First Quarter Review
At the end of 2015, the S&P 500 stood at 2043.94. By the close of the first quarter of 2016, it ended at 2059.74, squeezing out a meager 0.77% return. At first blush, it would seem not much happened in the first three months of the year but nothing could be further from the truth - in fact, just the opposite.
The markets swooned in January, making it the worst on record going back to the Great Depression. The S&P 500 lost more than 200 points before finally bottoming on February 11th at a price of 1810, which had the index down 11.4% year to date (YTD). From there the index rallied 13.7% to close out the quarter with many investors marred by the volatility.
While many factors contributed to the January swoon, chief among them was the continued weakness in the currency of the world's second largest economy, China, and the country's dwindling foreign currency reserves. China, for the past year, had been selling its foreign currency reserves to buy its own currency in an attempt to stabilize its exchange rate, and despite its efforts, the Chinese yuan continued to plummet just as it did prior to the August sell-off in financial markets last year.
What sparked the market rebound beginning in early February was that Chinese officials gave a barrage of reassuring messages regarding growth and its currency - it aggressively lowered interest rates and began injecting liquidity into their financial markets. In addition to support from China, other world central bankers stepped up to the plate as well to arrest the market's decline.
The Flip Flop Heard Around the World
After one of the worst Januaries on record, Fed Chair Yellen calmed market nerves in February and March by almost entirely backtracking from their message in December for raising rates. The FOMC lowered their collective 2016 guidance to two rate hikes from four and the market is now only pricing in one rate hike this year.
Yellen went on to further elaborate her views at a speech at the Economic Club of New York, "The Outlook, Uncertainty, and Monetary Policy," where she repeatedly mentioned the words "uncertainty" and "global." At her December FOMC meeting, she mentioned both words only once, focusing, as usual, on the state of the domestic US economy. Such a flip in tone and concern reflects in many ways the modern, globally interconnected world we live in today.
With the current level of uncertainty, it is likely the Fed will do nothing until markets stabilize for some time and global risks remain at bay. That being said, while the Fed's outlook remains murky, our call that the US economy is slipping closer to a recession has only strengthened.
US Economy in Confirmed Final Phase of Expansion
There are thumbprints investors can use to help identify which of the four phases of the business cycle the economy is in, whether early, mid, late or recession. Correctly identifying which phase of the business cycle one is in can help asset managers improve performance and help mitigate risks. One of the characteristics that occur late in the cycle is that the mood from corporate CEOs and CFOs begins to sour as their profitability peaks and their outlook diminishes.
Corporate profitability has been a reliable early warning indicator of a coming recession and bull market top. According to the April 4th quarterly review by Strategas Research Partners, the S&P 500 peaks on average seven quarters after corporate profit margins peak. Given the most recent peak in profitability came in early 2012, it would be safe to assume that both the US economy and stock market are on borrowed time. The reliability of a peak in profit margins to warn of a coming recession is shown below going back to 1949 where margins peak prior to recessions (red shaded regions).
Given the slide over recent years in corporate profitability, it comes as no surprise that CEO confidence is waning. Commentary from the first quarter 2016 CEO Economic Outlook Survey is provided below (emphasis added).
For the fourth quarter in a row, CEO expectations on the economy remain mixed, indicating an economy performing below its potential, according to the Business Roundtable first quarter 2016 CEO Economic Outlook Survey...
The Business Roundtable CEO Economic Outlook Index - a composite of CEO projections for sales and plans for capital spending and hiring over the next six months - increased modestly from 67.5 in the fourth quarter of 2015 to 69.4 in the first quarter of 2016. The index remains near three-year lows.
One of the alarming points from the survey was the CEO Employment Index, which has plummeted to levels not seen since the middle of the last recession. Typically, when outlooks begin to dim, one of the first responses of a CEO is to slow hiring intentions. As the following article illustrates, it's easy to see why CEOs are becoming less optimistic (emphasis added).
…Companies are being pinched by poor productivity and rising labor costs on one side and an inability to raise prices in a lackluster economy on the other. The risk is that they'll respond to the margin squeeze by cutting back on hiring and spending, leading to a recession.
"With wages picking up but productivity growing in slow motion, margins are likely to continue their declines, which have historically signaled an expansion near its end," JPMorgan economist Jesse Edgerton wrote in a March 21 research note.
