As expected, 2015 was a volatile year with considerable return dispersion among asset classes. Commodities and emerging market equities struggled with the rise in the U.S. dollar coupled with fears of a global slow down stemming from China. Large cap equities outperformed their small cap counterparts with a return of +1.4% in the S&P 500 versus -4.4% in the Russell 2000. Outside of the U.S., the strong dollar weighed on foreign returns for U.S. based investors, with international developed equities and the MSCI EAFE index down slightly for the year at -0.2%.
For the first time in 9 years, the Federal Reserve raised interest rates by .25%. This is a small move that we believe the U.S. economy can handle given healthy underlying fundamentals. Going forward the trajectory of future rate increases will be important. Global monetary policy will likely remain accommodative helping to stimulate economic activity.
Ultimately, we believe the consumer will continue driving the U.S. economy higher as consumption makes up roughly 70% of total output. Consumer confidence has remained in an uptrend, housing prices are back to pre-crisis levels, auto sales have been strong, job gains are positive, and interest rates remain low. The U.S. is still essentially a closed economy with exports comprising only 9.3% of total GDP in 2014 and exports to China making up less than 1%.
Despite a year filled with geopolitical concerns as can be seen from the chart above, the S&P 500 rallied 7% in the fourth quarter to eke out a small gain for the year. Part of the challenge for 2015 was the first significant slowdown in earnings growth since the financial crisis and was driven primarily by a slumping energy sector. Consensus estimates for 2016 are predicting mid-single digit earnings growth for the S&P 500. While last year's performance was largely driven by uncertainty and macro headwinds, it is important to stay invested for the long run and remember that a diversified portfolio is the best way to weather these storms. Asset allocation is key to volatility.
Fixed Income Update
The Barclays US Aggregate posted a loss of 0.55% in Q4 and the Intermediate index lost 0.51%. The losses were a result of short term rates rising in anticipation and confirmation of the December Federal Reserve rate increase. This pushed down the Aggregate to a 0.55% YTD gain and the Intermediate Aggregate to a 1.21% YTD gain.
The Fed's decision to raise short term rates by 0.25%, improvement in global growth expectations and strengthening in US wage rates all played a role in the overall increase in yields over the quarter as well as a flattening curve due to higher increases at the short end. This is all part of the normalization of monetary policy that we have been expecting to start for several years. It is a vote of confidence from the Fed that the economy is on the right track even if all of the numbers that they monitor are not quite at the desired targets.
There was bifurcation between investment-grade and high-yield spreads as the investment grade spreads softened and the high yield spreads widened. The degree of widening in the high yield was strongly dependent on the credit quality as the lower quality spreads widened considerably during Q4, especially in the energy sector.
The pace of Fed rate increases will be more important than the fact that rates have started to increase. Official Fed data shows rates will likely increase four times in 2016, while market futures suggest two increases as the most likely scenario. Slower rate changes result in better total returns as the price changes are more fully offset by the coupon payments.