Posts tagged 2015 Market Outlook
“Every unhappy family is unhappy in its own way.” The opening sentiment in Tolstoy’s great novel Anna Karenina works just as well for commodities markets in the summer of 2015 as it did for Russian aristocratic clans in the 19th century. Every major commodities “family” – from precious metals to energy and industrial metals – is unhappy. And the reasons are quite specific to each. Oil suffers from a supply glut. Copper and nickel feel the brunt of contracting production in China. Gold has lost its luster as a safe haven – nobody went piling into gold during the recent turmoil in Greece, for example.
Oh, sure, there are exceptions to the rule out there in the byways and back roads of the commodities world. Traders put a “squeeze” on robusta coffee futures last month and bid September contracts up to a ridiculous spread versus July delivery. But by and large, it has been a long and hard summer for the global economy’s major physical inputs. The chart below illustrates the shared pain.
As dismal a picture as this chart paints, it does not even tell the full story. From its last six years’ high point in April 2011, Brent crude oil has tumbled 61 percent. Copper has fallen by nearly 50 percent over the same period, and gold’s retreat has topped 40 percent. Imagine what the conversation would be if major equity indexes had spent the past six years falling on an order of this magnitude. When the S&P 500 gives ground in the high double digits, retirement nest eggs look fragile and the prospect of recession looms large. When oil prices plummet – well, we just pay less at the pump. Good news, right? Not necessarily. Commodities price trends give us important information about the world economy. Right now the news is decidedly mixed.
Awash in Supply
Oil bulls got sideswiped by a steady drip-drip of supply news in July, with accelerating OPEC production dominating the headlines. Saudi Arabia remained firm to its commitment articulated last November to gain share rather than support prices through restricted output. Production in Iraq reached record levels. And the prospect of Iran – holder of the world’s fourth-largest proven reserves – reentering the market after years of sanctions added a further depressive element. Meanwhile, US shale producers still appear mostly determined to power through the downturn and find ways to further reduce their cost structures rather than let up on output.
The China Malaise
The unhappy story told by industrial metals is set in China, which is by far the world’s largest importer of copper, aluminum, nickel and other key metals. Forget about all the eye-popping gyrations on the Shanghai and Shenzhen stock bourses. The really important story in China is the slowdown in growth, punctuated by a sharper than expected manufacturing contraction in both June and July and coming on the heels of forty straight months of declines in the domestic producer price index. Whereas the oil story is mostly (not entirely) about supply, the plight of industrial metals has more to do with demand. And weaker demand from China has hit the export accounts of other emerging markets. It should come as little surprise that the MSCI Emerging Markets index is off by more than 12 percent from its June highs.
All That (Doesn’t) Glitter
Then there is gold. It would be fair to say that the gold bugs who went running for the hills in 2009, worried about the inflationary tinderbox the Fed was supposedly opening with its quantitative easing programs, have not been rewarded for their excessive caution. But at least gold was a part of the “risk off” trade back in 2011 when we had our last really big pullback in equities. Fast forward to July 2015, with Greece once again on the front pages and consensus forming around the idea that a breakup of the Eurozone is a matter of when, not if. Over the course of this month, with Greek banks shutting down and Chinese stocks plunging into bear territory, the price of gold actually fell by six percent. This is perhaps a useful reminder of something we have said from time to time on the pages of these weekly commentaries. There is nothing magical or mythical about gold. It is a commodity, with a price that goes up and down like any other commodity. Lately, the movement has been mostly down.
Trouble Ahead, Trouble Behind
Unfortunately for gold bugs, oil bulls and any other species looking for commodities gains to ring out the year, the road ahead does not look much more promising than the road behind. First of all, neither the oversupply of oil nor the slowing of growth in China look set to end any time soon. Those headwinds are likely to continue. Secondly, those headwinds are likely to compound further still if the Fed goes ahead with its rate program, as expected sometime between September and December. Higher interest rates impose a natural cost on holding commodities – after all, investors do not get any interest or dividend income from storing bars of gold or barrels of oil. Now, if a rising Fed funds rate signals a faster tempo to global real economic growth, we would expect that growth to translate into higher commodities prices at some point. From where we stand now, though, that “some point” still seems to be some distance away.
To Our Clients:
We have heard from a number of you over the past several weeks with questions about what is happening in the markets – whether there is potentially cause for concern given some recent developments, and what else may be having an impact on your portfolio between now and the end of the year. In this letter we will share with you some observations that are contributing to our market view and decision framework.
Act I: The Year to Date
For an opening act, let us shine a bright light on what has been a rather unusual several months. In late April, benchmark German interest rates experienced a sudden and unexpected surge of more than 700%. June and the advent of summer brought with it a default by Greece on a loan payment to the IMF, raising the probability of a Greek exit from the Eurozone with unknown consequences. Finally, China’s high-flying domestic stock market got a little too close to the sun and collapsed, giving up more than 40% over the latter half of June before stabilizing as a result of massive government intervention.Yet for all that action, the one remarkable characteristic of US equities during this time has been a distinct lack of conviction. Consider the chart below, which shows the performance of the S&P 500 stock index in the year to date.
The S&P ended 2014 around a price level of 2080 (indicated by the dark gray dotted horizontal line). Following a very volatile January and then a strong breakout rally in February, the benchmark index has mostly traded in a range in more or less equal distances above and below the year-to-date break-even level. For the last five months, nothing has been able to catalyze a sustained upside or downside directional movement. What is causing this stubborn lack of conviction?
