The first quarter of 2016 was a tale of two markets. The first six weeks were a period defined by significant volatility, defensive sector outperformance, and a broad selloff in the general stock market. This fallout was stoked by fears of recession in the US, continuing slowdown in China and its impact on the commodity markets, and increasing corporate credit concerns. After February 11, a tremendous rally ensued that brought equities to breakeven for the year. The turnaround came on the back of positive key economic drivers of the US economic recovery, a renewed tone of dovishness from the Federal Reserve, upward momentum from commodities, and the US dollar weakening a bit from its highs. Economist Paul Samuelson famously quipped that the stock markets “had predicted nine out of the last five recessions,” showing that market-based indicators have had many false signals historically. Apocalyptic warnings often sound compelling because they promote immediate action. Conversely, long-term disciplined investing advice is not typically all-or-nothing, but it is time-tested. As confirmed by our prior blog post entitled, “A Successful Playbook for Investing in 2016: Agility, Opportunism, Discipline,” we did not see the US entering a recession and thus were able to play the trading ranges through nimble adjustment of stock, option, and fixed income exposure.
To dive a bit deeper into the initial downturn of January and early February, we saw that the Fed’s 25 basis point interest hike in December effectively amounted to a 100 basis point tightening once the negative impact of the rising US dollar and deteriorating credit market spreads were factored in. The dollar still remains the world’s premier funding currency and its strength has pulled down inflation expectations by lowering input costs, such as energy and materials, and reduced inflation implies slower economic growth. This hit dollar denominated commodities extremely hard, thus impacting global markets. According to the Wall Street Journal, the correlation between oil prices and the S&P 500 during the first 20 trading days was 0.74 and the two markets only moved in opposite directions twice. This came as oil prices plummeted below $30 per barrel. Although a positive for consumers, falling oil can be a short-term negative for financial markets when highly indebted energy producer earnings are severely hurt and their troubles trickle through to corporate defaults and a significant reduction of high-paying jobs. Since mid-February, the correlation between US stock and oil prices has normalized to 0.28. Furthermore, despite the continued deterioration in fundamentals and a lack of agreement between major global oil producers to freeze or reduce total output, market participants believe that the worst of the oil supply/demand dynamics are behind us and price stabilization to current levels in the mid-$40’s reflects the eventual balancing of the oil market.
The silver lining is that the rapid strengthening of the US dollar is largely behind us. The Fed has slowed down its expectations for future rate increases and seems to be much more worried about being too aggressive. This makes sense, as a main reason to embark on contractionary policy is to ward off inflation. Yet, expectations for the inflation rate five years from now have fallen to 2.5%, matching the all-time lows. Additionally, while manufacturing conditions are starting to stabilize, the capacity utilization rate now stands at 74.8%, below the long-term average of 80%, and well below the 83% level at which capacity constraints have raised inflationary pressures in the past. During the March Fed announcement, Chairwoman Janet Yellen said that it is appropriate for US central bankers to “proceed cautiously” in raising interest rates because the global economy presents heightened risks. Recent earnings seasons have proved that a strong dollar has weighed on US corporations with overseas revenues. A slight reversal in the dollar strength should undo compression to earnings growth in major publicly traded multinational corporates and renew investor sentiment.
Economic expansion around the world should continue at a slow pace in the near-term. First quarter United States real GDP nearly stalled, up a paltry 0.5% annual rate. The deceleration fits a pattern since 2010 of significantly slower growth in Q1, but declines have then reversed in Q2, up an average 2.3%. The domestic economy has benefited from expansion of consumption, government spending, and residential housing investment. US Nominal GDP growth for 2016 will likely be in the 2.3% to 2.8% range. In a way, growth has been just right: strong enough to moderate global slowdown concerns, yet not so strong that it raises expectations of rapid Fed rate increases and dollar appreciation. While we are in the latter stages of the economic cycle and risks remain, recent economic improvements have postponed any downturn.
Over the past two years, the S&P 500 has spent all but six trading days in a trading range of 1850 to 2150. At the same time, the median S&P 500 earnings growth rate has fallen from the high single digits to low single digits, making the few companies that have been able to grow quite attractive for market participants. One consistently bright spot in the economic recovery has been housing, which has a flow-through effect to other sectors. Low vacancy rates and scarce inventory have put upward pressure on both housing values and rents. For homeowners, this helps contribute to household wealth and typically boosts consumer spending. Moreover, housing helps financials through mortgages and insurance, utilities through new customers, and materials through input demand. Even with the US consumer benefiting from low energy prices, low unemployment, higher wages, and reduced debt loads, not all retail has benefited equally. The world of retail has been dominated by travel and hotels, low-budget experiences like games and media, furnishings and home remodeling, and health services. If a weaker US dollar is to remain, this will assist US consumer staples, industrials, and technology sectors.
We continue to operate in a challenging and volatile environment with overall earnings declining for the third straight quarter, the most since the financial crisis. However, there still are healthy stocks to choose from and various economic bright spots. This creates a market environment where proper stock picking is crucial and key indicators need to be monitored closely for inflection points. Therefore, as the US equity bull market heads into its eighth straight year, we are being very selective in the stocks we hold and focusing on growing and profitable companies. Additionally, we are utilizing put and call option strategies to add overall return to our investments. We are committed to actively managing your assets through volatile times and uncovering investment opportunities along the way.