Market volatility has been ruthless of late and I fully understand the toll it can take on the investor psyche. Even veteran investors will scratch their heads wondering if, maybe, it's different this time. Ah, but wait! Don't forget that old John Templeton quote about the four most expensive words in the English language: "This time it's different."
Quotes aside, in the trenches of volatility I urge investors to take a step back, take a BIG deep breath and review the economic fundamentals. Ask: is there a growing disconnect between the direction of the market and fundamentals?
Granted, late in economic cycles we typically see patches of weakness, and we're seeing some now. But, to explain the recent downside volatility as a symptom of a total breakdown in fundamentals would be short-sighted, in my opinion. Let's forget about the selling pressures and media hysteria for a moment and just review the fundamentals objectively.
Patches of Weakness are Relevant, but not Powerful
I'll start with the negatives. The rise in the U.S. dollar has had a measurable impact on corporate earnings. I recently wrote that if the dollar hadn't strengthened as much as it did, Apple said it would have posted $80.8 billion in Q4 revenue versus the $75.9 billion it actually reported. That meant an increase for the quarter of 2% instead of 8%. Google said the stronger dollar cost it $1.3 billion in Q4, and there are several other examples.
In the absence of strong and rising global demand, the stronger dollar can dent exports as the cost of goods rises for foreign buyers. That's possibly led some businesses to stall inventory build-outs, which combined with falling net exports have subtracted 1.4% from GDP. The dollar's rise is also clearly hitting U.S. manufacturing hard. Durable goods orders for December fell 5.1% and have declined at nearly an 11% pace over the past three months. Easing at the European Central bank as the Fed embarks on tightening may send the dollar still higher, with more attendant drag on net exports and more restraint on inflation. Taken together, a stronger dollar with subdued inflation will put pressure on corporate earnings as demand is impacted and corporations have less pricing power.
On oil, I've written that the decline in oil prices should help more sectors ultimately than it hurts, and we stand by that. But, another tail risk that's popped up recently is the notion that banks with energy loan portfolios could be in trouble. At the end of the day, any threat to 'credit' and adequate capitalization at major banks is likely to throw the market into a tizzy, and I think a good deal of the recent volatility stems from rising fears of big losses from energy defaults.
The Positives and Mitigating Factors Should Outweigh the Negatives
Continuing the oil/banks narrative, the problem seems to be much more of a European one, at present, than an American one. The biggest U.S. banks generally have less than 5% of their total loan portfolio in Energy and, because of regulations in the aftermath of the 2008 financial crisis, they are well-capitalized. Even still, they've been adding to reserves: Citibank by $250 million in the latest quarter, J.P. Morgan by $124 million, Bank of America by $2 billion. Recall too that within the oil sector, most loans are asset-backed, meaning that banks can make a claim on property if it comes down to it.
In Europe, the story is a bit different and worth monitoring closely. Europe was much slower to recapitalize following the financial crisis and, since European banks generally have fewer assets than their U.S. counterparts, the Energy hit is harder on a relative basis. The nominal size of Energy exposure is similar but, with fewer assets, it weighs more. Again, something to keep an eye on, but a well-diversified investment portfolio shouldn't have much European financial exposure at all.
Moving back to U.S. economic fundamentals, employment gains have been solid averaging 284,000 over the past three months. The unemployment rate has remained at 5% during this period, but is expected to fall to 4.6%. Inflation remains "subdued," as a result of the recent rise in the dollar and further plunge in oil prices, but is expected to move gradually toward 2% as those effects wane.
The recent budget deal should translate into somewhat firmer federal spending than we anticipated before the deal was agreed upon. Housing sales and construction are roughly on track, with our prior expectations for growth of residential construction in the vicinity of 10% this year. Household net worth jumped 14% in 2013 and rose 6.0% in 2014, driven mainly by gains in housing prices and equities. It has risen over 50% since the trough in early 2009 and, as of the third quarter of 2015, was nearly $18 trillion above the peak reached in mid-2007. Following an estimated increase of 4.8% in 2015, we expect household net worth to rise 4.2% over 2016.
Fundamentals of employment, wages, and wealth - aided by solid house price gains - should continue to support solid growth of Personal Consumption Expenditures of roughly 3%.
Bottom Line for Investors
Headwinds are growing, which is expected late in a business cycle, but at the end of the day the overarching question is are we headed for a recession? And, by our estimates the answer is "no" - and, you only rarely see a bear market with no accompanying recession. We estimate GDP growth for 2016 to come in at 2.4%, and global growth should exceed 3%. This is hardly the stuff of a recession and, though we do not expect big gains out of equities in 2016, we also don't see a case for abandoning a long-term equity strategy.
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