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First Quarter 2016 Review

Another False Start

Much like the beginning of the past two years, the beginning of 2016 was marked by a great deal of market volatility. Global equities fell rapidly in the first half of the quarter, with many indices posting declines in the double digits. This rout, like so many in the past, was driven by fears over slowing Chinese growth along with continued weakness in the energy space. Yet as the quarter progressed, these fears eased, and so too did central banks. As a result, markets recovered just as quickly as they had declined, with U.S. equities generally finishing the quarter slightly higher.

While such volatility has been a fact of life for investors for some time now, this quarter’s marked swings were particularly dramatic. In our view, it seems that the market is attempting to reconcile a slowing global growth environment with diverging central bank policy, or at least, the appearance thereof. Given the great deal of uncertainty surrounding both forces, it stands to reason that markets will react, or as it may be, overreact, to new pieces of information. This is unlikely to change as the year progresses, and a number of geopolitical concerns will only muddle the picture further. As such, if this past quarter is any indication, markets are likely to only get more interesting as the year progresses.

Early on in the year, fears over Chinese growth loomed quite large for markets, as a number of data points suggested conditions in the world’s second largest economy were deteriorating. While the Chinese government attempted to stabilize the situation through market intervention and currency devaluation, these actions seemed to only exacerbate the situation. Concerns over China weighed heavily upon markets in both the emerging and developed world alike, as investors contemplated the implications this could have on the global growth outlook. While this is not the first time such fears have been stoked, a number of concurrent factors added fuel to the fire. As oil hit lows not seen since the early 2000s, many investors worried that a slowdown in the energy sector could spread to the U.S. economy at large. A number of economic data points early on in the quarter seemed to validate these concerns, leading some to broach the topic of an impending recession. Though there was plenty of evidence to point to the contrary, such fears reflected the decidedly risk-off environment encountered at the beginning of this year.

Rapid Recovery

However, as the quarter progressed, fears quickly dissipated. Though concerns about its economy remained, China’s markets eventually stabilized, allowing global equities to turn higher. Oil also began to recover quite dramatically, as many major producers agreed to a tentative output freeze. Though fundamentals in the oil market remained quite weak, even the hope of a shift in market balances was enough to change investor sentiment on oil in the second half of the quarter. Markets also rose on several data points on the U.S. economy; a revised fourth quarter GDP estimate helped to abate fears a recession was imminent. While these certainly contributed to the market recovery, central banks also continued to do some of the heavy lifting.

Moves by several central banks reinforced the continued regime of loose monetary policy and helped equity markets recover. The first major event came at the end of January when, in a surprise move, the Bank of Japan announced that it was cutting rates below zero. With its latest tactic for dealing with continued sluggishness in the Japanese economy, the BOJ joined a growing contingent of central banks testing this unproven technique. Europe, which has been attempting to stimulate growth with negative rates for the past year and a half, doubled down on this course in March, pushing rates further down into negative territory and expanding asset purchases. Such actions undoubtedly contributed to the rally in equities seen in the second half of the quarter.

For the Federal Reserve, words alone were enough to move markets. After raising rates in December, many wondered when the Fed’s first move this year would come. With this quarter’s FOMC statements containing decidedly dovish language, it quickly became clear that another hike could take some time. Remarks by Janet Yellen at the Economic Club of New York further reinforced such beliefs, with the Fed Chair citing “global economic and financial developments” since the beginning of the year as the primary rationale for the Fed’s decision to stand pat. While Yellen did recognize U.S. data was improving, and that the Fed still plans to raise interest rates, it seems that it will be at a slower pace than previously expected. Such signs of a more cautious Fed were seen as good news for markets, and acted as another tailwind for equities in March.

Looking Ahead

Though markets have more or less recovered from their February lows, we believe it is important to remember that the volatility we encountered this past quarter was not unwarranted. Though they may be less on the mind of many investors, several of the issues weighing on markets in the early part of this year remain unresolved. While it appears as though China’s economy is indeed slowing, the severity of this slowdown, and its subsequent impact on global growth, remains unclear. Fears of a recession in the U.S. have subsided for the time being, but there still remains plenty of uncertainty here as well. Whether it is the question of economic growth, monetary policy or the implications of the upcoming presidential election in November, there will likely be a great many forces impacting equity markets as the year progresses. As the U.S. is a major (and some would argue sole) driver of the global economy at this point, we believe it is prudent to remain vigilant for signs of weakness.

In addition, we feel that geopolitical risk cannot be discounted by investors. Following the tragic attacks in Brussels in March, concerns about security in Europe have been renewed. The issue, further complicated by the ongoing migrant crisis and disagreement on how best to deal with ISIS, could impact markets as the situation develops. Meanwhile, the secondary and tertiary effects of slowing Chinese growth likely remain unduly ignored. While Chinese foreign policy or political and economic instability in commodity exporters like Brazil hasn’t impacted markets greatly, we believe such stories are only in their early stages. As the year progresses, such risks could make themselves more apparent.

With all of this in mind, we’ve spent a good deal of this quarter working to position portfolios for continued volatility. In particular, we have been developing methods to allow market volatility to better inform, and add higher conviction to, our portfolio management decisions. Though we are long-term investors, we believe that short-term market swings, especially of the kind seen recently, can yield compelling opportunities to cull or add to specific positions. While this has been our focus on the equity side, we have also been working to adjust our fixed income allocations to this environment. Specifically, given the likelihood of continued loose monetary policy, we have felt it prudent to add U.S. duration to the portfolio. At the same time, we’ve also become more selective about how we obtain exposure to corporate credit and emerging markets, given the volatility we’ve encountered. While we expect this volatility to persist, we are confident in our ability to react, regardless of what this highly fluid market environment may have in store.

As always, we welcome your thoughts, and greatly appreciate your support and trust.

Legal Information and Disclosures

This memorandum expresses the views of the authors as of the date indicated and such views are subject to change without notice. Drum Hill Capital, LLC (“Drum Hill Capital”) has no duty or obligation to update the information contained herein. Further, Drum Hill Capital makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Drum Hill Capital believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Drum Hill Capital, LLC.

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