2016 Outlook and Commentary
2016 Outlook and Commentary
Less than four months have passed since the U.S. Federal Reserve raised interest rates. This was the first rate hike in seven years, during which time the Fed Funds rate had been pinned at zero. This “trivial” rate hike triggered a panic, resulting in the worst calendar-year start to the stock market in our lifetimes. After some backpedaling by the Fed and the softening of its stance, the market then staged the strongest and swiftest recovery since the depths of March 2009. As a result, this rollercoaster market ended the quarter pretty much where it started.
What is causing this unprecedented volatility? The answer lies in the anemic health of the global economy and the market’s chronic dependence on central bank monetary policy actions. Like having a weak immune system, the low growth trajectory (even in the U.S.) makes economies vulnerable to shocks, both internal and external. Central banks around the world are pushing the limits on what they can do to stimulate their economies. In Germany and Japan for example, 10-year government bond rates are already at zero.
The U.S. economy is in better shape than most other economies, but every time the U.S. Fed raises rates, it puts additional pressure on global markets, and counter-acts other central bank policy actions. For this reason, it would be very surprising if the Fed continued to raise rates at all. It could be a “one and done” scenario over the near term. This would be welcome news for global economies and markets, at least in the short term.
Our views have only slightly changed since our prior year commentary. Three of the six risks we highlighted over a year ago in our 2015 commentary did in fact materialize. These risks are still present today:
- Earnings drop is larger than expected due to weak global growth, lower Capex, and consumer spending disappoints (people save instead of spend) – Earnings for the S&P 500 have dropped for four straight quarters. The savings rate is over 5.5%, the highest in over 3 years.
- Fed raises rates to test the market and market reacts adversely – The fed raised rates for the first time in December and the markets reacted adversely.
- Junk bond yields continue to move higher, leading to more bankruptcies as companies cannot roll over debt, eventually spreading to other markets – Junk bonds had a horrible year and continue to be under pressure, especially in the oil sector. More than 50 oil and gas companies filed for bankruptcy in 2015, and much more are at risk. Consider from 2014 to 2016 total oil company debt tripled to a whopping $3 trillion, some of which will sour. Also, these debt anxieties have put pressure on banks to act more conservatively, especially in high risk corporate lending.
And this potential risk is still lingering:
- Geopolitical instability in oil producing autocracies (75% of oil reserves are owned by national oil companies) could lead to skirmishes, wars, etc. – The IMF estimates that Arab oil-exporting states lost $340 billion in revenues in 2015 as a result of lower oil. In Saudi Arabia alone, oil revenues account for 90% of their government budget. Also, their currency reserves were sliced by $115 billion in 2015, down to around $600 billion. Sustained low oil prices would have devastating consequences in this region.
And new uncertainty/risk in 2016:
- Presidential Election – If you look at the stock market and compare against the 8-year Presidential cycle, the final year of a second-term President has historically been the only year where the market has averaged a negative return. (Can you guess which years are the best for the stock market?) This has to do with the uncertainty over the regime change, and the unknown new trajectory. Clearly, this election cycle will not disappoint, and the eventual winner will set the tone for the next four years and beyond. We have spent countless hours theorizing and forming investment theses for each of the potential winners. Our ideas will evolve over time, but the foundation is there. As a winner emerges, we will discuss this in more detail.
We have made some slight adjustments to our viewpoints from last year.
Investment Implications over the near term:
Continued Emphasis on Stock and Sector selection: Picking the right stocks/sectors will continue to be a differentiator in a slow and maturing bull market. In 2015 the leadership was limited to a small handful of stocks. The range of returns among the sectors was also very wide in 2015. We believe this dispersion will narrow, but still be above average in 2016. We also feel you will see an improvement in the number of stocks performing well this year versus 2015.
Quality Dividend and Quality growth: We believe there will be an above average premium on growth companies and on dividend companies with healthy payouts. Quality will shine in a mediocre economy. We want to avoid “bottom-fishing” and highly leveraged companies for fear of a relapse in global growth.
