Quarterly Market Review
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First Quarter 2016
Bonds Prevailed in Roller-Coaster Quarter
It was a turbulent start to 2016. Ongoing concerns about slowing growth in China, weak growth globally, and falling oil prices sent stock prices plunging in January and February. Although most central banks maintained aggressive stimulus programs, these efforts initially failed to offset investors’ concerns about worldwide economic weakness and the struggling global oil markets. By mid-February, indications of possible production cuts that could help reduce the global oil supply glut helped crude oil prices rebound off their lows. This factor, combined with central banks in Europe, Japan, and China maintaining and expanding their aggressive stimulus plans, eventually helped spark a turnaround in investor sentiment and global stock markets’ performance. In addition, the Federal Reserve (the Fed) adopted a more dovish tone, which gave stock investors another reason to become more upbeat.
In this environment, U.S. stocks staged a late-quarter rally that kept the broad market in positive territory for the quarter. Non-U.S. benchmarks also rallied in March, but non-U.S. developed market gains weren’t sufficient to offset earlier losses. Emerging markets stocks were the quarter’s bright spot, outperforming stocks in U.S. and non-U.S. developed markets as the U.S. dollar weakened and oil prices rebounded.
Many of the factors that sparked a sell-off among stocks led to gains for bonds. In particular, recession fears and weak global growth led to investor risk aversion that favored U.S. Treasuries and other high-quality bonds. Meanwhile, central banks maintained their aggressive stimulus plans, which helped drive down global bond yields and generate positive total returns for most fixed-income sectors.
U.S. Stocks: Late-Quarter Rebound Drove Gains
The stock market downturn that began at the end of December snowballed into a full-blown market correction by January 20, with the S&P 500® Index declining more than -10% to start the year. The risk-off trading continued until mid-February, when oil prices hit a bottom. Investor optimism gradually returned, and the S&P 500® Index finished the first quarter with a total return of +1.35%, thanks to a March rally of +6.78%, which offset the index’s losses in January and February.
Investors entered the quarter wondering if the U.S. economy was on the verge of another recession. An increase in jobless claims, weakness in the manufacturing sector, and a slowdown in fourth-quarter 2015 GDP (gross domestic product) fueled the recession fears. Furthermore, in December the Fed had embarked on U.S. rate normalization, implementing its first interest rate hike in more than nine years and indicating more increases were in store for 2016. At the same time, global conditions further soured sentiment. China’s growth continued to decelerate, growth elsewhere remained weak, oil plunged below $30 a barrel, and geopolitical concerns mounted. This combination of factors sparked a sharp sell-off among U.S. stocks.
The sell-off continued until mid-February, when oil producers indicated they would consider curbing supply levels to help bring oil prices off their lows. This sparked a turnaround in the oil markets, which eventually led to a rebound in the energy sector. These events, combined with additional central bank stimulus in Europe, Japan, and China helped improve investor sentiment. By mid-March, stock investors found additional relief when the Fed reduced its 2016 rate-hike forecast from four to two, expressing dovish caution in the face of ongoing global economic headwinds.
Despite the quarter’s strong volatility, sector performance was mostly positive, led by the more defensive areas of the market. Eight of the S&P 500 Index’s 10 sectors advanced, and all of the positive-performing sectors outpaced the index average. Outperforming sectors included telecommunication services, up +16.61%; utilities, which gained +15.56%; consumer staples, up +5.57%; industrials, which advanced +4.99%; energy, up +4.02%; materials, which advanced +3.61%; information technology, up +2.60%; and consumer discretionary, which advanced +1.60%. Political rhetoric regarding prescription drug pricing pressured the entire health care sector, which declined -5.50%, while concerns about the potential for energy-related credit losses weighed on the financials sector, which declined -5.06%.
In terms of capitalization and style, mid-cap stocks generally outperformed large- and small-cap stocks, while value stocks maintained an edge over growth stocks across the board. Mid-cap value stocks (Russell Midcap Value Index) were the quarter’s top performers, up +3.92%, while small-cap growth stocks (Russell 2000 Growth Index) were the weakest, declining -4.68%.
Non-U.S. Stocks: Emerging Markets Stocks Rallied, Outperformed Developed Markets
Non-U.S. stocks faced the same challenges and followed a similar performance pattern as their U.S. counterparts. However, non-U.S. developed markets generally ended the quarter with losses (in local currencies and the U.S. dollar), while emerging markets rallied.
