Equities Rally as Oil and Monetary Policy Remain in Focus
February 1, 2016
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Equity prices rose as markets continue to follow the lead from oil prices.
Over time, we expect oil to stabilize and believe that global monetary policy remains a tailwind for risk assets.
Turbulence is likely to continue, but for those who can tolerate the swings, we think it makes sense to stick with a pro-growth investment stance.
Volatility remained high last week as U.S. equities regained some ground, with the S&P 500 Index rising 1.8%.1 Stocks soared on Friday in response to the Bank of Japan’s decision to adopt a negative interest rate stance. Oil prices also rose over speculation that global production might fall. Corporate earnings were mixed, as results continued to be held back by the long-term decline in lower oil prices, a soft economic backdrop and the strong dollar.
Weekly Top Themes
- Fourth quarter gross domestic product growth was soft. The economy grew
an anemic 0.7% last quarter, with growth held back by slowing consumer
spending and the first decline in business investment since 2012.2 A slowdown in
inventory investment also detracted from results.2 For the year as a whole, 2015
growth increased a respectable 2.4%, matching the pace seen in 2014.2
- Last week’s Fed meeting came with no real surprises as the central bank
adopted a slightly more dovish tone. The Fed noted somewhat weaker
economic growth, but also sounded upbeat about demand and employment
indicators. Policymakers also indicated that inflation remains low and stated they
were “closely monitoring global economic and financial developments.” Absent
a quick and dramatic economic improvement, we do not expect another interest
rate increase before June.
- The energy sector continues to weigh on corporate earnings. With over half of
companies reporting fourth quarter results, earnings are beating expectations by
4.9% and revenues are missing by 0.3%.3 Earnings-per-share are on track to be
flat for the quarter, and up about 6% excluding energy.3
- Consumer confidence may be slowly improving. The Conference Board’s
Consumer Confidence Index increased 1.8 points in January, beating
expectations.4 Consumers may be looking past equity market weakness and
focusing on the positives.
- The anticipated “oil dividend” has yet to appear. Since oil prices started falling
in 2014, many observers (us included) expected to see an increase in consumer
and business spending. It doesn’t appear that this has yet occurred, and it looks
to us as if most individuals are saving their extra disposable income rather than
spending it. We expect consumer spending to rise, but acknowledge that lower
oil prices have so far caused more pain than benefits.
A Pro-Growth Stance Makes Sense, but Requires Patience
Investors have grown more risk-averse in recent weeks with slowing growth in
China, oil price volatility, weakness in manufacturing and Fed policy topping the list
of concerns. Economic data has generally been stronger than reflected by financial
market movements, and investors seem to be ignoring positive economic news and
overly focusing on the negatives.
At this juncture, we think investors have three options: (1) retreat and unload risk
assets in anticipation of a recession, (2) pause, become slightly more conservative
and await more clarity, or (3) maintain a pro-growth stance and accept that more
near-term turbulence may occur before risk assets experience a sustained upturn. We
think the first strategy is overly pessimistic and believe economic fundamentals are
better than what is priced into the market. The second option may be reasonable for
investors who are having difficulty weathering the current volatility. But for investors
with long-term time horizons, we think option three is most prudent.
It may take some time, but we expect that oil prices should stabilize and cease
being the main determinant of global financial market prices. The long-term drop
in oil should produce some economic stimulus and become more of a positive.
Additionally, global monetary policy remains a tailwind for risk assets. The Fed is
likely to raise rates, but any increase should be measured and slow. And last week’s
news from Japan reiterates that policy around the world remains in easing mode.
Investors are also awaiting signs of a global manufacturing recovery, which would
promote greater confidence in the strength of the world economy.
Our view is that financial markets have overreacted to the negatives. Turbulence is
likely to continue, but we expect both equity prices and bond yields to rise over the
course of 2016.
1 Source: Morningstar Direct, as of 1/29/16
2 Source: Commerce Department
3 Source: FactSet
4 Source: Conference Board
Last Week's Commentary
Markets Recover (for Now) as Investors Remain Wary
January 25, 2016
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Equity markets recovered ground last week, but volatility will likely persist.
