Posts published in December 2015
A popular parlor game for investors over the past couple weeks has been to guess whether the S&P 500 would finish the year out in positive or negative territory. Technically, of course, a calendar year is no different than any other string of 365 consecutive days. But we all know that the return representing the specific elapsed time from January 1 – December 31 holds a special place in the human psyche. Were the blue chip benchmark to ring out the year in the red it would be the fifth such calendar year loss so far this century. As it turns out, though, the index looks set to eke out a modest positive result for 2015, with most if not all the gains coming from dividends.
In other years of sub-normal returns for this key US benchmark, diversified investors have found varying degrees of comfort from the brisker performance of other asset classes. 2015, though, has been a stingy year across a wide swath of asset classes. The composite result is what one could perhaps best term as mediocre: not great, certainly, but not as bad as it could have been. We look here at some of the key forces that shaped the mediocre year gone by, and what they might mean for the next twelve months.
US Equities: The Year Earnings Mattered
At the beginning of 2014 – nearly two years ago – we asked the question “how much more?” in regard to whether US stock prices could continue to gallop ahead of earnings as much as they had for the two previous years. We were a year ahead of ourselves. Earnings was arguably the dominant headwind to share price gains in 2015. The current FY15 consensus, as the Q4 earnings season approaches, is essentially flat – minus 0.34 percent according to FactSet. Flat earnings growth begets flat price growth. It is true that much of the negative earnings performance came from beleaguered sectors such as energy and mining. But flat sales and weakened margins were hallmarks of performance across most sectors, particularly those more exposed to foreign currencies and global customers.
These headwinds are unlikely to abate significantly in 2016. For this reason, the scenario we have discussed in several recent commentaries continues to be our go-to model for next year; namely, a “quality rally” where companies with healthy balance sheets, robust margins and strong top line growth stand to benefit relative to the overall market. Currently the FactSet EPS growth consensus for fiscal year 2016 stands at 7.8 percent. Take that consensus with the usual grain of salt – these estimates almost always compress as the release dates approach. But the subset of quality companies in the index could fare rather better. Stock pickers of the world, unite.
Non-US Developed Markets: Dollar Dominant
Dollar-denominated investors had a hard time making money in non-US developed markets this year. The exception was Japan, where a 9.5 percent dollar-denominated return for the MSCI Japan index far outpaced comparable MSCI indexes for the rest of the G7. Most of Europe did fine in local currency terms. The MSCI EMU index returned nearly 12 percent on a local currency basis, but currency translation wiped out all but 90 basis points of that gain when re-expressed in dollars. The Pacific ex-Japan markets of Australia, Singapore and Hong Kong fared still worse, with double-digit dollar losses for the former two.
While currency markets are notoriously volatile and subject to rapid reversals, it would be challenging to make a compelling fundamental case against the dollar for 2016, and therefore little reason to foresee a meaningful mean reversion. Continuing policy divergence between the Fed and the ECB should be expected to bolster the dollar. A weaker dollar would be plausible if European exports were to surge in response to global demand (unlikely, given persistent demand weakness) or from the Fed needing to recant its December move and return to the zero lower bound (in which case we probably have a whole host of problems more pressing than the relative performance of US and non-US equities). We do not expect to see either of these outcomes, and thus remain underweight in our unhedged non-US DM exposures.
Non-US Emerging Markets: Waiting for Growth
Weak currencies were just one of a handful of problems facing emerging markets in 2015. Even in local currency terms, most countries on the MSCI Emerging Markets Index wound up the year deep in the red. And the two notable exceptions – Hungary and Russia, both of which scored large gains in both local and dollar terms – are hardly poster children for dynamic hotbeds of socio-economic growth. Growth, in fact, is the missing piece of the puzzle across many of the diverse economies which make up this asset class. The pain was felt most acutely in Latin America (down more than 31 percent for the year in dollar terms) but also hit former growth engine darlings such as Malaysia, Taiwan, Thailand and Indonesia. Over the entire asset class loomed the troubles of China, and the spectacular summer meltdown in its domestic equity market.
Here again, we believe the headwinds from 2015 are likely to provide further resistance to EM performance as the new year gets under way. The IMF has once again lowered its global growth estimate for the next year. Weak demand in major consumer markets, a large debt overhang and the potential for further negative surprises from China are all potential contributors to another year of weak performance. But there may be pockets of opportunity among the general gloom. Watch Argentina, long a capital markets pariah but now positioned for a return to normalcy under the new administration of Mauricio Macri. And with political and economic woes continuing to plague Brazil, there is a good case to make for Mexico as the jewel in the LatAm crown.
