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Market Commentary & Outlook Alesco Advisors LLC 4th Quarter 2015 The U.S. stock market enjoyed a rebound in the fourth quarter of 2015, helping to offset losses incurred during the correction over the summer and resulting in roughly flat returns for the year in total. The S&P 500 Index rallied 7.0% during the quarter, surpassing the 4.7% gain for the MSCI EAFE Index of developed market stocks and the 0.7% return for the MSCI Emerging Markets Index. A long-awaited increase in interest rates by the Federal Reserve contributed to a 0.6% loss for the Barclays Aggregate Bond Index. The S&P 500 gained 1.4% for the year including dividends, which is a reasonable pause after a series of above average returns over the past few years. 2015 Returns Market returns for the year in total were unusual in the sense that no major asset classes provided investors with positive returns of substantial magnitude. Tepid or negative returns for stocks are not abnormal, but those years are typically countered by gains for other investments such as bonds or commodities. For example, during the bear market from April 2000 through September 2002 when the S&P 500 Index declined 44%, diversified portfolio returns were buffered by gains of 29% for the Barclays Aggregate Bond Index and 23% for the Credit Suisse Commodity Index. When the S&P 500 declined 51% from November 2007 through February 2009, commodities sold off nearly as much but bonds managed to cushion losses by providing a gain of 6%. A broad dispersion of returns was still present in 2015, but somehow it feels different when the S&P 500 is at the top of the chart, since it might initially appear that any actions taken to diversify a portfolio beyond the popular benchmark resulted in failure. In fact, diversification worked again in 2015, with different asset classes experiencing a broad range of returns. Portfolio values generally held up well since the best performing investments happened to be the largest portions of the portfolio, and the worst performing investments were among the smallest. A Year of Resiliency 2015 was a display of resiliency for the U.S. economy. GDP is estimated to have grown by 2.5% for the year, ranking among the top years recently despite facing some meaningful challenges that combined to cause a correction in U.S. stock prices over the summer, when the S&P 500 lost 11.9% between May and August. These challenges included: (1) collapsing oil prices that dealt a serious blow to the energy sector, which had previously been a major driver of economic growth in the U.S., (2) a slowing Chinese economy that sent shockwaves through global markets over the summer and continues to weigh on markets, Service | Integrity | Value 1 1 A Year of Resiliency (continued) (3) troubles in the Eurozone that resurfaced over the summer, as a standoff between Greece and its European creditors resulted in a shutdown of the Greek banking system and rekindled an underlying threat to the existence of the Eurozone, and (4) an increase in interest rates by the Federal Reserve in December after months of speculation and delays. These rising rates are in contrast to the European Central Bank and the Bank of Japan, which are moving monetary policy in the opposite direction by expanding quantitative easing programs. Growth in the U.S. was also higher than most other developed countries, and the combination of higher growth and increasing interest rates resulted in a 9% gain for the U.S. dollar in 2015, negatively impacting foreign sales for American companies. Despite these challenges, the U.S. economy firmly held its ground, growing at a pace that was above average since the 2008 recession. Some of these difficulties are unlikely to be as significant of a hindrance during 2016. For example, we do not expect the U.S. dollar to replicate the sharp gains experienced in 2015. The majority of the dollar’s gains occurred during the first three months of the year, and levels have largely stabilized since then. Currency gains are driven by higher interest rates and economic growth rates; market expectations are already in place for continued interest rate increases in the U.S. and a more rapid rate of economic growth relative to most of the rest of the developed world in 2016. If either of these factors fail to reach forecasted levels, currency appreciation would be muted, or potentially even negative. Additionally, oil prices appear unlikely to repeat the $16 per barrel decline experienced in 2015 since they started out 2016 at just $37 per barrel. However, there is potential for continued pressure on oil in the near term as negative sentiment regarding China and a lack of production restrictions from OPEC weigh on prices. Offsetting these factors is a dramatic decrease in active rig counts and aggressive cuts to investments in new drilling. These changes will eventually weaken supply as production from existing wells becomes depleted. U.S. Consumers in Good Condition U.S. consumers are well-positioned to continue contributing to the economic expansion. This is evidenced by surveys of consumer confidence, which have been climbing due to a combination of encouraging factors. Chief among these is the improvement in employment measures. 