Investors appear to be ignoring most economic fundamentals, and we believe conditions are healthier than what the markets reflect.
It may take time, but we believe confidence should improve over the coming months.
Equities remained volatile last week as the S&P 500 Index gained 1.4%
following two weeks of sharp declines.1 The rebound didn’t appear to be
driven by any fundamental shifts, although rising oil prices and expectations of
additional policy support from the European Central Bank and Bank of Japan
helped. In some ways, last week’s bounce may have been due to a reaction
from oversold conditions, and we are not seeing technical signs that would
suggest these gains will have sustained traction. Investors remain skeptical and
seem to be looking for the next crisis.
Fundamentals Remain Stronger than Sentiment Suggests
The S&P 500 began the week at 1,880, dropped all of the way to 1,812 on midday
Wednesday, and subsequently surged 5% to 1,906 by market close on Friday.1
As dramatic as those moves were, oil saw even bigger swings as prices plummeted
early in the week before staging a comeback. Pessimism about the economy and risk
assets has spread rapidly this year, with every downtick in oil prices triggering selling
pressure, and (as we saw last week) the reverse has been happening as well.
We believe these wild gyrations are not in keeping with economic fundamentals.
The weakening Chinese economy, falling oil prices and a slowdown in global
manufacturing are dominating investor attention and are causing some to forecast
a U.S. recession. We doubt that will occur. Consumer spending should continue to
improve as a result of higher wages and lower oil prices. Government spending is
also rising and should contribute to growth in 2016. The fourth quarter earnings
season is still young, and while results are far from perfect, the numbers and forward
guidance point to a decent economic outlook.
Weekly Top Themes
- Economic data were mixed last week. Housing starts fell 2.5% in December,2
and unemployment claims surprisingly rose to a six-month high.3 On the bright
side, preliminary purchasing manager index readings for January moved higher,4
and existing home sales in December jumped 15% after falling the previous two
- Despite rising anxiety about the corporate sector, it appears healthy to us.
We see high profits, rising cash holdings, comfortable debt servicing ratios and solid
net worth. Absent some sort of shock such as a recession or rapidly rising interest
rates, we don’t expect these conditions to change.
- We are not forecasting changes at this week’s Federal Reserve policy meeting.
There are no expectations that the Fed will shift interest rates and we don’t
anticipate any material changes in the Fed’s forward guidance. We expect the
Fed will highlight recent turmoil and reference deflationary concerns, which will
reinforce the sense that the bar remains high for additional rate increases.
- Relative stock and bond yields may be a bullish indicator for equities.
According to UBS, at last week’s low, the yield on the S&P 500 Index was 47
basis points higher than the 10-year Treasury yield. Since 1990, there have been
82 instances of yield spreads of this magnitude or greater. In each instance, the
S&P 500 was higher four months later and the average gain was 9.5%.6
Markets May Remain Rocky Until Confidence Improves
Equity markets have been in full blown panic mode so far this year. Yet, as we
indicated earlier, we think investors are ignoring fundamentals or exaggerating the
negatives. There are a number of headwinds to global growth, but we think the
global economy is still healing and expect the U.S. expansion to continue.
The key downside risks to the economy appear to be weak manufacturing and
economic and policy issues in China. We expect manufacturing will gradually
improve as inventories decline. If and when we start seeing manufacturing indices
above 50 (indicating growth), that should go a long way toward quelling investor
panic. Likewise, uncertainty surrounding China is putting stress on emerging
economies and pressuring commodity prices. We think risk assets will remain
vulnerable until investors become more confident that the Chinese economy is
stabilizing. Our forecast is that confidence will slowly improve as fundamentals
become more firm over the coming months. In the interim, however, investors will
likely be in for a bumpy ride.
1 Source: Morningstar Direct, as of 1/22/16
2 Source: Commerce Department
3 Source: Labor Department
4 Source: Markit U.S. Manufacturing PMI
5 Source: National Association of Realtors
6 Source: UBS