Economic data in Europe generally remained mixed. The region’s economy continued to slowly expand, unemployment inched lower, and manufacturing remained consistent with steady growth. However, consumer confidence sagged, the services sector showed signs of slowing, and inflation hovered in slightly negative territory. In response, the European Central Bank (ECB) in March announced a new package of stimulus measures, including an expanded asset purchase plan, broad interest rate cuts, and new incentives for banks to lend by borrowing from the central bank at negative interest rates. Investors responded enthusiastically, driving European stocks higher in March. Overall, though, the late-quarter rally could not offset the steep losses in January and February, and European stocks generally declined for the quarter.
Early in 2016, weak economic data prompted the Bank of Japan (BoJ) to adopt a negative interest-rate strategy (in addition to maintaining its asset purchase and other stimulus programs). By March 31, economic growth remained stalled, the yen continued to strengthen, and inflation remained well below the central bank’s 2% target, prompting speculation the BoJ would expand its aggressive stimulus plan in the second quarter. This speculation drove stocks higher in March, but similar to Europe, the rally was not enough to offset earlier losses, and stocks generally declined for the quarter.
The mid-February recovery in oil prices provided a boost to emerging markets stocks, triggering a late-quarter rally. Signs China’s economy was stabilizing provided additional support, as did a weakening U.S. dollar. Furthermore, speculation Brazil’s disgraced president would be impeached and a new government would be installed helped lift Latin American stocks. Emerging markets stocks advanced more than +13% in March, offsetting earlier losses and driving a solid first-quarter gain of +5.71%.
Global Bonds: Yields Tumbled on Weak Growth, Central Bank Policy
Risk aversion returned to the financial markets, as concerns about weaker global economic growth (particularly in China), still-plunging oil prices, and a severe equity market sell-off triggered a flight to quality, pushing U.S. Treasury yields lower. Central banks in Europe, Japan, and China responded with additional stimulus measures, including negative deposit rates in Japan and Europe, while the Fed delayed another short-term interest rate hike, citing concerns about the global economy. Riskier assets, including corporate bonds, responded strongly to this monetary stimulus (and a rebound in oil prices), which drove Treasury yields higher mid-quarter. But in March, the Fed reduced its rate hike forecast for 2016, and Treasuries rallied again.
Against this backdrop, the U.S. Treasury yield curve flattened, with longer-maturity yields falling at a greater pace than shorter-maturity yields. For example, the yield on the two-year Treasury note declined 33 basis points (1 basis point equals 0.01%), while the yields on the 10-year Treasury note and 30-year Treasury bond declined 50 basis points and 41 basis points, respectively, according to Bloomberg. Overall, longer-duration (greater price sensitivity to interest rate changes) securities outperformed shorter-duration securities.
All major sectors of the taxable U.S. investment-grade bond market advanced during the quarter. Treasuries and corporate bonds outperformed the market, while mortgage-backed securities (MBS) and agencies underperformed. Treasury inflation-protected securities (TIPS) were among the quarter’s top performers, benefiting from higher long-term inflation expectations stemming from the Fed’s more dovish tone. Within the MBS sector, agency MBS largely accounted for the underperformance, lagging due to heightened interest rate volatility. Meanwhile, a rebound in energy prices, combined with central bank accommodations, fueled a late-quarter rally in the corporate high-yield market. High-yield bonds generally outperformed the broad investment-grade bond market for the quarter.
Elsewhere, municipal bonds (munis) continued to advance, as the tax advantages, perceived "safe-haven" status of the asset class, and favorable supply/demand dynamics supported muni market gains. But, as usually happens during strong Treasury market rallies, munis underperformed Treasuries.
Outside the U.S., European bond markets were among the best performers, led by the U.K., France, and Germany. Japan was the leading performer in the Asia/Pacific region. Non-government securities generally outperformed government bonds as riskier sectors snapped back during the quarter and as investors sought yield in the declining interest rate environment.
After an extended period of strength, the U.S. dollar weakened against most major foreign currencies, largely due to the Fed’s decision not to raise interest rates and to reduce its projected number of rate cuts this year. A weaker dollar boosted returns for unhedged non-U.S. bonds for U.S investors. Although the U.S. dollar rallied +2.6% against the British pound (due to concerns about the U.K.’s potential exit from the European Union, referred to as "Brexit"), it was down -4.8% against the euro, -5.0% against the Australian dollar, -6.3% against the Canadian dollar, and -6.8% against the Japanese yen, according to Bloomberg.
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Source: Barclays Indices