Investment Review

Winter 2016

While many investors were waiting for the inevitable rise in short-term interest rates expected when the Federal Reserve tightened its monetary policy, some investors may have missed the increase in short-term rates already underway as a result of market forces. Looking at the zero- to two-year segment of the yield curve—the segment that many believe will be most affected whenever the Fed “normalizes” interest rates—it may be surprising to see how much rates have increased since 2013.

In fact, the yield on the 2-Year U.S. Treasury note has nearly doubled since the beginning of 2015, rising from 0.45% in January to almost 0.90% in late November. The yield on the 1-Year U.S. Treasury note more than tripled, from 0.15% to more than 0.50% over the same period. The 6-Month U.S. Treasury bill’s yield rose from a low of 0.03% in May to over 0.30% in late November. Yet, despite the higher rates, we have not experienced the conjectured financial storm in the fixed income market.

Last year was the worst year for the S&P 500 since 2008. Earlier in the year, Japanese shares hit a 15-year high, U.S. job growth was the strongest since 1999, and the NASDAQ Composite reached a new high.

Below are some headlines that appeared during the fourth quarter.

• IMF Downgrades Global Economic Outlook Again
• U.S. Trade Gap Widens Sharply on Strong Dollar
• Iran Nuclear Deal Formally Adopted
• U.S. Growth Cools in Third Quarter
• Number of First-Time Home Buyers Falls to Lowest Levels in Three Decades
• Eurozone Economy Slows as Exports Weaken
• Spot Gold Hits Six-Year Low
• U.S. Factory Activity Hits Six-Year Low
• Oil Prices Skid to Seven-Year Lows
• Junk Bond Selloff Intensifies

 
We are not offering these headlines to explain market returns. But they do serve as a reminder that investors should view daily events from a long-term perspective and avoid making financial decisions based solely on the news.

Investment Review

Looking at broad market indices, the U.S. equity market again outperformed both developed international and emerging markets during the fourth quarter. In a repeat from the third quarter, U.S. REITs recorded the highest returns, outperforming equity markets.

The value effect was negative in the U.S., developed international, and emerging markets. Small caps outperformed large caps in both developed international and emerging markets, but underperformed in the U.S.

Benchmark Funds	Q4 2015	12 Months Ending 12/31/2015
U.S. Large Cap Vanguard 500 Index Fund	+7.0%	+1.3%
U.S. Large Cap Value iShares Russell 1000 Value Index	+5.6%	-4.0%
U.S. Small Cap iShares Russell 2000 Index	+3.6%	-4.5%
U.S. Small Cap Value iShares Russell 2000 Value Index	+2.8%	-7.7%
International Vanguard Total International Stock Index Fund	+2.7%	-4.4%
Emerging Markets Vanguard FTSE Emerging Markets ETF	-0.7%	-15.8%
U.S. REITs Vanguard REIT ETF	+7.0%	+2.4%
Investment-Grade Bonds iShares Core Total U.S. Bond Market ETF	-0.5%	+0.5%

 
Individual Asset Classes

U.S. Stocks

In a turnaround from the previous quarter, the U.S. equity market recorded positive performance. Small caps underperformed large caps, and value indices underperformed growth indices across all size ranges. U.S. stocks are 53% of the world’s market capitalization.

International Developed Market Stocks

In U.S. dollar terms, developed markets outside the U.S. underperformed the U.S. equity market but outperformed emerging markets indices. Small caps outperformed large caps in international developed markets. Value indices underperformed growth indices across all size ranges in non-US developed markets. International developed market stocks are 37% of the world’s market cap.

Emerging Markets Stocks

In U.S. dollar terms, emerging markets indices underperformed developed markets, including the U.S., during the quarter. Small cap indices outperformed large cap indices in emerging markets. Value indices underperformed growth indices in emerging markets across all size ranges. Emerging markets are 10% of the world’s market cap.

Real Estate Investment Trusts

U.S. REITs were one of the best-performing asset classes during the quarter, outperforming equities. But REITs outside the U.S. underperformed international broad equity market indices. There are 97 U.S. REITs and 240 REITs in 22 countries outside of the U.S.

Investment-Grade Bonds

Interest rates across the U.S. fixed income markets increased in the fourth quarter. The yield on the 5-year Treasury note gained 39 basis points to end the quarter at 1.77%. The yield on the 10-year Treasury note increased 22 bps to 2.27%. The 30-year Treasury bond added 14 bps points to finish with a yield of 3.01%.

The short end of the yield curve experienced the largest increase in yields during 2015. Short-term corporate bonds declined 0.14% during the quarter but gained 1.01% for the year. Intermediate-term corporates fell by 0.42% during the quarter but climbed 1.08% in 2015. Short-term municipal bonds returned 0.08% for the quarter and 1.21% for the year. Intermediate-term municipal bonds returned 1.26% for the quarter and 3.28% for the year.

In Conclusion

The question of how far the Fed will go in raising its overnight target rate is still open. Similarly, we can ask ourselves a more complex question: Will the market lead the Fed or is the Fed leading the market through setting expectations?

Read about our thoughts on expected volatility in the markets in 2016.