Equities Remain Under Pressure as
Investors Focus on the Negatives
February 8, 2016
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Equity prices are trending down as investors face a host of possible risks.
In our view, there is a disconnect between financial market prices and economic realities.
Volatility and downward price pressures may persist, but equities should outperform bonds over the coming year.
U.S. equity prices fell again last week as investors followed the “de-risking” theme that has dominated most of 2016. The S&P 500 Index dropped 3.0% for the week.1 Oil prices staged a slight rebound last week, as expectations rose for coordinated production cuts from OPEC countries and Russia.1 The dollar experienced a sell-off last week as well, which provided some support for the hard-hit commodity-related equity sectors.1 Investor attention remains heavily focused on Federal Reserve policy as market participants scrutinize every economic release and policymaker communication for hints of the timing of the next Fed move.
Weekly Top Themes
- The January payroll report was mixed, but overall pointed to continued economic growth. The headline numbers showed that a less-than-expected 151,000 jobs were created last month, although the unemployment rate fell to 4.9%.2 The report also showed that wages have been accelerating. Average hourly earnings rose 0.5% in January, putting the year-over-year increase at 2.5%.2
- Corporate profit margins are likely to remain under pressure. Rising wages have the potential to cut into profits. Additionally, productivity measures are weak (productivity fell 3.0% in the fourth quarter).3 Should these trends persist, it would likely create a negative backdrop for corporate profit margins.
- The energy sector continues to weigh on overall corporate earnings. To date, three quarters of S&P 500 companies have reported fourth quarter results. Revenues are in line with expectations, while earnings are ahead of expectations by 4.5%.4 Earnings per share are on pace to fall 2% for the quarter, although excluding energy, EPS would increase by 4%.4
- Corporate buyback levels are high, which could be a potentially bullish signal for equities. Through last week, U.S. companies have announced buyback authorizations of $85 billion in 2016, which is the strongest start to a year in history.5
- The Fed should remain on track to slowly normalize interest rates. Unless market rioting forces the central bank to change its stance, we expect the Fed to stick with its plan to gradually increase rates. At this point, our best estimate is that the next interest rate increase will occur in June.
Stock Prices Should Recover, but it May Take Some Time
So far this year, investors have focused on the negatives and seem to be forecasting a relatively high chance of a U.S. or global recession. Slowing growth in China remains a source of anxiety and could have adverse implications for emerging economies in particular. Wild swings in oil and downward price pressures in commodity markets remain a concern. Investors are also focusing on widening credit spreads, which seem to point to the possibility that tightening credit conditions could put a damper on economic growth. Together, these factors have contributed to a broad risk-off move in financial markets, causing a tough start to the year for equities.
In our view, global economic fundamentals are less dire than market prices imply. It seems to us that investors may be overreacting to fears rather than taking a sober look at fundamentals. We do not believe conditions are in place for a recession in the United States or in the global economy. The U.S. has experienced a moderate economic expansion, and we expect that will continue. Europe should also continue to recover. While Chinese growth is slowing, it remains in positive territory. Falling oil prices remain a risk, but we believe the long-term decline has more to do with oversupply than falling demand.
Nevertheless, investor sentiment has taken a hit and will likely remain negative until we see better economic data from both the U.S. and China, as well as a stabilization in oil prices. We expect these developments will occur over the coming months, but the timing is unclear. When it does become more evident that the economy remains on track, that should pave the way for improved performance from risk assets. We believe equities will outperform bonds over the next six to twelve months. But we also acknowledge that volatility should remain high, and there may additional downward pressure on stock prices in the near term.
1 Source: Morningstar Direct, as of 2/5/16
2 Source: Bureau of Labor Statistics
3 Source: Labor Department
4 Source: FactSet
5 Source: Wall Street Journal
Last Week's Commentary
Equities Rally as Oil and Monetary Policy Remain in Focus
February 1, 2016
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