2015 was another solid year for job growth as 2.2 million jobs were created, pushing the unemployment rate down to 5.0%. Service | Integrity | Value 2 2 U.S. Consumers in Good Condition (continued) It will be difficult to maintain this pace of employment gains going forward, since job openings have increased and further improvement is more likely to be reflected in wage gains than job creation. In fact, recent data show what may turn out to be the beginning of an upturn in wage increases. Consumer balance sheets have experienced a corresponding improvement, with eight years of deleveraging resulting in household debt levels reaching their lowest point since 2002 (before the housing bubble). This burden is even lighter when viewed in terms of monthly payments since the current debt is at lower interest rates. Don’t Expect Average: The Rarity of Normal One important investing principle on display in 2015 was that the voyage in search of high long-term returns for growth investments requires navigating turbulence in the shortterm. For example, the annualized return for the S&P 500 during the ten year period ending in 2015 was 7.3%, yet achieving a return near 7% in any given year was unlikely. There are other notable positive economic factors to consider. Housing prices continue to climb, credit remains reasonably available, and interest rates are expected to persist at low levels regardless of the exact number of rate increases by the Federal Reserve during 2016. Lower expenses incurred from cheaper energy costs should also serve as a tailwind. History indicates there is typically a lagged effect between drops in energy prices and the beneficial effects on economic activity until consumers become assured that the decline is a long-term improvement in their budget and not simply a short-term respite. Corporate Earnings Corporate earnings came under pressure in 2015, with earnings per share for the S&P 500 Index expected to experience a decline for the year for the first time since 2009. This is primarily due to gains in the U.S. dollar hurting exports and significant losses in the energy sector. The impact of these two factors can be seen in the divergence between manufacturing and the rest of the U.S. economy. This phenomenon is not merely limited to recent history either. The annualized return for the S&P 500 and its predecessors has been 10% since 1926. The number of calendar years in which the index achieved a total return of between 8%-10% over those past 90 years? Zero! Markets do not advance in a straight line, but they do advance over time. Accepting year-to-year volatility of returns is part of the price that investors pay in return for long-term growth of a portfolio. Service | Integrity | Value 3 3 Corporate Earnings (continued) Manufacturers have been affected by the decline in capital investment for energy exploration and production and are more sensitive to the negative effect of a stronger dollar on exports. Fortunately the impact on the broad economy has been limited since manufacturing only represents 12% of the U.S. economy. Businesses have taken advantage of high profit margins in recent years to deleverage and build up cash reserves. The improved financial flexibility this provides is one reason for the economy’s solid performance in 2015. Looking Forward: Challenges & Opportunities Heading into 2016, there are a number of challenges that may confront capital markets and the U.S. economy. Primary among these is the management of the slowing Chinese economy and the potential for continued devaluation of the yuan. Stock market returns so far in 2016 have been poor in large part due to China. Contact Us If you have questions or comments, or would like additional information regarding our services, please contact us: Alesco Advisors LLC Tobey Village Office Park 120 Office Park Way Pittsford, NY 14534 Phone: (585) 586-0970 Toll Free: (800) 277-3440 [email protected] Visit us on the web at www.alescoadvisors.com However, there remain some notable factors that provide support for the economic expansion to continue. The economy does not typically enter recessions as a result of falling commodity prices, which instead should help to support economic growth as the energy sector stabilizes and lower input prices translate into higher disposable income for consumers and improved earnings for businesses. High levels of employment and long-awaited improvements in wage growth are expected to foster strong consumer demand. The fundamentals underlying the U.S. economy appear secure, and make us optimistic about the prospects for investment opportunities going forward. As Federal Reserve Chair Janet Yellen recently stated, “it’s a myth that expansions die of old age.” Our advice to investors remains unchanged: construct an asset allocation that balances long-term growth potential with shorter-term liquidity needs, incorporate broad diversification to manage risks, and control costs. This is our approach to investing and we believe that following these fundamental tenets will provide you with the highest probability of long-term investing success. Service | Integrity | Value 44