Dallas Fed Index report last week.
At the same time, two-year yields rose significantly over the course of 2015, and by late December were at their highest level since 2010. As a result, the yield curve flattened considerably. Intraday last Tuesday, the difference between 10- and two-year yields reached its tightest level, on a closing basis, since early 2008.
But by far the biggest loser in 2015 was the commodities complex. While oil prices managed to bounce toward the end of the year, the gains were short-lived. Crude fell 3% last Monday following Iran’s confirmation that it plans to add 500,000 barrels per day to exports once sanctions are lifted. The selling accelerated on Wednesday following news of a further increase in inventories. The 2015 collapse in commodities has been brutal on any emerging market currencies tied to commodity exporters. Case in point: Last week, the Russian ruble fell to its lowest level of the year versus the dollar.
More of the Same, With a Nod to Munis
Unfortunately, despite the year-end advance, stocks will face obstacles in 2016 similar to those seen in 2015. Valuations on US equities remain elevated by most measures, particularly based on long-term cyclical earnings. Profit margins are likely to remain under pressure as wages firm. In addition, should the dollar appreciate further, this will negatively affect companies dependent on exports. And international events may still trigger volatility, as we saw over the weekend with a major selloff in China, a sign that the country still represents a systemic risk. As such, we have only modest expectations for US equities in 2016, and would not expect a revisit of double-digit returns.
We also expect bonds to continue to struggle as interest rates drift higher on the back of Federal Reserve tightening and some stabilization in inflation expectations. Still, we believe the rise in yields will be contained, with the 10-year Treasury yield rising to around 2.75% by the end of 2016.
That said, one area of the US bond market that does merit attention is the municipal market. To be sure, there is a prospect for some headline risk, as we saw last week when Puerto Rico announced it will default on $37 million of bond payments that were due Jan. 1. However, that has long been expected, and we believe the broader tax-exempt market remains on solid footing. The bottom line: We continue to favor municipal bonds within a fixed income portfolio.