Key Points

Despite the stark differences in the first and second halves of the first quarter, a few themes dominated the performance trends.

In the first quarter, many stocks were boosted by the turnaround in oil and the dollar while the broadening adoption of negative interest rate policy weighed on the performance of others.

Looking ahead to the second quarter, more volatility is expected. The trends that may drive second quarter performance could again include the price of oil and the value of the dollar, along with changes in inflation expectations.

Stocks were close to flat at the close of the first quarter, hiding the down and up rides they took to get there. The MSCI All Country World Index fell -11.3% during the first half of the quarter, bottoming on February 11, and then rebounded back to where the year began as the quarter ended.

Key trends in the first quarter
Despite the stark differences in the first and second halves of the quarter, a few themes defined the performance trends. Two of the major drivers for the best global stock market performances were the reversal in trend for oil and the dollar, which helped lift stocks the most in Canada and the emerging markets, while the broadening theme of negative interest rate policy (NIRP) contributed to the worst performances of the quarter from Japan and Switzerland.

First quarter reversed best and worst of 2015

Annual ranked performance from best to worst of world stocks, the 10 largest developed markets, and emerging markets.

Geographical performance is represented by annual total returns of the following: MSCI AC World, MSCI USA, MSCI Japan, MSCI United Kingdom, MSCI Switzerland, MSCI Germany, MSCI France, MSCI Canada, MSCI Australia, MSCI Nordic Countries, MSCI Spain, MSCI EM (Emerging Markets).

Source: Charles Schwab, data from FactSet, MSCI as of 4/1/2016.

From a global perspective, the first quarter marked a reversal of the best and worst performing countries of 2015. The leadership of Japan in 2015 was turned over to Canada. Canada’s reversal was driven by the turnaround in the trend in oil prices, which rebounded from a low in the mid-$20s to around $40 by the end of the quarter, lifting stocks in the energy sector. We have commented in the past on the importance of sectors to country performance. The Canadian stock market has historically tracked the energy sector. In fact, the MSCI Canada Index performs much like 1.4 times the world energy sector, as you can see in the chart below.

The rise in oil prices in the first quarter helped boost Canada’s energy-driven stock market

Source: Charles Schwab, Bloomberg data as of 4/1/2016.

The MSCI Emerging Markets Index has tracked the moves in the broad trade-weighted dollar closely over the past year, as you can see in the chart below (the dollar index is inverted). The weakness in the dollar this year helps explain the new found strength in emerging markets. In 2015, market participants demonstrated concern that a rising dollar would pose a risk to emerging markets by making their dollar-denominated debt more costly. Thanks to the turnaround in the dollar in the first quarter of this year, emerging markets were the second best performing stock market.

Emerging market stocks benefitted from the rise in the dollar in the first quarter

Source: Charles Schwab, Bloomberg data as of 4/1/2016.

Among the worst performers in the first quarter, Japan joined the other poor performing countries after adopting a negative interest rate policy in January, lowering rates below zero. As we wrote then, the effectiveness of slightly negative interest rates is far from assured and increasingly negative interest rates may not just weigh heavily on the stock market, but on drivers of economic growth as well. The performance of Japan’s stock market has slumped below the trend in the Japanese economy depicted by the composite purchasing managers index (PMI), as you can see in the chart below.

Negative interest rate policy (NIRP) weighed on Japanese stocks in the first quarter

Source: Charles Schwab, Bloomberg data as of 4/1/2016.

Looking ahead to the second quarter

Looking ahead to the second quarter, more volatility is the most likely outcome. While the favorable trends of the second half of the first quarter may continue to lift stocks, a reversal in the value of the dollar or oil prices would likely weigh on stock market performance. There are also other emerging trends that may be less favorable for stocks and bear watching.

A key trend to watch is the renewed slide in inflation expectations that began in the last few weeks of the first quarter. The close relationship between the market expectation for inflation in Europe and the relative performance of the financial sector can be seen in the chart below. This relationship is driven by high inflation lifting longer-term interest rates and widening banks’ profit margins on lending and by signaling a stronger growth outlook. If inflation expectations continue to decline, the financial sector would likely be under pressure. Since the financials are the largest sector of the world’s stock market, a falling financial sector would make it hard for the overall market to move higher in the second quarter.

A renewed decline in inflation expectations could be bad news for financial sector in the second quarter

Performance of MSCI World Financials Index and MSCI World Index indexed to 4/1/2015.

Source: Charles Schwab, Bloomberg data as of 4/1/2016.

The message from the market
A key message from the first quarter is a reminder that double-digit stock market pullbacks are common and don’t necessarily mean stocks are headed for a prolonged and deep bear market. In fact, the world’s stock market had a double-digit decline during more than two-thirds of the past 35 years and yet more than half of the time those years ended with a gain, as you can see in the chart below.

Double-digit declines are common and don’t usually mean losses for the year

2016 performance through end of first quarter.

Source: Charles Schwab & Co., Inc., Factset as of 4/1/2016.

Not overreacting to short-term pullbacks is critical to long-term investing success. The first quarter offered investors a reminder that a long-term perspective is beneficial, especially during periods of heightened volatility.

©Charles Schwab & Co.

Jeffrey Kleintop is senior vice president and chief global investment strategist at Charles Schwab & Co.