The Haves and Have Nots
Confirming the dismal profit picture for US companies even outside the beleaguered energy industry was a research report done by Bank Credit Analyst (US Equity Strategy, 03.21.2016). They looked at the current pricing power for 60 of the S&P 500 industry groups and their data has negative implications for forward corporate earnings.
What their research found was that more than half of the industry groups (32/60) were cutting their selling prices, and nine of the industries could not raise their prices by more than 1%, which means that more than two-thirds of industry groups could not raise their selling prices more than the rate of overall inflation rates. Clearly, corporate America faces a profit headwind and why profit margins, and thus CEO and CFO outlooks, are likely to continue to decline.
What was interesting is that the companies with positive pricing power were mostly confined to defensive sectors like consumer staples and telecommunications.
Inflationary Pressures Building
Another thumbprint seen in the latter part of a business cycle is rising wage inflation. Here, the unemployment rate is driven lower as the available pool of workers declines. Economics 101 teaches us that falling supply while holding demand constant leads to rising prices and that is what we have currently with rising wages as the unemployment rate has been cut in half since 2009.
Shown below is a figure of how asset classes perform in mid and late cycles along with an image of rising wage inflation, now at its highest level since 2007. In a late cycle, when inflationary pressures build as manufacturing and labor spare capacity falls, we see that returns from stocks diminish materially from mid cycle while commodities and cash become the best performing asset classes.
A Summer of Discontent?
We have a lot of headline risk ahead of us, which is likely to keep investors on edge. A quick rundown of upcoming events is listed below:
- Greece in the limelight again - Greek officials are testing the waters again with debt forgiveness ahead of the IMF/World Bank spring meetings in Washington (04/15-04/17). Recently, WikiLeaks released a transcript from two top IMF officials involved with handling the Greek bailout in which the IMF is considering playing chicken with Germany to force them into Greek debt forgiveness or bail on the bailout (article link). Merkel's response was… not having it (article link). Greece's next big debt maturities occur in July of this year.
- Brazil - A special impeachment committee could present its findings as soon as mid-April for President Dilma Rousseff (article).
- UK - the "Brexit" referendum is Thursday, June 23 (article link).
Market Liquidity Still a Concern
"A rising tide lifts all boats."
In addition to the heightened potential for increased market volatility this summer, we continue to be concerned about the loss of global market liquidity. A rising "tide" of increased market liquidity is associated with rising stock prices while a decline in global liquidity tends to be associated with falling markets. Liquidity can be extremely important when it comes to the overall direction of the market as famous investor Stanley Druckenmiller, who along with George Soros famously "broke the Bank of England" in 1992, said in a speech early last year (click for source).
"…earnings don't move the overall market…focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets."
Bank of America (NYSE:BAC) has come up with a measure that tracks global liquidity (in red) and observing how liquidity and the S&P 500 (in black) move together clearly illustrates the quotes from Kennedy and Druckenmiller. We have highlighted in red the periods when global liquidity was negative and you can see that these periods covered the 2000-2002 bear market, the 2007-2009 bear market, the mini-bear market of 2011, and it also turned negative just as the S&P 500 peaked last summer. Until global liquidity improves by moving back into positive territory, a defensive posture is prudent.
"Unless someone like you cares a whole awful lot, nothing is going to get better. It's not." - Dr. Seuss, The Lorax
My wife and I are fortunate enough to have a DVD player in our van to help entertain three little girls under the age of 6 while driving long trips in the car. Over the course of the last few years, I've clouded my head with the quotes from many of the movies my girls watch as I now listen to more movies than I watch. One of the more enjoyable movies I've listened to is Dr. Seuss's The Lorax and while reading a recent Bill Gross newsletter I could not help but think of the above quote and other financial parallels to the movie. Here is a condensed version of the plot:
(Wikipedia) A boy living in a polluted town visits a strange isolated man called the Once-ler at the far end of town. The boy pays the Once-ler to explain why the area is in such a run-down state. The Once-ler explains to the boy how he once arrived in a beautiful valley containing "Truffula trees." The Once-ler proceeded to cut down the Truffula trees to gather raw material to make Thneeds, which everyone needs.
The Lorax warned the Once-ler not to cut down the Truffula trees, but the Once-ler ignored him, instead contacting all his relatives to help him with his business.
The Once-ler's small shop soon grew into a factory and new equipment was made to keep up with the demand for more Thneeds.
The last Truffula tree falls. Without raw materials, his factory shuts down; without the factory, his relatives leave. Then the Lorax, silently, with one "very sad, sad backward glance," lifted himself away through the clouds.
