Quarterly Economic Review First Quarter 2016
For global investment markets, the quarter’s destination was modestly inconsequential. The journey to get there, however, was one for the record books. The quarter’s roller coaster ride began on day one when ham-fisted stock market controls by the Chinese government had anything but their intended outcome. By the time newly minted circuit breakers were deemed not such a good idea, the Chinese stock market had suffered two declines of 7% in the first week. Looking for causes beyond the obvious, investors collectively inferred such market behavior could only suggest an all out collapse of the Chinese economy. So began the hunt for confirming data of a hard landing and a quest to de-risk portfolios and insulate against Chinese influenced markets, such as oil and other commodities.
By mid-February, pandemonium reigned. Investor sentiment was lower than during the financial crisis, and investment markets were six weeks into a nosedive that left the majority of global stock markets down at least 10% and in some cases much more. The markets were in need of triage and central banks, once again, came to the rescue. Prompted by a stunning combination of unconventional monetary policy out of Japan, promises by the European Central Bank, further monetary accommodation by China, and assurances of restraint by the U.S. Federal Reserve, investors took a much needed step back to reassess economic fundamentals.
The ensuing multi-week rally may have been kicked off by central banks, but it was fueled by economic fundamentals. Domestic labor market dynamics are positive, as are those for housing. Oil looks to have bottomed as supply and demand move closer to balance. U.S. inflation (currently desirable) has ticked higher, and perhaps most importantly, the dollar’s unrelenting 18 month rise reversed in recent weeks. This single factor has multifaceted benefits ranging from an assist to U.S. GDP growth, a boost to inflation and commodity prices, improved profitability of multinational companies, and greater returns for globally diversified investment portfolios.
Despite the recovery, or because of it, risk remains. Interest rates are low and falling, and the yield curve has not been this flat since the great recession. Credit spreads have also widened and inflation expectations are diminished. All are economic red flags. Moreover, market stability and higher inflation can be self-defeating if the U.S. Federal Reserve becomes more hawkish. Even the anticipation of a less accommodative Fed would likely push the dollar higher â€” reversing many of the previously listed benefits. Corporate performance and stock prices have also gone in opposite directions. The recent rally, sending stocks within reach of a new all time high, comes at a time when S&P 500 companies have collectively registered five quarters of year-over-year revenue declines and four quarters of negative earnings growth. This includes expectations of an 8.5% decline in earnings for the just completed quarter! Higher prices on lower earnings translates into less attractive valuations, less opportunity for gain, and less downside support when challenges are encountered.
Key Economic Fundamentals
U.S. growth outpaced many other developed economies last year, but 2015 was not the breakout period many hoped it would be. Dollar strength and weak global growth weighed on an otherwise resilient domestic economy last year. Driven by similar themes, growth will likely slow modestly in 2016.
As with the third quarter, the final three months of 2015 were driven exclusively by the consumer. Outside of continued favorable growth in housing, investment spending was a drag, and dollar strength weighed on trade dynamics. Forecasts suggest first quarter growth will slow, possibly to less than 1.0% annualized.
Following a period when economic data came in more or less as expected, results in the initial weeks of Q1 proved disappointing. By mid-month, however, outcomes began to more closely match recalibrated expectations. Early period capital market weakness and the subsequent recovery were fueled, in part, by these factors.
A reversal of the dollar’s previously unrelenting year and a half climb also brought relief to investors and many pockets of the economy. Commodities, particularly oil, emerging markets, manufacturers, and multinational companies all benefitted from dollar weakness.
Aside from a few outliers, such as France, India, and various Eastern European countries, leading economic indicators have been trending lower. The absolute level and pace of decline is most concerning for China, but U.S. trends have been unfavorable as well. Dollar weakness would help to ease domestic economic pressure.
Economic growth in the four largest economies (Eurozone, U.S., China, and Japan) is expected to either slow or flatline in 2016. Forecasts of a net deceleration in advanced economies is expected to be offset by emerging nations. Strong and accelerating growth in India would be a key driver as would “less bad” results out of Russia and Brazil.
Labor market strength continued in 2016. Payroll growth averaged in excess of 200,000 jobs per month, and initial jobless claims continued below 300,000 for a 56th sequential week â€” a record dating back to 1973! The labor force participation rate also continued to rise, hitting the highest level in two years. Ironically, this improvement actually drove a slight uptick in the unemployment rate as an abundance of jobs has pulled people back into the workforce. This will be a critical driver of long-term economic growth. This goes double considering weak investment spending has led to paltry gains in worker productivity. Hopefully, these favorable dynamics will chip away at the number of long-term unemployed individuals, still elevated, as well as continued labor market slack evidenced by the U6 or “underemployment” metric.
