Macro

Market Reboot

April 13th, 2016 | By Nick Sargen

Highlights

  • Returns for U.S. financial assets were little changed in the first quarter, but there was a large gulf between the first half, when risk assets plummeted, and the second, when they recouped their losses. The reversal mainly reflected diminished worries about the U.S. and global economy and a firming in oil prices.
  • The outlook for the U.S. economy continues to be mixed: Overall, we continue to expect a 2% trend-like growth this year. The Federal Reserve has signaled it will proceed cautiously in tightening policy in the wake of developments abroad.
  • In this context, we favor credit over equities, on grounds that credit spreads adequately compensate investors for risk of increased defaults. While we view the stock market’s valuation is fair, modest revenue growth, narrowing profit margins, and lower quality of earnings are concerns, as is the ongoing narrowing in the breadth of market advances.
  • The main risks to the outlook continue to be adverse developments abroad. Worries about China have diminished recently, but Brazil and several other emerging economies are struggling. Within Europe, the focus will be the June 23 referendum on whether the U.K. should stay within the European Union (EU).

A Topsy-Turvy Beginning

For investors who like thrills, the first quarter did not disappoint, as U.S. and global markets went on a roller-coaster ride. The stock market and other risk assets experienced one of the worst starts to a year in memory, as investors fretted about weakness in China, plunging energy and commodity prices, the possibility of Fed tightening, and the potential spill-over to the U.S. economy. At the low point in mid-February, the major U.S. stock indexes were down more than 10% for the year, and many observers believed a bear market decline of 20% or more was in the offing, while the high yield bond market was pricing in a significant risk of recession.

Just when markets seemed trapped in a vicious cycle, sentiment turned positive. One catalyst was acknowledgment from Fed officials of market concerns about overseas developments and statements that they were not in a rush to raise interest rates.  The Chinese authorities also took measures to bolster the economy and to stabilize the yuan. At the same time, reports that Saudi Arabia was considering freezing its oil production helped establish a floor for oil prices. By the end of the quarter, U.S. financial markets were back to levels at the start of the year.

Amid all of this, it is worthwhile to consider what factors, if any, have altered the landscape for the U.S. economy and financial markets in the balance of this year.  Following are our main conclusions:

  • The U.S. economy has been resilient to developments abroad, and recession risks have diminished recently.
  • The corporate sector is challenged, as firms encounter difficulty growing their top line while profit margins have receded from record levels. Meanwhile, default rates are on the rise owing to a shakeout in the energy and mining areas.
  • The Federal Reserve is cautious about tightening policy and will take financial conditions into account. That said, the Fed continues to be more optimistic about the economy’s prospects in the medium term than market participants.
  • Perceptions of risks abroad have shifted away from China, although problems persist in several prominent emerging economies. The spotlight is about to shift to the U.K. and Europe as the June 23 referendum approaches.

A Resilient Economy

The U.S. economy is off to a sluggish start this year, and growth in the past two quarters is estimated to have been below the 2% trend rate since the expansion began in mid-2009.  Nonetheless, the slowdown is likely to be temporary. First, some of it reflects the lagged effects of a tightening of financial conditions that began in mid-2015, which has been partly reversed in the past month and a half.  Second, it also reflects a drawdown in inventories, which is nearly complete, as well as the effects of a slowdown abroad.  Third, jobs growth has been very solid and wages have begun to edge higher. 

One of our central messages is that the U.S. economy is well diversified and not heavily reliant on exports, which makes it resilient to developments abroad.  The main areas of weakness globally are manufacturing and energy/mining.  However, these areas account for only about 12% and 3%, respectively, of the U.S. economy, and manufacturing activity turned positive in March for the first time since last summer.  By comparison, the services sector, which represents the overwhelming majority of the economy, has continued to expand at a steady pace.

Similarly, the economy appears to be on solid footing when one looks at the composition of aggregate demand. Consumer spending, which accounts for nearly 70% of total spending, has been growing at nearly a 3% rate over the past five quarters. Also, residential housing, which traditionally has been the sector most closely linked to U.S. recessions, has been buoyant, growing at more than a 9% rate over the same period.  The combination of solid jobs growth, moderate wage increases, and rising household formation bodes well for the future. In these circumstances, we believe the risk of a U.S. recession in the next 12-18 months is considerably below what had been priced into financial markets at their lows.


Challenges Facing the Corporate Sector

At the same time, the corporate sector faces considerable challenges ahead, the most notable being a deterioration in profits and concerns about excessive leverage and rising defaults, especially in the energy/commodities area.

In the aftermath of the 2008 financial crisis, U.S. businesses were able to restore overall profitability within a span of two years by shedding workers and cutting back on capital spending. These actions enabled U.S. businesses collectively to raise overall profit margins to their highest levels in decades, and they were able to maintain these margins even as job growth was restored.

More recently, however, overall profit growth has declined from peak levels reached in mid-2014.  While the steepest declines have been in the energy area, profits and margins have fallen even, excluding energy producers. Businesses, in turn, have responded by cutting capital spending on equipment and structures in the past two quarters.  One consequence of sub-par investment spending in recent years has been a marked slowdown in productivity growth. As wages move higher, profit margins will compress further if productivity growth remains low.

