The Markets	12/31/15 Close	09/30/15 Close	4th Qtr. Change	12/31/14 Close	12 Mo. Change	YTD Change
Dow	17,425	16,285	+7.00%	17,823	-2.23%	-2.23%
NASDAQ	5,007	4,620	+8.38%	4,736	+5.72%	+5.72%
S&P 500	2,045	1,920	+6.51%	2,059	-0.68%	-0.68%
MSCI EAFE	1,716	1,644	+4.38%	1,775	-3.32%	-3.32%
10-yr Treas. yield	2.27%	2.06%	+0.21%	2.17%	+0.10%	+0.10%
Fed funds rate	0.25% to 0.50%	0 to 0.25%	+0.25%	0 to 0.25%	+0.25%	+0.25%

(stock indices are before dividends; yield and rate changes are absolute changes)

Despite a market decline toward year-end, the quarter was generally positive for stock market returns. Still, for the year US stocks had their worst performance since 2008 and both the Dow and S%P 500 finished with small negative returns. (Including dividends the S&P was up 1.4% and the Dow was barely positive.) The downward pressure was largely due to declining oil and commodity prices and global growth concerns, although the more tech-heavy NASDAQ had a decent year overall. International stocks were mixed, with Europe performing far better than Asia and emerging countries. The lackluster returns extended to bonds, with the aggregate US bond index also slightly negative including income, and high yield bonds faring even worse at down nearly 6%.

It was widely reported that 70% of investors lost money in 2015 and hedge funds were not immune, with the average hedge fund losing more than 3% in a reminder that strategies that rely on making speculative bets can backfire. Gold was down over 10%, its third year of decline in a row. Oil hit an 11-year low as most countries kept producing even at low prices and natural gas was even worse, hitting a 14-year low.

The final revision for third quarter GDP growth was up 2.0%, down from the prior estimate of 2.1% and well below the 3.9% for the second quarter. (see Looking Forward) The change was due to drawdown of inventories but consumer spending was up 3%, a good sign. Still, the savings rate was the highest in four years, and coupled with low wage growth this may be a sign that consumer habits are changing. Jobless claims extended the string of staying below 300,000 for 43 weeks and the improved job market led to higher consumer confidence. New jobs added averaged 220,000/month for 2015.

The Fed finally raised US short-term interest rates as expected (see The Seven-Year Itch) two months after the three-month Treasury bill hit 0% for the first time ever. Meanwhile, the European Central Bank reiterated that “there is no limit to how we can deploy any of our tools” to stimulate growth. The ECB extended its bond buying program at least six months and lowered overnight bank deposit rates further to
-0.3% after previously saying rates had bottomed. Parts of Europe are adjusting to negative interest rates, where you pay to have money in the bank but you get paid to borrow money.

US auto sales hit an all-time high in 2015 even as auto makers are announcing investments to adapt to a changing transportation world (ride sharing services, artificial intelligence, driverless cars). Home sales softened at year-end because of new lending paperwork requirements and tight supply but housing starts and permits hit eight-year highs in November. First-time homebuyers are at a three-decade low but the “desire to own” has increased. The service sector slowed but still grew while manufacturing actually contracted in November and December. This led to exports hitting a three-year low and the trade deficit increasing. Inflation is still tame but core inflation (excluding volatile food and energy) was up 2.0% in December, the highest since May, 2014.

The 12-country TransPacific Partnership was finalized but still must be approved by Congress. A 200-country climate change agreement was reached even as Beijing literally shut down due to air pollution. Congress agreed to increase the debt limit and to roll back some of the spending cuts called for by the sequester of two years ago, increasing spending by $80 billion. A number of popular personal and business tax breaks were made permanent and others were extended through 2016. The tax package also formally lifted the 40-year ban on US oil exports, and those shipments resumed by year-end.