In the present, he now realizes what the Lorax meant. He tells the boy. The Once-ler then gives the boy the last Truffula seed and tells him to plant it, saying that if the boy grows a whole forest of the trees and keeps them protected from logging, the Lorax, and all of his friends may come back.
Today's Once-ler is the Fed and the other central bankers which keep "cutting" interest rates hoping to spur the next debt binge from consumers and corporations to help grow the economy. Just as demand for "Thneeds" grew ever stronger, the investment community has grown addicted to central bank stimulus to prop asset markets ever higher. Like the Once-ler, who eventually was faced with no more trees to cut, central bankers have been looking at zero interest rates for years wondering where the next rate cut will come from. Furthermore, we now have several central banks such as the European Central Bank (ECB) and the Bank of Japan (BOJ) now pushing their markets into negative interest rate territory.
The world faces a slow growth environment and central banks have done all they can to reignite growth but they keep having to come back to satisfy an ever growing need for more stimulus. We truly face a difficult reality as Bill Gross articulated in his April newsletter, "Zeno's Paradox" with excerpts below (emphasis added):
The reality is this. Central bank polices consisting of QEs and negative/artificially low interest rates must successfully reflate global economies or else. They are running out of time. To me, in the US for instance, that means nominal GDP growth rates of 4-5% by 2017 - or else. They are now at 3.0%. In Euroland 2-3% - or else. In Japan 1-2% - or else. In China 5-6% - or else. Or else what? Or else markets and the capitalistic business models based upon them and priced for them will begin to go south. Capital gains and the expectations for future gains will become Giant Pandas - very rare and sort of inefficient at reproduction. I'm not saying this will happen. I'm saying that developed and emerging economies are flying at stall speed and they've got to bump up nominal GDP growth rates or else…
Unless real growth/inflation commonly known as Nominal GDP can be raised to levels that allow central banks to normalize short term interest rates, then south instead of north is the logical direction for markets.
We have trillion-dollar central bank balance sheets, near zero interest rates in much of the developed world and yet little growth to show for it. Like the impact of medication that over time loses its effectiveness, we are reaching the point in which central bank intervention is counterproductive and simply not enough. We saw this late in January when the BOJ moved short-term interest rates into negative territory. Unlike prior stimulus measures, the Japanese stock market is down double digits since the move and rather than weaken the Japanese Yen to stimulate exports, the Yen has actually rallied.
In Europe, we've seen ECB President Mario Draghi step up stimulus measures even further by expanding its money printing and The STOXX Europe 600 Index rallied only marginally and has since already given back most of the gains post the ECB meeting.
Developed and emerging countries all across the globe are grappling with high debt loads, which is why central bank intervention has not had a meaningful impact and why the US and the globe face the risk of slipping into a recession. Monetary policy is never meant to work alone but rather in concert with fiscal stimulus and we've had just the opposite here in the US and elsewhere.
Consumers need to save but we all can't cut back on our budgets or we would be in a depression. Someone has to do the spending, which becomes another person's income, and in times like these, it is government spending that needs to kick in. In the Great Depression, it was FDR's New Deal that helped revive the economy along with war spending during WW II. The most glaring modern New Deal I can see is a massive overhaul of US infrastructure, which the American Society of Civil Engineers (ASCE) grades a D+ and says the estimated investment needed by 2020 is $3.6 trillion.
Given our current extremely low interest rates, the Federal government could launch a multi-year spending project to improve our infrastructure, which would pay the economy dividends for decades to come and improve productivity just as our freeway system and dams did during the Great Depression. Rather than do productive fiscal stimulus this cycle, however, we squandered it by bailing out Wall Street and wasting $536M on failed businesses, i.e. Solyndra.
How likely is it that we will get productive fiscal stimulus out of Washington anytime soon? Not likely, according to the following Wall Street Journal article:
The Obama administration is racing to make final a flurry of regulations affecting broad swaths of the economy, further riling US businesses in an election season that has already been tough on corporate interests…
Business uncertainty from Washington may not change anytime soon. Presidential front-runners in both parties have shown greater hostility toward business in some ways, with Democrats promising stiffer regulation and Republicans calling for new tariffs or an end to subsidies.
What we are facing currently is a slowing economy not just here but abroad that is reacting less and less to monetary stimulus with the specter of a recession ahead growing each month. What is needed most is fiscal stimulus, which is highly unlikely.