An additional headwind is the combination of sluggish growth abroad and a strong dollar, which has hampered overseas earnings of U.S. multinationals. The impact on the stock market is greater than on the economy, as revenues of S&P 500 companies from abroad are in excess of 40% of their total profits.

The principal area of concern continues to be the extreme stress in energy, which is a highly-leveraged sector of the economy. According to JP Morgan researchers, the energy sector in its high yield universe could experience annualized default rates of 20% in the next two years. Moreover, they contend the improvements in prices for energy and other commodities since mid-February is unlikely to alter the outcome materially.  As of the end of March, the U.S. high yield default rate was up to 4.4% from 3.6% in February, and it is expected to reach 6% by the end of this year.  Excluding energy and commodities, the current default rate is very low – a mere 0.4%.


The Fed and the Markets

One of the most noteworthy changes since the beginning of this year is the revised expectations about U.S. monetary policy. When the Federal Reserve raised interest rates in December by 25 basis points, the consensus view among the FOMC participants was there would be four additional rate hikes totaling 100 basis points in 2016.  This compared with expectations of two additional rate hikes that were priced into the U.S. bond market.

Amid concerns about the global economy, plummeting prices for oil and other commodities, and a steep sell-off in risk assets, however, the FOMC ultimately decided against raising interest rates in the past quarter. Moreover, Fed Chair Yellen recently indicated the Fed would proceed cautiously in raising interest rates, considering how conditions abroad added to uncertainty about the economic outlook. In fact, the bond market is now pricing in only one rate hike in 2016.

One of Yellen’s most telling observations was her acknowledgment that the impact of weak global conditions on the U.S. economy was cushioned by a decline in bond yields as investors lowered their expectations about future policy tightening: “Financial market participants appear to recognize the FOMC’s data-dependent approach because incoming data surprises typically induce changes in market expectations about the likely path of policy…This mechanism serves as an important “automatic stabilizer” for the economy.”

This acknowledgement poses an interesting issue: Namely, are the Fed’s pronouncements about the economy and inflation influencing market expectations; or is the Fed altering its path of policy in response to market developments? Our assessment is the latter is more often the case, because over the past seven years the Fed’s forecasts of the economy consistently have been too optimistic.

Currently, the main disparity between the Fed’s view of the economy and the markets’ view is the medium-term outlook for 2017-2018, where market participants are less convinced than Fed policymakers that core inflation will reach the 2% target level.  Our own view falls somewhere between the two – namely, we believe inflation will stay tame in the current year, but then rise gradually in ensuing years. If so, this implies a rise in bond yields that is somewhat greater than what is currently priced into the bond market.


Risks Abroad

Our assessment at the beginning of this year highlighted several risks to the outlook including: (i) the possibility that further declines in oil could exacerbate default risks in U.S. energy companies; (ii) the risk of a more severe slowdown in China; and (iii) problems in Europe arising from an influx of refugees from the Middle East and North Africa.

While we continue to be concerned about defaults in the energy sector, the latest developments suggest that oil prices may have bottomed.  Meanwhile, the Chinese authorities have pursued expansionary policies to bolster the economy, while also signaling that they wish to see the RMB fluctuate in a trading range against a basket of currencies. Consequently, investor worries about China have diminished, at least for the time being.

Nonetheless, while these developments have contributed to a rally in emerging markets, several countries continue to struggle. The most noteworthy is Brazil, whose economy is experiencing the worst downturn since the post-war era, and where the political situation has deteriorated to the point that impeachment proceedings against President Rousseff are now considered likely. While market participants are hopeful the outcome will improve the country’s fortunes, there is a risk that a long-term quagmire could ensue, which would likely lead to another round of selling.

Within Europe, an agreement that the EU reached with Turkey has lessened worries about an ongoing influx of refugees for the time being.  However, investor focus is now shifting to the June 23 referendum in the U.K. While the consensus view is that Britain will vote to stay in the E.U., the consequences of it leaving would be far greater than prior worries about Greece, considering the much greater importance of Britain’s economy and financial markets.  Nervousness about the vote is evident in the recent selloff of the British pound, which would be especially vulnerable if  Britain opted out.


Portfolio Positioning

Weighing these considerations, we are continuing to overweight corporate credit (both high yield and investment grade) in fixed income portfolios, because credit spreads are unusually wide for a non-recessionary period. Within the corporate sector we favor higher quality (investment grade over high yield and BBB/B over CCC in high yield) due to increased default risk and valuation considerations.  In terms of duration, the risk is skewed to higher rates as labor market conditions tighten, but uncertainty about the global economy and ongoing policy easing abroad are likely to temper increases in bond yields in the near-term.

With respect to equities, market valuation is fair, with the stock market pricing in 7% long-term profit growth that is close to its historic trend.  However, the quality of earnings and late-cycle dynamics create downside risks that are concerning.  Therefore, we continue to favor companies with low operational and financial leverage, and we have increased the overall quality of our equity portfolio.