Looking Forward

Now that the Fed has finally raised rates, all eyes will return to parsing every Fed statement for clues on how they will evaluate the economy and possible further rate increases. The Fed has said repeatedly that they will be “cautious” and that their policy will continue to be “accommodative”, which means rates will be kept at levels that will hopefully spur growth. It will, however, be a delicate balancing act and current consensus is that we will see only one or two more increases through 2016 even if the economy gains its footing.

With GDP growth now averaging 2% annually over the past five years, it may be that 2% growth is the “new normal”. While that would still be growth, which is certainly better than recession, it would not be at a rate sufficient to spur needed wage growth and to create more jobs with decent wages. It would also kill any possibility that we can grow our way out of the growing government deficit, which was a bit of a pipe dream even under the best scenario. But the greatest strength of the US economy is that it has been remarkably resilient and adaptable, and there could always be unexpected developments like the energy boom of pre-2015 that could kickstart growth.

The US dollar has enjoyed a strong rally, gaining 24% against a basket of currencies since July 2014. 2015 was a slower rise for the dollar but it was still up versus other major currencies except the Swiss franc, against which it was flat. The strong dollar has hurt foreign investments, since it can offset gains in local currency terms, and it has hampered growth in US manufacturing exports. If other central banks begin to pull back on stimulus policies, or even begin raising rates as well, the dollar will be less attractive to investors and could weaken. If, however, other central banks don’t make changes and the divergence between US interest rates and other countries’ rates grows, the dollar would be more attractive and could continue to strengthen.

Our Portfolios

Stocks usually get most of the attention in portfolio discussions and for good reason – they provide greater long-term growth, are far more volatile and are generally just more interesting. Bonds, by contrast, can be more esoteric, with bond ratings, interest rates, specific bond provisions and “spreads” between bond types driven by investor preference all coming into play. Those are some of the reasons, in addition to greater diversification, that we typically prefer to use bond funds instead of individual bonds.

With the recent rate increase, albeit a small one, we have taken time to re-examine and ultimately confirm our fixed income strategy.

When rates rise, the bonds with lower rates in a fund will fall in price. But as those bonds mature, the fund manager will reinvest in bonds with higher current rates, increasing income. The short term pain of lower bond prices is offset by higher income over the long term.

This process was confirmed in a study of intermediate-term bond funds by Vanguard in which they assumed rates would rise a total of 2% in eight increases until July 2019. Compared to returns if rates did not rise (the return would be pretty smooth and would just be the income earned), the rising rate scenario resulted in a loss of 0.15% in the first year (income and price change) with positive returns thereafter. The cumulative returns take a bit longer to turn in favor of the rising rate scenario, but it is still positive. Of course, different types of bonds can react differently, and long-term rates don’t always change in lock-step with the short –term rates controlled by the Fed, but the principle remains the same.

The media and the pundits use the same inflammatory terms in referring to bonds as to stocks – soar, plummet, etc. But the reality is that the volatility and range of returns for bonds is a fraction of the range of returns for stocks, which can potentially drop by up to 50%. As long-term investors, we value the relative stability provided by bonds compared to stocks and are perfectly willing to weather the short term effects of higher rates. (And the recent increase was so completely expected that the impact had already been reflected in the bond market.)

So while we may make some minor adjustments in the mix of bond types in our portfolios and are always evaluating the specific funds for consistent performance in their area of the market, we are maintaining our overall bond allocation in all of our portfolios. Bonds do share many investment characteristics with stocks, including the folly of trying to be too “cute” and making significant changes based on short-term conditions rather than long-term objectives.

The Seven-Year Itch

It was seven years to the day that the Fed kept short-term interest rates essentially at zero before raising them on December 16. Courtesy of Jeanna Smialek at Bloomberg News, here’s a recap of those seven years (of which 2012 was apparently relatively uneventful).
Here’s What 7 Years at Zero Rates Have Looked Like
The Federal Reserve is expected to raise interest rates on Wednesday, exactly seven years after the central bank cut them to almost zero in response to the deepest recession in the post-World War II era. As this unprecedented era of easy monetary policy closes, here’s a walk through seven years at zero to highlight the obstacles that policy makers navigated to restore labor-market health and enable liftoff.