We believe the upside resistance tracks back to a main theme raised in our Annual Outlook back in January: namely, that after a three year run in which stock price gains far outpaced growth in corporate earnings, those earnings were likely to act as a limit on price growth. The May 21 high water mark for the S&P 500 this year represents about a 4.3% total year to date return, which is not too far away from consensus projections for fiscal year 2015 earnings per share growth for the companies which make up the index. The upside directional headwinds, then, may be mostly about earnings.
On the downside we see a similar phenomenon: there has not been a single pullback this year of a peak-to-trough magnitude of 5% or more, and for the most part the reversals have found support at key technical indicators like the 100 and 200 day moving averages. Now, part of the downside resilience is arguably event-driven – neither China’s stock collapse nor the Greek debt crisis resulted in a worst-case outcome. More broadly, though, we do not see a compelling bear case for US equities. The low likelihood of a near-term recession, along with a sense that the key prevailing risk threats are outside the US, help make the case for downside support.
Act II: The Year Ahead
Keeping to the theme of events impacting market performance, perhaps the most significant development that has yet to play out in the second half of the year is the Fed’s decision on interest rates. This event is of particular interest to diversified portfolios with significant yield exposures – for example to high dividend stocks, convertible bonds and REITs. Generally speaking, exposure to these asset classes makes sense in a world of near-zero interest rates. They have been, and continue to remain, an important part of our asset allocation strategy. Recently, though, there has been a very close inverse correlation between short-term movements in interest rates and the price performance of enhanced-yield assets. The chart below provides one such illustration, showing the year-to-date performance of high dividend stocks compared to the yield on the 10-year Treasury note.
We believe the Fed is likely to make its initial move on interest rates sometime between September and December, with the timing depending mainly on the growth, inflation and employment data points that come in between now and then. So, it would be reasonable to ask what we are planning to with our enhanced-yield exposures in a rising rate environment.
To answer the question we need to consider the larger picture. Short-term traders are focused entirely on the first rate hike – as illustrated by the above chart – but that is not the right focus for the long term portfolios under our management. What kind of economic environment do we expect to prevail over the intermediate term – in the next two to three years? The base case scenario driving our investment decisions is an environment of low growth in the US and other developed markets, and a continuation of below-trend growth in emerging markets. This scenario envisions a very gradual pace of interest rate increases, with the Fed ever ready to suspend a rate increase program if low positive growth turns flat or negative. We believe that enhanced-yield assets will continue to play an important role in this environment, as yields on high dividend stocks, REITs, Master Limited Partnerships and other similar assets are likely in these circumstances to remain attractive relative to high quality fixed income issues. We also believe that the underperformance of enhanced-yield assets in 2015 is partially a case of “sell the rumor, buy the news”. Once the first rate hike takes place and the world does not come to an end as a result, we expect phenomena like the “dividend-rate trade” to subside.
There are of course many other variables at play that we continue to monitor closely. We will continue to share our thoughts with you as and when our views adapt to evolving market realities.
2014 was a year of both higher job growth and consumer confidence, which in turn helped boost retail sales for most of the year. A post-recession high for December consumer confidence, in conjunction with lower gasoline prices, should be a winning combination for more discretionary spending amongst consumers. However, the retail sales data that came out on Wednesday showed a -0.9% decline as well as a downwards revision to the previous release of the strong November numbers from a 0.7% advance to 0.4%.
This brings about the biggest drop in retail sales since last January. Not surprisingly, gasoline stations had the largest decline among the retail sectors with a -6.5% drop (falling oil prices mean gas stations are making less money). We would expect a gas windfall to produce a big bump in middle class spending, but consumers’ savings at the pump don’t seem to be translating into spending elsewhere yet.
The retail sectors that grew in the month of December are arguably the more “staple-like” sectors: food and beverage, furniture and home furnishing, and health and personal care. In contrast, some of the hardest hit retail sectors were clothing stores, motor vehicles, and electronic stores.
Let’s step back from the December figure and consider the larger context. Over the past five years retail sales have grown steadily, while the household savings rate has declined slightly. In 2014 savings fell somewhat more notably, but at the same time the rate of retail sales growth tapered off and in fact was lower than at any time since the end of the recession. This could be a sign that households are doing things with their savings other than going to the mall – paying down debt, perhaps. That may be the signal we are seeing from the December retail number. It also may tie into the stagnation in wage growth we highlighted in last week’s market flash.
Another factor to consider is that maybe the American consumer’s behavior is beginning to change. As noted above, retail sales growth for the year is the lowest that we have seen since we were in the midst of a recession in 2009, which is especially interesting considering that 2014 has been the best recovery year since the recession ended. And although we saw one of the most successful Black Fridays of all time this past November, consumers – and even retailers – showed a noted (if perhaps only anecdotal) reversal in attitude towards the overt commercialism of the day. More and more shoppers are forgoing the mall for their computers to shop, and the holiday season cash cow – where retailers have traditionally made the majority of their yearly earnings – is changing. How this change will impact the broader economy is still a work in progress.
Monthly leading indicators can provide a good spot check on the economy, but are oftentimes misleading as they are subsequently revised and provide a data snapshot of just one month. All in all, we don’t feel that December’s disappointing retail sales numbers are anything to fret over, but we shouldn’t ignore them completely. Traditionally consumer spending drives the US economy as the highest component of GDP. If consumer habits are indeed changing, the very basis of the economy and the way it operates will likely be changing along with it.