Economic Insights - December 2015
Asset Allocation: The Final Capitulation
Today’s economic and investment environment is characterized by widespread caution, foreboding or just outright pessimism. The angst seems almost palpable. It’s in headlines and pull-quotes: “People who have a hard time landing jobs are finally getting hired. A Fed hike may stop that.” “[It’s] Time to Bring on the Bear.” “Global growth will be disappointing and uneven in 2016.” “Is it safe?” Two of the few strategists to correctly forecast the 2014 plunge in U.S. Treasury yields say rates will dive again in 2016 from weak growth. Many say the Fed rate hike was a mistake and a recession is coming. Some forecast the S&P 500 Index to be virtually flat again in 2016.
Some of that fear and anxiety makes sense for several reasons. Oil prices collapsed 68% since July 2014. In response, thousands of workers have been laid off in U.S. oil fields, oil-related capital spending has been slashed, and prices of high-yield energy bonds have plunged, bringing the dread of recession. Second, the stock market rally will begin its eighth year next March, an aged bull by any measure. Also, some believe the long rally has been propelled, not by strong fundamentals, but by the trillions of bond purchases by the Fed and other central banks; if that’s the case, rate hikes will squash the rally. Further, there are a few precursors of recession on the horizon: widening spreads between yields on junk bonds and U.S. Treasurys; flat to falling profits; and an inventory overhang. Finally, there is trepidation about contagion from a financial crisis from weaker growth and debt problems in emerging markets.
There may be less cause for alarm. First, most of the anxiety noted above is related to the plunge in oil prices and the soaring U.S. dollar. Those trends are closely linked and both may have run their course. The dollar surged as growth slowed in China and emerging markets, the U.S. economy stayed resilient and investors began to anticipate Fed rate hikes. China’s growth is stabilizing, rate hikes are now reality, and dollar strength has already hurt U.S. business, so the dollar move is in a late stage. Further, oil prices crashed more in response to soaring supply than a nosedive in demand. OPEC has refused to lower its supply targets as no member is willing to give up market share. After 18 months of collapse, the recent relapse in oil prices is likely the final capitulation by oil bulls.
As noted in our last commentary, prices of copper, aluminum, gold, and broad commodity indices have stabilized in the last six weeks, even as oil plummeted to its recent trough. We don’t foresee much of a rebound in oil or weakening of the dollar. But, if commodity prices are bottoming and the dollar is peaking, growth should revive, capital spending pick up, and deflation fears diminish.
Further, if the current environment is really as dire as many suppose, Treasury yields should have plunged and stock indices registered a bear market as investors expunged risk assets and flocked to safe havens. But, that didn’t happen. The S&P 500 Index was still just 4.2% below record territory at yearend and yields on 10-year U.S. Treasury bonds have spent almost no time below 2% since April. Much lower stock prices and yields may be coming shortly, but we don’t expect it.
More Real Income:
Finally, the collapse in commodity prices has given consumers around the world the biggest boost to real incomes in ages. Yes, the positive effects have been slow to appear. But, as the current distress gradually wanes and households gain confidence that gas and food prices will not soon soar, consumer spending should respond. In the United States, the impact of cheap gasoline is already evident in more miles driven, strong sales of SUVs, higher savings, and greater spending at restaurants and leisure activities.
Is Flat the New Up?
It was in 2015; the S&P 500 Index lost 0.73% in price for the year. But, we expect better than flat in 2016. The above analysis implies positive equity returns. U.S. earnings and capital spending growth should turn up as the impact of the commodity collapse on energy and materials companies is purged from year-over-year comparisons. U.S. household real income is rising not only from lower food and gas prices, but also by improving wage growth. So, consumer spending should climb, enhancing business revenue and profits, even though margins might suffer from higher wages. Overall, earnings growth could rebound to low double-digits, giving the potential for decent equity returns with dividends.