1. Rates Cut to Zero – December 16, 2008
Fed officials lowered the federal funds rate into a 0 to 0.25 percent range in December 2008 as the nation’s economic state deteriorated and the collapse of Lehman Brothers sent shock-waves through global financial markets. The Fed “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” officials said in their post-meeting statement.

2. Unemployment Peaks – October 2009
By 2009, the Fed was staring down a different kind of crisis: one of joblessness. America hemorrhaged an average of 424,000 jobs a month that year, and by October unemployment had reached 10 percent, its highest level since 1983. The broader underemployment index was even higher at 17.1 percent.

3. Easy the World Over – 2010
By 2010, reverberations from the financial crisis were being felt around the world and central bankers were striving to mitigate the fallout. The Bank of England cut rates to 50 basis points in March 2009, where they’ve remained ever since, having descended from 5.75 percent in late 2007. The European Central Bank slashed its deposit facility rate to 25 basis points (it would go on to raise that rate in 2011 only to cut it again later that year). The Bank of Japan cut interest rates for the first time in seven years in 2008, among other measures. Even bigger Japanese policy changes would come in 2013 in the form of an explicit 2 percent inflation target and open-ended monetary easing commitment.
Monetary policy easing abroad aids the U.S. by supporting global growth, but lower interest rates overseas can also encourage capital to flow into higher-yielding U.S. assets, pushing up the dollar and hurting U.S. exports by making them more expensive.

4. Debt Ceiling Debacle – July 2011
Several times during the Fed’s expansionary era, fiscal policy — or fiscal inaction — has gotten in the way of the recovery. Congressional lawmakers in July 2011 allowed the nation to tiptoe to the brink of default on debt that it had already incurred by failing to agree on a higher borrowing cap for the nation. Congress ultimately came to a deal. But the spectacle shook confidence and Standard & Poor’s downgraded the U.S. credit rating, dealing a blow to the stock market and probably hurting growth. Cuts to government spending that followed added to the economic headwinds.

5. Taper Tantrum – Summer 2013
In May 2013, then-Chairman Ben Bernanke testified to Congress that the Fed could start slowing the pace of its bond purchases later in the year, conditional on continuing good economic news. Markets went haywire at the prospect of less stimulus, with the yield on 10-year Treasury note shooting up as investors fled to safety.

6. Dollar Ascends – Summer 2014
The greenback, which has strengthened by around 21 percent since mid-2014, has become a focal point for Fed officials as liftoff approaches. Weak growth and easy monetary policies abroad are pushing money into dollar-denominated debt, and when the U.S. lifts rates that could intensify pressure on the currency to appreciate. Even if that risk doesn’t stop the Fed from raising rates, currency strength will likely cause policy makers to take their time in tightening. The dollar is one factor that “means that monetary policy for the U.S. is more likely to follow a gradual path,” Chair Janet Yellen told a congressional committee on Dec. 3.

7. Yuan Devaluation – August 2015
U.S. officials have had to contend with a series of international developments over the past seven years, including China’s surprise yuan devaluation in August. The world’s second-largest economy allowed its currency to fall as its growth slackened, roiling global markets and inflicting massive losses on domestic stock prices. The decision and its fallout was seen by many as the grounds for the Fed’s decision to delay liftoff in September.

8. Slow Recovery
One more reason why the Fed has held rates near zero for seven years: growth just hasn’t been very good. The U.S. suffered a deep contraction that wasn’t matched by a robust rebound, and credit standards remained tight throughout — hindering the transmission of easy money to the real economy. The tepid pace of growth, while better than the outright recessions experienced in Europe and Japan during the last seven years, meant it took a lot longer to recover what the U.S. had lost in the crisis.