“Simple can be harder than complex: You have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.”
The choppy trading in global stock markets has set the tone for a turbulent year ahead. Since the start of 2016, investors have pulled about a billion dollars daily out of equity mutual funds through Friday, January 15. The beneficiary of these equity sales has been the natural safe haven: cash and U.S. Treasury bonds.
With markets off to their worst start since 1927, investors are nervous. And unlike last August, it doesn’t appear this market is going to bounce back anytime soon. The panicky price action has brought the market bears out in full force. On Friday, the Dow Jones Industrials lost another 391 points, oil traded below $30 for the first time in 12 years, and Europe officially entered bear market territory (20% decline from a prior market high).
Global head-scratching
So what’s causing this dramatic reduction in investors’ appetite for risk?
Some of the reasons, in our opinion, are familiar:
- China's slowdown,
- Plunging oil prices, and
- The strong dollar.
However, unlike five months ago, when it seemed the global economy was picking up momentum, investors are beginning to think that perhaps there is a fundamental deterioration in global growth. This fear of a recession is fueling a selling stampede in global markets. We think, barring seismic-type events stemming from a sudden devaluation of the Chinese currency, further deterioration in credit spreads, or tensions in the Middle East flaring up, the probability that the U.S. economy slips back into recession remains relatively low.
As this juncture, it’s important to outline some key data points to help put the current market turmoil in perspective.
To begin with, market pullbacks in the 10% range are not uncommon and are healthy for markets. In fact, we should experience about one per year. However, until last August, we had not experienced a market correction of 10% since 2011, and we thus had grown accustomed to low volatility in markets (thanks to our Fed’s accommodative zero interest rate posture (ZIRP). Last August, when the Chicago Board Options Exchange Volatility Index (VIX), a measure of investor fear, spiked to 50, we mentioned in "China's currency reset is a game changer" that such events tend to cluster -- experiencing a few back-to-back market pullbacks, after such low volatility, should be expected. The VIX recently spiked again and touched 30.95 on Friday.
Cautionary note: the chart below illustrates the market uptrend that began during the European debt crisis in 2011 has been broken. It appears the neckline of a large head and shoulders top (technical analysis jargon) is forming, signaling the reversal of a prior bullish trend.
Source: Bloomberg
China's slowdown
The Chinese economy is undergoing a massive transition, from an export-led economy to a consumer-led economy. This means lower rates of growth but just how low remains the big question for markets. The market consensus is hoping for about 6.5% GDP growth rate in 2016, down from about 7% in 2015 (we may never really know the actual numbers). Adding to investor’s concerns, Chinese regulators continue to fumble the ball when dealing with its market regulations. It now seems that Chinese policymakers are struggling to find the proper tools to help engineer an economic “soft landing”in their slowing economy.
If growth rates come in lower than 6% for China's economy in 2016, it could trigger further Yuan devaluation by the PBoC to lift its economy. Yuan devaluation exports deflation globally, and it would likely trigger a new round of global currency wars by Central Banks. China shocked markets when it suddenly devalued its Yuan in August 2015, and central bank officials have been struggling since to make sense of China's intentions.
Another really interesting piece of information related to the Yuan is this:
As the dollar has strengthened, it has become increasingly costly for the Peoples Bank of China (PBoC) to maintain the Yuan's peg to the dollar. It's estimated that China has lost more than 700 billion in foreign-exchange reserves (currently about 3.3 trillion) since mid-2014 by maintaining its currency link to the U.S. dollar.
Source: Bloomberg
Plunging oil
The free fall in crude oil prices has continued to unsettle commodity, stock, and corporate bond markets. Oil prices dipped below $30 on Friday and West Texas crude prices have fallen nearly 20% year-to-date. The current situation appears to be overwhelmingly supply-based and dollar-related. And with sanctions on Iran lifted, there is more oil coming to market. At some point, there will be a balanced market clearing level, perhaps as soon as the second half of this year.
Currently, the plummet in oil prices below $30 a barrel is causing a lot of distress in the energy sector, and banks are preparing for the worst by putting aside extra loan loss reserves. According to a recent Standard & Poor’s report, 50 percent of energy junk bonds are now distressed, meaning they are at risk of default. Distress in the oil patch could reduce S & P earnings by 7 - 8% in 2016.
The Strong Dollar
Last, on one hand, the fallout in oil prices can be viewed as a positive for global consumers; on the other, it could lead to geopolitical risks. Commodity exporting countries have seen their currencies continue their year-long decline against our dollar in 2016. The Brazilian real has plunged about 36% against the dollar over the past year.
The U.S. economy is in a soft patch
Manufacturing indexes have fallen recently, bordering on contraction, but this has occurred before in mid-cycle ‘soft patches’. Keep in mind, the modern U.S. economy is dominated by services — which have held up to date much better than expected. While recessions are never ruled out as a possibility at any time, key signals continue to show a low probability of a U.S. recession, such as healthy consumer and steady, albeit slow GDP growth.
Non-bank lending tightness portends downside growth risk
In an October 2015 research note, UBS analyst Stephen Caprio stated: “In sum, we believe non-bank lending standards illustrate an overall tightness in U.S. financial conditions that signal a downside growth risk in the U.S. economy. While bank lending standards are healthy, we ultimately believe this misdiagnoses the pulse of the corporate credit cycle. Nearly all of the additional financing provided to non financial corporates has come from non-bank sources, post-crisis” Caprio continued, “In short, non-bank liquidity has been the main driver of the corporate credit cycle post-crisis, and there are now early signs that it is evaporating.”
What can you do to protect your portfolio?
Data and sentiment change daily. With so many new market variables at work, it’s important to maintain a clear, calm, and longer-term perspective. It's of particular importance to embrace a disciplined process to guide investment decision-making during challenging periods of heightened volatility. Our disciplined investment approach actively uses a set of principles that grows and protects your wealth as we guide you through the ups and downs of the stock market.
It's also important to keep in mind that markets provide a benchmark for asset valuation. According to a FactSet Earnings Insight report 9.4.15 cited in our market viewpoint entitled "Is this the end of the Goldilocks Economy?", the S&P 500 consensus earnings estimate stood at $128 per share for 2015. Earnings for the S&P 500 came in at about $120 per share in 2015, roughly the same as 2014, resulting in a flat year for the market in 2015.
Uncertainty presents opportunity
For 2016, the S&P 500 Index consensus forward 12-month EPS estimate is $125.48. In our view, market valuations now look pricey at a time when our Fed has begun raising interest rates, global trade is slowing, and corporate profit margins appear to be peaking. Also, the ongoing Chinese yuan depreciation presents significant deflationary/market risks as other countries may be forced to devalue to remain competitive.
Given our outlook for 2016, we maintain our underweight position in equities and overweight cash/credit-related assets relative to our asset allocation model benchmarks. At this market juncture, it's prudent to have above average cash on hand for future undervalued investment opportunities. We remain vigilant as the current market uncertainty presents an opportunity to identify mispriced assets due to disparities between fundamentals and capricious investor sentiment.
Sources: The Wall Street Journal; Bloomberg News; Financial Times; Investors Business Daily; Forbes.com; CNBC.com; The Economist.
Observations and views expressed herein may be changed at any time without notice and are not intended as investment advice or to predict future performance. It is not an offer, recommendation or solicitation to buy or sell. It is based on information generally available to the public from sources believed to be reliable. Changes to assumptions may have a material impact on any returns detailed. Past performance is not an indication of future returns. Please consult your financial professional before making an investment decision.