Sectors we like – We accurately forecasted the top performing sectors last year. For the remainder of 2016 we continue to like consumer and technology sectors and have recently increased allocation to industrial sectors with the dollar appreciation having abated. We have liked the health care sector for the last few years, but feel 2016 will be challenging given the sector is in the crosshairs of both political parties for a variety of reasons.
Oil – We believe oil found a bottom in February of 2016 (barring global recession). Demand for oil has not subsided. The catalyst that sparked the peak in the oil price was a surprise decision by OPEC not to cut oil production. The catalyst for a bottom in oil prices (to the minute) was “leaked” rumors surrounding discussions between Russia and Saudi Arabia about freezing production (Some would argue the bottom was called when Barron’s cover read “Here comes $20 oil” came out in early February). Bottom line, unless there is a viable oil substitute to replace demand, the price of oil will be driven by the supply side. The template for successful navigation of oil companies is the same template as we used for banks during the financial crisis. Over leveraged/ low asset quality oil companies will still struggle with sub $80/barrel oil and many more will go bankrupt. High asset quality and low debt ratio companies will survive and some will thrive as oil price recovers.
Global Markets – We will continue to avoid direct emerging markets exposure. China’s share of global manufacturing exports grew from 2% in 1991 to over 20% in 2013. This market share growth rate will not continue. More emphasis on capturing emerging middle class in China will be our strategy. We favor large consumer, industrial, and technology companies and will avoid global financial companies. Central bank policies around the world are putting too much strain on their banks and insurance companies.
Rate-sensitive investments – We were a little surprised at how low interest rates have stayed in the last year, especially longer dated maturities. Rate sensitive investments have performed better than expected as a result. Given the persistent stagnation and lack of global inflation, we have and will continue to include more interest rate sensitive investments such as REITs and Utilities. However, just because interest rates seem to be “tethered” today does not mean they will stay this way, so we will watch inflation expectations and rates closely and make adjustment as needed. We also will continue to avoid low quality bonds. Conversely, banks will struggle if rates stay low and the yield curve continues to flatten.
Aggressive opportunity – The recent dollar weakness and commodity recovery could uncover some interesting investment opportunities. Also, we are in the early stages of some strong secular trends some of which are being led by a small handful of disruptive companies. U.S. home building continues to build momentum. These are a few examples of some opportunistic themes that can be explored this year.
Summary
We do not anticipate the markets running away to all-time highs and beyond given all the uncertainties we have detailed, especially with the upcoming Presidential election. At this time we continue to keep our investment focus in the U.S. and more heavily weighted towards large-quality companies. This has been the “sweet” spot in the markets for the last few quarters (really since 2011), and has served us well. Stocks are not cheap at these levels, and we could see further earnings weakness. If we continue to muddle along for a few quarters and/or suffer another relapse, holding high quality companies provides a solid margin of safety. If the Fed does indeed hold off on additional rate hikes, increasing investor sentiment could drive the market higher in the near term.
What do we anticipate for the economy and markets over the longer term? The answer will depend on whether the global economy will continue to muddle along and eventually recover, or will it inevitably fall into recession, taking the U.S. economy along with it. The U.S. economy is the most economically diverse and self-reliant country in the world, but still not immune to contagion. How far will central banks take monetary policy? And how effective will the policies be? How and when will the Fed unwind prior actions and normalize rates? When will inflation wake up from its deep slumber? Has globalization peaked? What policies and agenda will our new President have? Will the new President be effective in pushing through her/his agenda? There are simply too many crosscurrents and unknown variables to make a long term forecast with any accuracy at this time. The good news is we do not need to have all the answers at this time to be effective at managing your wealth in this environment. Knowing which questions to ask puts us ahead of most. We will manage prudently and as we get more long term visibility we will make adjustments accordingly.
We humbly thank you for entrusting us with your wealth.
The Vigilare Wealth Management Team.