Since Q2-2015, S&P 500 volatility, as measured by the CBOE VIX index, has risen substantially on the back of concerns of potential contagion from the Chinese economy and other emerging markets, weak global demand, declining commodity prices, a strong real exchange rate, and very recently, the European banking sector. We believe that most of the drivers behind the greater uncertainty are still present and that therefore, volatility should remain a feature of US equity markets at least in the first half of 2016.
Low crude oil, steel, coal and agricultural prices alongside a strong real exchange rate have placed strong downward pressures on US industrial output. Production has contracted by 1.8% since the end of 2014 led by support activities for mining (96% of which support oil and gas extraction), mining activities (oil, gas, coal) and electric and gas utilities. In aggregate, in 2015, mining output declined by 11%.
Manufacturing output has not grown since July 2015 while the ISM PMI declined from 57.5 index points in November 2014 to 48.2 index points in January 2016 beneath the 50 index point expansionary threshold, and the weakest level since 2009. The ISM production sub-index was situated at 50.2 index points in January, following two months below 50 and an overall declining trend since the end of 2014. The ISM employment sub-index dropped to 45.9 index points in January; well in contractionary territory and the weakest it has been since 2009. In turn, capacity utilization in manufacturing was situated at 76.6% in December, marking a slight downward trend since July.
In 2015, negative contributions to manufacturing were led in large part by oil and gas machinery, agricultural machinery, fabricated metals, iron and steel production and foundry production. From a final demand viewpoint, the greatest weakness in goods demand has occurred in exports, which declined by 11% from Q3-2014 to Q4-2015 on a nominal basis and 2% on a real basis. Non-residential investment growth has also slowed down on both nominal and real perspective. Based on the components showing weakness, it would appear again that commodities and a strong real exchange rate are in fact driving the increased weakness.
The service sector may also be showing the first signs of weakness; weakness that although currently isolated in industry would create a much larger issue if it were to filter to the service sector. In spite of still being expansionary, the service sector business activity index has seen an important drop of broadly 6 index points in January to 53.9 points, the weakest level since mid-2012 and to the lower-end of post-crisis data. Drops of this magnitude are usually observed prior to moments of relevant economic distress and may indicate the presence of large underlying fundamental processes. Nevertheless, we must restate that for the moment the business activity index remains in positive territory.
So far, there is no outright weakness in employment data, yet there are some concerning signs that need to be monitored. On the positive side, the number of unemployed and unemployment rate continued to decline through January, with the latter at roughly 5%. On the downside, although initial and continuing claims for unemployment insurance remain subdued at low levels, there is arguably a moderate upward trend since the final months of 2015. The non-farm payroll openings rate was at 3.8% of payrolls in December. Although above the baseline of 3.6% since April 2015, and healthy by historical standards, the lack of upward directionality since April may point to material underlying weakness.
From an income perspective, private sector average real weekly earnings also continued to grow through December 2015 following consistent growth since mid-2014 and very strong growth in 2015. This has contributed to a 4% increase in real per capita disposable income since mid-2014 and a rise in the household saving rate from 4.7% to 5.4% in 2015. Although positive, these dynamics will not be tremendously important if the labor market situation worsens.
Despite our concerns with most of the economic sectors, consumers have not yet shown any material sign of weakness. The headline consumer confidence index remains anchored, with the January 2016 figure at 98.1 index points, broadly in line with 2015 levels. However, the expectations index has seen a moderate declining trend throughout 2015.
We believe that the drivers behind the headwinds slowing the US economy are still present and that therefore, certainty of economic strength is much lower than where it has been in 2014 and 2015. Our rationale? It is unlikely that the US real effective exchange rate will decline to an extent that provides strong tailwinds for US industry. The Fed's commitment to monetary tightening, Canada's exposure to crude oil, alongside increased uncertainty in financial markets that should place upward pressure on the USD, quantitative easing in the Eurozone, Brexit risk in Britain, and weakness in emerging markets make protracted depreciations unlikely. With regards to crude oil prices, the EIA expects world production of crude oil to exceed consumption through the first half of 2017 and an average price of 37.6 USD per barrel for both WTI and Brent in 2016 (February 9, 2016 forecast). Having said this, actual prices could vary significantly around this expectation, given the high level of uncertainty present in the markets. The EIA also expects natural gas prices (Henry Hub) to remain subdued in 2016 at an average price of 2.64 USD/MMBtu.
For these reasons, expect continued market volatility in the coming months.
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