2015 was a year with plenty of market volatility, but it offered very little in the way of market returns. Breadth was narrow last year and returns were concentrated in a handful of names such as the FANG stocks (Facebook, Amazon, Netflix, Google Alphabet). Going into this year, most market forecasts were for another year of relatively muted returns, but instead the U.S. markets have gotten off to one of their worst starts in markets history. Geopolitical tensions, the continued deterioration of oil prices, China growth concerns, U.S. political uncertainty and the prospect of rising interest rates have all helped fuel the decline. The market sell-off has unnerved many investors, causing them to extrapolate this tough start to the rest of the year.
There is a strong consensus among market participants that 2016 will be highly volatile thanks to divergent central bank policies.1 Coming off its first rate hike in a decade, the Federal Reserve is viewing the strength in employment and other segments of the economy as a reason to raise rates and resume a more normalized monetary policy, although Yellen's latest comments indicate a softening in light of pressure exerted by declining equity prices, higher interest rates for riskier borrowers and a rising dollar. Meanwhile other central banks such as the European Central Bank (ECB), Bank of Japan, and China are all taking opposite monetary action to stimulate growth in those regions. While the ECB left rates unchanged in January, ECB President Mario Draghi left the door open for March rate action, should additional stimulus measures be necessary to stimulate growth.
Concerns about the continued devaluation of China’s currency as a signal of economic distress appear overdone. China’s economic growth has indeed slowed, with GDP growth coming in at a record 25-year low of 6.9% for 2015.2 But China’s economic slowdown is somewhat expected given its transition from a manufacturing to a more service-based economy. In fact, the deterioration in the Shanghai Composite Index is often cited as an indicator of weakness without acknowledgement that its performance is linked largely to old economy, state-owned companies versus those in service industries.3
The overarching question is: will China’s fiscal policy actions be enough to ward off a hard economic landing? This question is complicated by a perceived lack of government transparency, causing investors to question if the “official” data is understating economic reality. While the health of the Chinese economy and confusion over its currency policy has global ramifications, particularly on demand for commodities, it has limited direct impact on the U.S. economy. Second-order effects to watch, however, include pressure on commodity-exporting countries hurting demand for U.S. exports.
Domestic Manufacturing Slowdown
More troubling from a domestic economic standpoint have been recent signs of economic weakness in the domestic economy which have tempered the Fed’s original intent to raise interest rates this year another 3 to 5 times. Currently, the strength of the U.S. economy appears bifurcated, with manufacturing slipping into recession (dipping below 50 the last two months) while the service sector, which makes up 88% of the U.S. economy4, continues to grow.
In the past, the manufacturing sector has been predictive as a leading economic indicator. Bank of America/Merrill Lynch recently raised the probability of a U.S. recession to 20%, up from 15%. The firm also cut its 2016 growth forecast from 2.5% to 2.1%.5 But investors should take comfort from the Fed’s vow that future rate increases will be data dependent.
Continued Decline in Oil Prices
The huge decline in oil prices to below $30 per barrel has caused energy companies to make drastic decisions such as cutting jobs, dividends, and capex. One of the scariest ramifications of the decline in oil prices is the potential impact on the high yield market and systemic risk to lenders and the overall economy should oil companies default on their debt.
But low energy prices can be a positive as well. So far, lower energy prices and the associated savings have not trickled down to the consumer discretionary sector. Consumers have preferred instead to save money and pay down debt. But eventually as markets stabilize and wage levels continue to increase, the American consumer may start to spend his discretionary funds.
Since 1970 there have been six “flat” years for the S&P 500 Index (-2% to +2%). The good news is that following those years, the Index returned between 11-34%.4 Certainly this year has gotten off to a rough start thanks to geopolitical issues, global growth concerns, and profit taking, but there is some cause for optimism thanks to the abundance of pessimism. To quote the famous investor Sir John Templeton, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” 4 This suggests that the bull-market run may not be over just yet.
Market valuations are now more reasonable with a 12-month forward P/E ratio of 15.2 according to FactSet6, but this is still above the 5-year and 10-year average. While the aggregate expectations for slight growth (0.1% in Q1 2016) have now turned negative (-0.6%), analysts do expect earnings growth to return for the remaining quarters of the year.
Telecom Services and Health Care are currently expected to demonstrate the highest earnings growth in Q4 on a year-over-year basis. Energy, Financials, and Materials have seen the largest earnings estimate decreases since the start of the year. As the Q1 2016 earnings season gets underway, investors will be focused on company commentary discussing the impact of oil and gas prices, the stronger U.S. dollar, and slower global economic growth on sales and earnings.
Outside of the U.S., European equities have received bullish attention from investors. The European equity markets are expected to benefit from low interest rates, a declining currency, and cheap commodities and oil prices in 2016.7
Finally, energy prices are likely to remain low in 2016 due to a continued global oversupply imbalance and reduced demand. Energy does not look attractive in the short term.8 However, mid-range and long-term investors may look for an entry point as the global economy improves, driving demand, and as supply imbalances are offset by lower levels of production.
Whether 2016 will bring another year of lackluster returns remains to be seen, but markets should continue to be volatile. Certainly the markets have gotten off to a volatile start at the beginning of the year thanks to concerns about low oil prices, the U.S. economic outlook, and the potential for a China hard landing. There has been a mass re-pricing of market risk which has driven world markets into correction territory. But accompanying this correction could be some amazing buying opportunities for those who maintain a long-term perspective.
1. TIAA-CREF Asset Management: “2016 Economic and Investment Outlook”; WEISS: “2016 Outlook: Stop Waiting for Godot!”; Fidelity: “New Year, Old Trends”
2. “China’s economy grew 6.9 percent in 2015, a 25-year low” http://www.cnbc.com/2016/01/18/china-reveals-key-q4-2015-gdp-data.html
3. Matthews International Capital Management: “Asia Insight” http://micm-llc.com/resources/docs/micm-llc.com/0116-AsiaInsight.pdf
4. Schwab Advisor Perspectives: “Questions for the New Year, 1/9/16” http://www.advisorperspectives.com/commentaries/20160109-charles-schwab-questions-for-the-new-year
5. “Nearly $8T wiped off world stocks in Jan, US recession chances rising: BAML” http://www.cnbc.com/2016/01/22/probability-of-us-recession-rises-to-20-pct-baml.html
6. FactSet: “Earnings Insight - S&P 500” http://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_1.15.16
7. J.P. Morgan Asset Management: “Asset Allocation Views”; TIAA-CREF Asset Management: “2016 Economic and Investment Outlook”
8. Goldman Sachs: “Top Market Themes for 2016” http://www.goldmansachs.com/our-thinking/pages/outlook-2016/infographics.html ; WEISS: “2016 Outlook: Stop Waiting for Godot!”
This communication is for informational purposes only and does not constitute, and is not to be construed as, an offer or solicitation to buy or sell any securities. This communication is not investment advice, and you should consult with your investment adviser about whether a particular fund is an appropriate investment for you. Past performance is not an indicator of future results. Private placements are highly speculative and illiquid assets, and investors may lose their entire investment.
Opinions expressed in this communication reflect current opinions of Artivest as of the date of this communication only. This communication is based on information obtained from sources believed to be reliable, but no independent verification has been made and Artivest does not guarantee its accuracy or completeness.
“Artivest” refers to Artivest Holdings, Inc. and its affiliates, as the context requires. All brokerage services are provided by Artivest Brokerage, LLC, an SEC registered broker-dealer and member FINRA/SIPC.