It may not feel like it, but the U.S. stock market made an historic comeback during the first quarter of 2016. From its low on February 11th the stock market has rallied more than 11%, wiping out the losses for the year. This is the biggest quarterly comeback for the market since 1933. The bond market has continued to be volatile but ended the first quarter with modest gains as interest rates fell during the quarter.
Economic growth in the U.S. continues to be sluggish, although it remains positive. The U.S. GDP grew roughly 1.9% last year, which was less than the Federal Reserve was expecting. Economic data suggests only a slightly higher GDP growth rate for this year. This disappointing growth, as well as muted inflation projections, has led the Fed to slow down the frequency of their interest rate hikes. They had been planning four rate hikes per year for the next three years. They are now planning only two for this year. Economic growth outside the U.S. continues to be sluggish as well.
The Fed, as well as many economists, has projected the core inflation rate to rise to 2% by 2018. We remain somewhat skeptical of this timeline. With current economic conditions and dropping commodity prices, it is difficult to imagine a scenario that leads us to increases in inflation. Also, for the past twelve years, we have been warned of higher inflation, “Two years out.” While we acknowledge that the Fed has more economic data at their fingertips than we do, we still see deflationary pressures worldwide. This has kept inflation low and has the potential to keep it in check in the future.
On the investment front, we think we will see continued volatility in both stocks and bonds for the remainder of this year. In the near term, stocks could have limited upside potential as the yield curve flattens and questions linger about corporate earnings. Fears about higher interest rates in the future are also likely to keep stock returns muted. As concerns about higher interest rates and inflation abate we should see the outlook for stocks improve. It is very difficult to predict when this will happen. For the bond market, we would not be surprised to see this year turn out much as 2015 did with slightly lower interest rates and negligible gains. In short, there are many variables out there that will impact the performance of the markets this year and at this point it is difficult to know how things will turn out.
Changes can happen quickly in the investment world and by our next letter we may have a different outlook. Current economic conditions lend themselves to frequent updating. Given the number of economic question marks, we remain cautious.