Highlights: 

• The New Year began with the media constantly reminding us of one of the worst equity market starts in a long time. However, stocks staged a strong recovery later in the quarter to further remind us that a long term perspective is essential to a successful investment policy.
• The U.S. Federal Reserve indicated it would take a more cautious approach to future interest rate increases while the European Central Bank announced a larger-than-expected stimulus package.
• Chinese policy makers continue trying to steer its economy towards a healthier growth path while avoiding the inevitable stumbling blocks of a transitioning economy.
• Other emerging market countries followed China's lead in turning to monetary easing in an attempt to stimulate their commodity-dependent economies.
• Japan's central bank shocked the markets when it enacted the country's first negative interest rate policy, but the immediate results were surprising.

Commentary:

Equity markets opened the year in chaos, with continued volatility in oil prices and concerns over economic conditions in Europe and China stoking fears of a global recession.  Calmer heads ultimately prevailed with many investors likely concluding that underlying global fundamentals did not justify the level of market pessimism.  Central banks and interest rates were common themes throughout the quarter.

After raising interest rates for the first time in almost a decade in December, the U.S. Federal Reserve signaled caution on future rate increases. Policy makers initially predicted that the benchmark rate would be raised four times in 2016, but now expect to raise the rate just twice this year.  Federal Reserve officials believe a cautious approach on rates is appropriate in the face of a still vulnerable U.S. economy, weak global growth and a central bank with few tools remaining to respond if new threats derail the ongoing recovery.  One of the major initial results of these monetary actions was a severe weakening of the US dollar.  
    
The European Central Bank (ECB) also took an expansionary stance by unveiling a larger-than-expected stimulus package during the quarter in response to the Chinese market turmoil and low energy prices that threatened to undermine the region’s inflation target.  The latest round of ECB stimulus measures included a series of rate cuts, additional bond purchases and ultra cheap loans for banks.  However, they came with the caveat that while interest rates may likely remain low for a long time, they were unlikely to go any lower due to concerns about the impact on Europe’s already precarious banks.  This conundrum is not unique to the ECB as central banks across the globe deal with the conflict of the impact of very low interest rates on bank lending versus the impact of higher interest rates on economic activity.   
   
This can be visibly seen in China where, amidst a transition to a healthier-but-slower growth path emphasizing consumer consumption and services, China’s central bank is increasingly finding itself struggling to balance its need to ease credit to support economic growth against its stated goal of keeping its currency (the yuan) stable.  This was seen during the quarter when the People’s Bank of China freed banks to lend more by lowering the amount of deposits that banks must hold in reserve, but was an action that was perceived as a move to deliberately weaken the yuan.  China’s government leaders are also walking a tight rope in trying to stimulate its economy.  China’s leaders made it clear that they are emphasizing growth, but risked favoring business interests at the expense of unrest amongst discontented workers.  China’s economy has shown signs of steadying recently, with growth in the service sector largely offsetting contraction in the manufacturing and industrial sectors.  This led the government to announce a 6.5% to 7% growth target for 2016, a goal which will be closely monitored by investors now that China is aggressively pursuing stimulus measures.

Perhaps taking a cue from China, several other emerging market central banks turned to monetary easing, specifically a wave of interest-rate cuts, to power a long awaited rally in emerging markets stocks and bonds during the quarter.  During the last month, central banks in India, Indonesia, Turkey, Hungary and Taiwan have all lowered interest rates in response to soft economic growth, with more developing countries likely to follow suit in the coming months. In addition, after plunging to start the year, a firming of oil prices and other commodities also helped drive emerging markets higher during the quarter.  Longer term, it would be healthy if these developing nations could begin to decouple from dependence on oil, but that is unlikely to happen in the near term.  Stabilizing oil prices was a respite for many of these developing countries, where mounting debt burdens, especially in many Asian and Latin American countries, and credit quality for many government and corporate borrowers remain an ongoing concern.

Continuing with the theme of central banks, Japan’s central bank drew much attention in January when it set the country’s first negative interest rates. This was done in an ongoing attempt to kick start its economy and head off deflationary pressures that have led to steadily falling Japanese real wages and caused consumers to hold off purchasing big ticket items.  However, Japan’s subzero rates have produced some unexpected results.  Rather than seeking higher yield through riskier investments, there has been increased demand for government bonds, even as many yields went below zero.  In addition, the yen vaulted to 18-month highs against the U.S. dollar instead of falling.  It is likely that both of these trends will eventually reverse as the Bank of Japan has sent a strong signal to the market that it is determined to continue to do whatever it takes to infuse inflation into the Japanese economy.  A determined central bank, a depreciating currency and increasing demand for riskier assets will hopefully be the elixir Japan is looking for to reignite its stalled economy.

In summary, financial markets continue to reflect the widely held belief that lower rates of economic growth, nominal inflation and lower interest rates will persist for the foreseeable future.  Although there is still uncertainly, particular overseas, an environment of low interest rates, subdued inflation and lower energy prices generally implies expansion in terms of both economic activity and confidence.  Because of the uncertainty, from an investment policy perspective we continue to suggest insulation rather than relying on any forecast.  Investors who insulate their portfolios with sufficient amounts of cash and fixed income exposure to allow investment in well diversified equity holdings are most likely to prosper over time.   

Urban Financial Advisory Corporation - April, 2016