Low interest rates, housing market gains, favorable labor market dynamics, and cheap gas have all contributed to the U.S. consumer remaining resilient and confident. Balance sheets are strong, debt levels are reasonable and household net worth hit a new high at the end of 2015. To the extent the newfound wealth of diminished energy prices has not found its way into retail cash registers, it has driven some of the highest savings rates we have seen in years. Contrary to what some believe as a negative, this phenomenon enhances future economic stability and can improve longer-term economic growth through improved capital formation, business development, and capital investment. For investors, who fundamentally forego immediate gratification in hopes of enhanced future purchasing power, consumer behavior is well aligned.
As shown by the ISM graph on the following page, we have had at least a one month reprieve from the declining trend in the service economy and the contraction in manufacturing. One month does not assure a trend and in this case one is not likely in the offing. Dollar strength, low energy prices, and weak global growth have been the culprits behind manufacturing weakness and the stunning 15 month decline in the utilization of U.S. manufacturing, mining, and utility infrastructure. Recent dollar weakness has helped, but may reverse if/when the Fed resumes a more hawkish monetary stance (i.e. less accommodative). Likewise, energy prices have jumped, taking modest pressure off of mining, but future gains will be harder won. Finally, ongoing global weakness appears to be a given, and is thus unlikely to provide relief.
The two pillars of U.S. economic strength, of late, have been the consumer and housing. As a contributor to GDP, investment in residential housing has grown at an annualized rate of 8% or better for the last six out of seven quarters. Over half of these quarters registered annualized gains in excess of 10%! Building activity has steadily increased in recent years, home builder sentiment hit new highs in recent months, and annual home price gains have accelerated over the past year. Mortgage rates, already attractive, plummeted in the first quarter and should remain favorable provided inflation is contained and the Fed moves according to plan (i.e. slowly). Provided buyers are not priced out of the rising market, and builders manage to find adequate labor and land (increasingly a challenge), housing should continue to be a positive.
Capital Markets Review
Equity market fundamentals have deteriorated, however. Operating margins for the S&P 500 have trended lower since peaking in 2014, and earnings expectations for 2016 have declined substantially over the past year. The first quarter of 2016 will mark the fifth quarter in-a-row of year-over-year revenue declines and the fourth quarter of negative earnings growth.
Fixed Income Markets
Fixed income markets are suggestive of economic weakness. Low and falling interest rates, wider credit spreads, diminished inflation expectations, and the flattest yield curve since the great recession are not positive signs.
This commentary was written by Robert W. Lamberti, CFA, VP and Co-Chief Investment Officer of Summit Financial Resources, Inc. and Summit Equities, Inc., 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600, Fax: 973-285-3666. Securities and Investment Advisory Services offered through Summit Equities, Inc. Member FINRA/SIPC, and Financial Planning Services offered through Summit Equities, Inc.â€™s affiliate Summit Financial Resources, Inc. Sources of Performance: MorningstarÂ®. Indices are unmanaged and cannot be invested into directly. The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity. Standard & Poor’s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Wilshire 5000 Index is a market capitalization-weighted index of the market value of all stocks actively traded in the United States. The index is intended to measure the performance of all U.S. traded public companies having readily available price data. The MSCI Emerging Markets Index is an index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performance in global emerging markets. Emerging markets are considered risky as they carry additional political, economic, and currency risks. Real Estate Investment Trusts, REITs, are securities that invest in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, however, have liquidity constraints. The Barclays Capital U.S. Aggregate Bond Index is a market capitalization-weighted index comprising Treasury securities, Government agency bond, Mortgage-backed bonds, corporate bonds, and some foreign bonds traded in the U.S. Fund Category Performance is not inclusive of possible fund sales or redemption fees. Investment grade bond analysis included bonds with ratings of AAA, AA, A, and BBB. Municipal and Corporate Bonds are backed by the claims paying abilities of the issuer. TIPS are inflation-indexed securities issued by the U.S. Treasury in an effort to widen the selection of government securities available to investors. Past performance does not guarantee future results. Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding market of other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader. Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance. Consult your financial professional before making any investment decision.