Commodities: Goodbye, China Supercycle
Every unhappy family is unhappy in its own special way, said Tolstoy at the beginning of Anna Karenina. So it went with the major subgroups of commodities this year. Gushing supplies and weak demand smacked oil prices, freakish weather patterns plagued natural gas sales, tepid demand from China undermined industrial metals while the expectations game around Fed interest rate policy was a net negative for precious metals. To each commodities class its own dismal story.
Among these stories, though, we see the end of the China supercycle as the key driving trend. Even assuming that Beijing’s policy mandarins engineer a smooth transition from unsustainable levels of investment to a healthy rise in domestic consumption – far from a given – that outcome is not likely to restore demand for commodities to the go-go levels of the 2000s. But while we do not foresee a surge in commodities prices for the coming year, we do believe there will be some stabilization around current price levels in major markets like oil and copper. We continue to see $40 as a reasonable intermediate support level for crude, though we have reduced our upper band of the expected intermediate trading range from $60 to $55.
Fixed Income: Negative Rate Wonderland
To be perfectly honest, we never thought much about negative interest rates before 2015, apart from the occasional theoretical thought experiment. Now it looks as if they are here to stay, at least for the foreseeable future. The implications remain bothersome. Why would anyone pay the German government for the “privilege” of lending it money for a five year term? The widespread presence of negative rates upends many of the basic assumptions built into the financial and economic models that attempt to explain how the world should work. The direct implication is that the world is not working, and nobody really understands why.
We have analyzed a wide range of fixed income asset classes, perused many reports and arguments for or against taking on exposure to EM or non-US DM debt, high yield, and various “unconstrained” strategies aiming to profit from monetary policy divergence. Our conclusion is that it is nearly impossible to model potential rational outcomes for the intermediate future based on data from the past five, ten, twenty or even fifty years. If the mechanism is broken, models derived from a time when the mechanism worked are not likely to be helpful. Fixed income is the space in our portfolios where we manage risk, not where we seek to generate alpha-based outperformance. For 2016 that means sticking with the highest quality, most predictable and therefore least interesting exposures available from mainstream US government, corporate and municipal asset classes.
The Trend Is Your Friend
There is a thread of commonality weaving through our thoughts on all these asset classes, which is that 2016 is likely to be a year of trend continuation more than it is likely to exhibit sharp mean reversion. These trends – strong dollar, weak global demand, monetary policy divergence and China’s slowdown key among them – look set to continue for the near to intermediate term. Trend continuation, however, does not necessarily imply higher predictability for asset class performance. Baseline volatility is higher now than it has been for several years. While it is still lower than it was in the final throes of the 1990s bull market, we expect to see a continued uptrend in baseline volatility as the year progresses.
Eventually that uptrend is likely to herald an end to the current bull run. That may be a topic of more importance for 2017 than for 2016, but there are never guarantees as to timing. The coming year calls for agility, discipline and a calm mind. We will be there for whatever the year has in store. Happy New Year to one and all!
Credit is due to the Yellen Fed for setting clear expectations and then delivering on them. Markets expected a 25 basis point increase in the target Fed funds rate, accompanied by an accommodative policy statement, and that is just what they got. “Monetary policy remains accommodative” was the key phrase in that statement, underscoring the reality that data trumps calendar when it comes to the size and timing of policy actions in 2016.
Nonetheless this is something of a brave new world, a definitive coda in the policy-driven economy of the past seven years. There are plenty of risks as well as opportunities in the year ahead. Here are five observations informing our thinking as we see out 2015.
#1 – Sell the Rumor, Buy the News
Counter-intuition was a theme in many asset markets in the immediate lead-up to and aftermath of the 12/16 announcement. Asset classes that typically fare poorly in rising rate environments, such as precious metals and high dividend stocks, were strong outperformers on the day. The dollar was mostly muted against other major currencies. Most likely, expectations were largely baked into prices well in advance of Wednesday and thus the news itself gave little reason for further action. If anything, the trading dynamic Wednesday afternoon was characterized by some holiday bargain shopping in recently oversold corners of the market.
#2 – Ignore the Short Term Noise
We expect to see higher than average volatility prevail through the remainder of the year, and we attribute this to little more than the residual noise following a major policy event. The S&P 500 opened Wednesday morning at 2043 and closed Thursday afternoon at 2041, with this net return of zero punctuated by an aggregate spread of three percent over the two day period. The two year Treasury yield is at a five year high, while the ten year still sits below its average over the same period. We do not see much in the way of meaningful trend signals coming from the market until this residual froth settles, and recommend riding out the volatility to the extent possible.