The long tumble in commodity prices ought to ensure that inflation expectations remain muted and that any rise in long-term Treasury yields will be modest. The Fed will likely keep a slow pace of rate hikes, perhaps three during 2016, and stay accommodative throughout the year. So, interest rates should not climb enough to squash the stock market. Capital is still cheap and should promote decent returns.
A Bear Market?
We don’t think so. Big bear markets are usually associated with recessions and the odds of one in 2016 don’t seem too high. Noted above were three signs that typically portend a recession, but they come from the combined commodity-price crash and soaring dollar. If those trends have nearly reached a zenith as we expect, then recession omens should fade in time.
We don’t have the same hope for valuations; U.S. price-earnings ratios are already pricey. Using reported earnings, the PE of the S&P 500 Index at yearend was 21.4, well above the long-term average of 17. The PE using operating earnings was more moderate at 19.2, versus a long-term average of 18.9. Positive returns this year will have to come from earnings growth.
While valuations in Japan and the Eurozone are hardly more attractive, the potential for positive earnings or growth surprises may be better than in the United States. Broad indices in both countries out-performed in 2015 with MSCI Japan and developed Europe up 8.1% and 5.5% in price, respectively. We expect those better returns to continue in 2016.
The Future of the Investment Cycle
Well, the Fed finally did it! Seven years after cutting rates to near-zero for the first time in history, the Fed raised the funds target range to 0.25% to 0.5%. It was an historic move also for a new set of mechanics that allows the Fed to peg the rate at the desired level. Banks now receive interest on excess reserves (IOER), so the Fed raised the IOER to 0.5%, the upper bound. The lower bound is set by the rate the Fed offers on its Reverse Repurchase agreements (RRP), or 0.25%. To keep the Funds rate in the desired range, the Fed has to sop up excess cash in the financial system each night. Money market funds reportedly hold $3.5 trillion and could make those funds available overnight at rates below the lower bound since they are not eligible for the IOER. With RRPs, the funds can lend to the Fed at 0.25% and would be unwilling to lend elsewhere for less.
The question then became how much the Fed would have to borrow to peg the Funds rate above its lower bound target. The answer was much less than expected, under $300 billion so far, to keep the Funds rate around 0.35%.
The Hiking Path
In its policy statement, the Fed expressed confidence in the U.S. labor market and overall economy. The last two payroll reports were superb; the broadest measure of unemployment fell to 9.9% in November from a peak of 17.1% in October 2009. The Fed’s projections of the path forward show a median rate of 1.375% at the end of 2016, 2.375% at yearend 2017, and 3.5% in the long term. This is based on an expected unemployment rate of 4.7% in 2016 through 2018 and 4.9% in the long term. This means four rate hikes per year for two years, faster than we and financial markets are thinking given the strong dollar, lack of inflation, slumping profits, and widening credit spreads. The sharp downturn in commodity prices suggests that inflation will not accelerate anytime soon. Still, anticipation of rate hikes has been enough to bump long and short Treasury yields up a bit, with short rates rising relatively more, flattening the curve from about 1.4% in early October to 1.22% at yearend. Some yield history is shown in the chart below:
The key to future rate hikes and long-term yields is inflation: whether inflation firms as the Fed anticipates, its tolerance for sub-2% inflation if it doesn’t, and the path of inflation expectations. Fed Chair Yellen reinforced the view that ultra-low inflation is “transitory” and we agree. If commodity prices stop plunging from the prior year, measured inflation will move toward the Fed’s 2% target. As noted above, it’s likely that oil prices are at or near a trough. But the high level of oversupply and the volume of ongoing production suggest demand growth will be slow to catch up. So, a big rebound in prices is not likely. This will keep inflation expectations muted and long-term yields from surging. Even so, inflation hasn’t gone away; it’s just resting.
Other than a few central banks in developing countries that are raising rates to protect their currency, the Fed is the only central bank tightening policy. It seems correct: the U.S. economy is robust, the job market is excellent, and consumer confidence is rising. Barring a further collapse in oil prices that would revive deflation fears, the Fed is likely to move the funds rate up to the 1% plus range by yearend 2016. 10-year Treasury yields will respond too, possibly spiking to 3% or so before ending the year a bit lower. Actual rates for yearend 2015 and a rate outlook for yearend 2016 are shown below:
How Long Can the Cycle Last?