#3 – Inflation is the New Jobs
The big event on macro calendars for the past several years has been the jobs report – “where for one brief moment the interests of Main Street, Wall Street and Washington align” as the Wall Street Journal likes to say in its first Friday of the month live blog. We’re not sure that the mid-month Consumer Price Index report will earn its own following of econo-journalist fanboys and fangirls next year, but it should. Assuming that the prevailing employment trend doesn’t go into sharp reverse, we expect that prices will be the key variable influencing the size and timing of future Fed action. The FOMC policy statement released Wednesday made repeated mention of near-term and long-term inflationary readings and progress towards the 2 percent target. Although reasonably balanced, we give somewhat more weight to the possibility for a faster than expected pickup in prices (outside the volatile energy and food sectors). It may be time to dust off those TIPS for portfolio inclusion.
#4 – The Fed and the Spread
While the Fed has occupied the spotlight for much of 4Q15, the real action in 2016 may be less in future rate hikes than in risk spreads between Treasuries and other fixed income asset classes. It is always worth remembering that risk spreads have a direct effect on household financial decisions through mortgages, personal loans and the like. High yield spreads have taken a hit recently, in part due to another wave of commodity price slumps, but we would be more concerned about investment grade spreads as a wild card that could inflict collateral damage on other asset classes. The Office of Financial Research (OFR), an independent office of the Treasury Department whose annual Financial Stability Report should be required reading for anyone invested in global asset markets, calls out “elevated and rising credit risks in the US nonfinancial business sector” as a key area of potential weakness. US companies have benefitted greatly from historically cheap borrowing costs in the past five years, serving up dividends and buybacks and other things investors hold near and dear. Those good times may be nearing an end.
#5 – Commodities: More Pain, but Stable
Speaking of commodity price slumps, we have listened to a number of quarterly earnings calls from energy companies over the past couple months. In expressing their views on 2016 the dominant theme is an impersonation of Rocky 2’s Clubber Lang: “My prediction? Pain”. The supply-demand imbalances that have sent crude prices down to seven year lows this year will not work themselves out overnight. Nonetheless, the impact of US E&P downsizing should start to be felt and inventories should gradually recede from their recent record levels. Demand should improve as well, with China a likely buyer of more oil at lock-in price levels for its strategic petroleum reserves. While we do not see a return to fortune and favor for commodities in the near term, we also do not necessarily see commodity prices as a key risk story for 2016. In our most-likely scenario model we have modestly narrowed our crude price range to $40-55 from $40-60.
There are plenty more blips on our radar screen: emerging markets, corporate earnings, geopolitics and US elections – among others – are all in the mix, set to surprise, befuddle, delight or antagonize investors in the year to come. We will have plenty more to say about all of them. Happy holidays.
The S&P 500 reached an all-time nominal high water mark of 2130.82 on May 21 of this year. Since then 203 calendar days have elapsed, making this by far the longest post-peak recovery gap in the past three years. The chart below shows the price performance of the benchmark index since 2013. In April of that year the S&P 500 regained the previous all-time high of 1565 set in October 2007. Since then, of course, it has gone on to set successive new all-time highs on a regular basis. As the chart shows, the recovery period following pullbacks from each new high has been relatively brisk. For each pullback of 3 percent or more it has taken about 41 days on average for the index to reclaim the previous record high. That is the context in which the current 203 day gap appears striking. It may simply be a transition to a new, more narrowly selective phase of the bull, as we have argued in recent commentaries. However, we cannot rule out the potential that it could augur something worse.
The Earnings Corridor
The current top-heavy formation of the market started to take shape after a breakout rally in February propelled the index to yet another new high on March 2. The market then entered what we have termed an “earnings corridor”. Roughly speaking, the upper and lower boundaries of this corridor are about 3.5 percent and -1.0 percent respectively from where the S&P 500 began the year. The chart below provides a close-up view of the contours of the earnings corridor and the periodic deviations therefrom.
According to FactSet, average earnings per share for companies in the benchmark index are expected to be just about flat this year. The notion that prices would settle into an earnings-bound trading range – after three years of strong expansion rallies from 2012-14 – is to us entirely plausible. It is why we didn’t panic during the August correction. Although never certain, the data at the time suggested a higher likelihood for a return to the earnings corridor than the beginning of something truly awful. While subsequent events have justified that thinking, we do have a greater than average level of concern over what we see as a composite picture of technical weakness. The source of that weakness: failure to establish a new high water mark; testing of support at the lower boundary of the earnings corridor; and repeated breaching of the 200-day moving average support.
Top-Heavy in Rough Seas
To this weak technical picture we must add the contextual variables with the potential to act as catalysts for further downside, with monetary policy divergence and commodity weakness high on that list. OPEC’s Vienna debacle last week has oil prices testing support levels in the mid-30s and setting new post-recession lows. China’s currency is in another funk, and November saw another large net outflow of foreign exchange reserves. The wildly negative reaction of many asset classes to the ECB’s modest policy decisions last week threw a number of trend-dependent hedge strategies for a loop. Much of this week’s volatility may be coming from this space, with funds unwinding or covering positions to deal with the damage incurred last Thursday. A general consensus view of below-trend holiday retail spending is also not helping to impart any holiday cheer.
These rough seas may blow over, particularly once we get past the Fed next week (at this point, a no-action outcome would in our view be far more damaging to market sentiment than the expected 25 basis point rate rise). We have not changed our most likely scenario for 2016 from the “quality rally” we have described in previous commentaries. If a few industry leaders can sustain double-digit earnings growth in an environment where growth is challenged, go there. That is our thinking. But the risk X-factors are out there, and we are not ignoring the potential for them to inflict further mayhem in the weeks ahead.
The headline macro calendar does not dispense its favors evenly throughout the year. Some weeks are notable more for the sound of crickets chirping than anything else, while others are a cacophony of urgent headlines sending market indexes hither and yon. This past week falls resoundingly into the latter category. As we look ahead to 2016 we are focused on the possible direction of three key current trends: interest rate divergence, commodity price weakness and below-target inflation. Thanks in part to the Fed, ECB, OPEC and the Bureau of Labor Statistics, we have plenty of new inputs to our scenario models.
The Divergence Insurgency
Within the space of 24 hours yesterday and today we learned that interest rate divergence is basically a done deal, put a fork in it. The immediate reaction to ECB Chairman Mario Draghi’s announcement of a 0.10 percent reduction in the deposit rate was negative; while that action was exactly in line with consensus expectations, markets were hoping for a more aggressive 0.20 percent cut and threw a tantrum when it didn’t materialize. Nonetheless, 10 basis points still qualifies as “easing”. So, when the Fed meets two weeks from now and in almost every likelihood raises the target Fed funds rate by at least 25 basis points, we will officially have divergence. Today’s jobs report, with a slight November beat and healthy upward revisions to October and September, effectively removes whatever outside chance there was of staying put for one more FOMC session.
The economics textbooks would tell us that markets will at some point adjust to the effects of policy divergence; namely that European exports will become more competitive and eventually lead to an appreciation in the Euro. For the more immediate future, though, we see the most likely reality as more of the same in terms of US dollar strength, with all the attendant implications for US companies’ stagnant top-line growth. That, in turn, plays into our general thesis that equity markets in 2016 will be far more selective in according preference to those companies which can still turn double-digit revenue and EPS numbers against the currency headwinds.
Commodities: Waiting for Demand
A strong dollar won’t help the price of crude oil and neither, for the time being, will OPEC. Today’s meeting reaffirmed that the Saudi-led hands-off bloc continues to carry the day. WTI crude is just barely defending a $40/bbl support level as we write this, and further weakness could be in store in the days and weeks ahead. There was a high volume of chatter leading into today’s meeting in Vienna, with intermittent tales of a Saudi-led production cut bubbling up out of the rumorsphere, but in the end the consensus outlook was right.
Logically, it would have made little sense for the Saudis to change their position now, just as the impact of US production cuts in nonconventional drilling is likely to be felt. They stake their case on preserving/gaining market share and reaping the benefits as demand rises in response to lower prices. That being said, demand for any commodity is a function of global growth. China is expected to substantially increase its crude purchases next year, perhaps even doubling them, in no small part to bulk up its strategic petroleum reserves. But China’s overall economic slowdown, and rebalancing away from raw material-intensive sectors towards domestic consumption, is likely to continue as a restraint on how robustly energy and industrial commodities generally can recover.
Inflation: The Joker in the Deck
Once the Fed raises rates later this month and markets collectively exhale, chant om and bid each other namaste, attention will shift to the cadence of future policy actions. Those, in turn, will be largely influenced by general price trends. There is little today in the way of conclusive evidence for a widespread inflationary breakout, and the wage numbers in today’s BLS jobs release remained well within the modest tenor of recent months (in the neighborhood of 2 percent on an annual basis). But anecdotal evidence of upward wage pressures continue to percolate into the discussion threads of the quarterly analyst calls for retailers and other labor-intensive sectors. Portfolio allocations to TIPS and other inflation-protection assets appear to be gaining currency as a key variable for 2016 strategic allocation models. There are many factors at play, but we see a net bias towards higher than expected inflation as a potential near-term development. That in turn would imply a brisker rate hike cadence than we see being factored into current expectations. Which, to close the circle of this commentary’s thought process, could widen further still that EU-US monetary policy divergence. We may indeed be heading into a year of “interesting times” in the ancient Chinese sense of the phrase.