Rate forecasts for yearend 2017 are a bit fuzzy. If the economy remains robust and resilient, the Fed will surely raise rates in 2017 beyond our yearend 2016 estimate. If oil prices stabilize, inflation could well rise above 2% sometime next year and long-term rates would follow inflation expectations higher. At some point, perhaps also in 2017, that could bring a collision between rising interest rates and those sectors most sensitive to higher interest costs. The high-yield sector is already struggling as spreads have widened dramatically in anticipation of rising defaults, mostly in the energy sector.
We’re less worried about U.S. high-yield bonds than we are about emerging-market corporate debt if U.S. Treasury yields rise toward 3% or 3.5%. Many EM currencies have already plunged against the U.S. dollar, making it very difficult to repay dollar-denominated debt. Higher U.S. long rates could bring EM problems of excessive debt to a head sometime in 2017. In that event, it would be hard for the United States to escape at least some contagion from the ensuing EM crisis. So, it’s possible that the investment cycle could be winding down in 2017, suggesting that U.S. Treasury yields could end next year below the level at which the year began. Equity returns might not be pretty if that happens, since stocks, as noted, are no longer cheap.
Global Economic Overview
For the past couple of years, growth around the world has diverged from the familiar trajectories of the prior decade. Expansion in China and other developing economies has slowed markedly as they are forced to deal with the aftermath of the long boom and commodity super-cycle driven by an enormous investment surge in China. For those countries, 2016 will be another year of slower growth, of unwinding credit, and of supply and capacity excesses built during the economic rush of the last 15 years. By contrast, in the United States and the Eurozone, recovery should continue with moderate growth, supported by a resilient consumer sector whose real incomes benefit greatly from the plunge in commodity prices.
The risk for 2016 is that the credit excesses, slower growth, producer-price deflation, and a plunge in EM profits bring financial instability or a crisis that spreads around the world. That risk and struggle with the aftermath is clear and ongoing. But, a resilient U.S. economy, better growth in Europe and Japan, supportive tax and fiscal policy in China, and a likely trough for commodity prices should allow the developing world to avoid a widespread crisis in 2016.
The United States:
The two-tier U.S. economy will likely continue through the early part of 2016. The industrial side of the economy is struggling with a moderate inventory overhang and a strong currency. The bulk of the trouble is in the energy and materials sectors where profits and capital spending have collapsed and layoffs continue in response to the deep plunge in commodity prices.
On the other hand, the household sector is robust: confidence is rising; auto sales are vigorous; housing activity is healthy; the job market has been terrific; the pace of wage growth is modestly increasing; and real incomes are rising sharply from lower energy and food prices. With solid domestic demand, improving manufacturing, and a trough for energy prices, U.S. growth should be about 2.5% or more in 2016. Forecasts for selected U.S. data are in the tables below and in the tables at the end of the commentary.
Signs point to modest growth in 2016 of 1.5% or more. Business surveys stayed solid in December. Confidence is rising; while still very high, unemployment is falling relatively fast; and loan demand is improving as banks relax lending standards. The Eurozone continues to benefit from much cheaper energy costs and a weaker currency. The bond purchase program by the European Central Bank is keeping interest rates low and the lower costs are being partly passed through to small businesses.
The economy is struggling with too much debt and dramatic overcapacity in industrial sectors. Those troubles may be compounded by the widespread anti-corruption campaign that could be keeping local leaders too cautious in effecting reforms. Monetary policy has eased considerably with several cuts in interest rates and reserve requirements. Fiscal policy is ramping up with a larger central government deficit and more infrastructure projects on tap. Recent data is still weak but is no longer deteriorating. China has lots of room for more stimulative policy and plenty of resources to avoid a hard landing at least in the intermediate term.