Q1 2016 market review & outlook: what you already know

Equity markets

In the first quarter the US markets (VTI) were slightly negative on a total return basis at -1.4% to be surpassed by the Emerging Markets (VWO) at +1.5%, and foreign Developed Markets (VEA) went negative -4.2%. Note our quarterly data is as labeled, to March 28. 

We prefer a longer view, pictured below, and over the last 12 months all were negative. Before we start jumping out windows, let’s bear in mind that the total return of the US markets (VTI) over the last 36 months was 35.8%. 

Within the US market large caps were slightly positive, while small and mid cap sectors declined about -8.0% and -4.6% respectively, and growth vs value didn’t matter much.

Volatility has been largely stable, well, except for Fed/oil/China induced surprises. We expect more surprises, although not of the magnitude easily seen below in August. That we presume to be have been a mere “teachable moment” for the Fed. We do anticipate a growing probability of volatility through this year. There are any number of possible provocations including geopolitical issues, an unexpected weakening of the economy, disruption of global oil supplies, the unpredictability of the Fed, or simply domestic politics which seem to have an unlimited capacity for grim surprises.

Fixed Income & interest rates

Below is a graph of 30, 10, and 2 year constant maturity Treasury rates along with the Effective Fed Funds rate. It strikes us as odd behavior given the contemporaneous declarations by the Fed of impending interest rate hikes. Evidently, a substantial portion of the market didn’t quite get on board with the Fed.

The yield curve is probably more important than the absolute rates. The 10’s less 2’s spread as below reveals a curve flattening, again while the Fed threatens to raise rates. Robust economies tend to be associated with a curve widening, and an inverted curve is a leading indicator of recession. So we’re stable for now, but major forces are at work here and not necessarily in harmony. Do we have a Fed tightening into a weakening business cycle?

Credit spreads are the market’s own way of tightening, of adjusting the price of credit risk to reflect changing conditions. As perceived credit risk changes, the price of credit responds.Junk spreads have been widening, at peak almost doubling since last June with significant relief in February.

We see the same story with investment grade spreads (note the slight change of time frame). The market has been tightening since ~Sept 2014 with significant relief again in Feb.

Inquiring minds might ask what happened in February 2016?  Perhaps Obama won another Nobel Prize? Was the market pricing in a huge improvement in credit quality, perhaps driven by a positive and unexpected surge in economic conditions? Or was is something else? Maybe oil prices started to stabilize?

We retain our bias to short corporate investment grade product, but contemplate changing to incorporate slightly longer duration if and when we get clarity on the Fed’s strategy. Our bias is primarily a function of risk budget, not necessarily opportunity cost of forgone duration... simply put, we’re not inclined to go long in front of the Fed.

Money velocity: At any rate, now that we know the cost of money, let’s look at how fast it’s moving. We summarize: not much and slowing, either of which are bad news.

Labor markets

We see a decade’s trend of increasing numbers of Not in Labor Force and a declining labor force participation. We do note an upturn starting in Sept of 2015 and hope it continues. The big picture, however, is that we have a huge structural problem. Fewer people have skin in our economic game. While it is partially driven by aging demographics and emerging technologies, we believe the primary cause is slow growth in connection with a variety of failed social policies. We’ve run them through the mill before: education, tax, and punitive hidden marginal penalties on social benefits that preclude a transition from welfare to independent employment.  We need all citizens to have skin in the game.

But the official unemployment rate looks robust, and we note is and has been below the Fed’s target. In their world we are at full employment.

The US$ dollar strengthened dramatically for most of 2015 and will apply pressure to reported earnings of US based multinational companies, the full extent of which we’ll start to see shortly. The dollar has weakened ytd and any Fed tightening will bring back upward trend. The US$ remains a haven during times of geopolitical tumult. Trade weighted US$ below:

Commodities: still crushed and crying for mercy

Let’s see, it is ‘buy low, sell high’, right?

Outlook

Our outlook from year end remains fundamentally unchanged. We do note, however, recent work at the St Louis Fed Revisiting GDP Growth Projections which we quote, “Based largely on predicted trends for labor force participation, GDP is projected to grow at an average annual rate of 2.2 percent over the next decade.” This is not their official projection, but rather utilizes a methodology assumes among other things that GDP per labor force participant continues to grow at the same rate as it did for the 2010-15 period. We wonder about that. Regardless, this seems to be a sensible outlook if one is optimistic. It in fact exceeds the annual growth projected by the Congressional Budget Office for potential GDP, which is expected to converge toward 2.0 percent over the next decade. We shall call this the sunny side of life, and one wonders how 2% growth for the next decade will sustain the standard of living of our country and the looming crisis of excessive debt and unfunded government liabilities?

We do just love stable hockey stick forecasts with no discernable downturns on the horizon for a decade, don’t you?

On the other hand GDP Now also a venture of the St Louis Fed paints a very different picture, at least for Q1 2016:

“The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2016 is 0.6 percent on March 28.”

As our Gentle Readers contemplate the skew, bear in mind that Ms. Yellen’s Fed is and remains without qualification “data driven”.  The economic & market consequences of Fed actions sometimes create long term trends or behaviors that can be difficult to reverse.  So we shall look at one particularly stunning example of revisions that can happen to data from time to time? For example Personal Spending in January was revised:  

“from a 0.5% increase reported a month ago, it was now revised to a paltry 0.1%. In nominal dollar terms, this means that instead of US consumer spending a whopping $67.5 billion more in January, the increase was a paltry $14.7 billion, a delta of $52.8 billion!”

Source: One Third Of Q1 Economic Growth Was Just "Revised" Away

Ooops.

Valuations

If we examine S&P 500 Forward 12 Mo. p/e’s over 5 or 10 years, (see p.23, courtesy of Factset) one senses the market is now fully valued. Projected earnings for Q1 2016 are weak: “For Q1 2016, S&P 500 companies are predicted to report year-over-year declines in both earnings (-8.7%) and revenues (-1.1%). Analysts currently do not expect earnings growth and revenue growth to return until Q3 2016. “

“Downward revisions to earnings estimates in aggregate for the first quarter to date have been well above recent averages. The percentage decline in the Q1 bottom-up EPS estimate (which is an aggregation of the earnings estimates for all 500 companies in the index and can be used as a proxy for the earnings for the index) since December 31 is -9.3% (to $26.42 from $29.13)... In fact, if -9.3% is the final number for the quarter, it will mark the largest percentage decline in the bottom-up EPS estimate for a quarter since Q1 2009 (-26.9%).”

The energy sector hurts the aggregate numbers significantly.  “If the Energy sector is excluded, the estimated revenue growth rate for the S&P 500 would jump to 1.8% from -1.1%. “ So the core may be doing just well enough to get by... or not.

We present a slide from Ed Yardini’s  S&P 500 Industry Briefing of 3/22/2016.

Bear in mind there are a variety of valuation metrics & methods, and this is just one. We don’t see a lot of upside these days, but we are of dour disposition.

For some time we have not seen much will change the basic the basic outlook: low and slow growth which batttles the growing dead weight of destructive, costly policy impediments.  Swiss Re has been kind enough to provide one example: The money tap continues to run, while the costs continue to increase. 

It is called mal-investment and is driven by wealth transfers of a whole variety of means. Consider their estimate of interest income forgone by US investors on account of ZIRP (zero interest rate policy) is expressed as a % of GDP, and it is staggering. So much for the social contract of save your money and work hard.

Nothing will change until the election. Beyond that no one has any visibility. In the meantime we will likely see some backwardation induced from the 4-4 paralysis of the Supreme Count. One might surmise further increases in regulatory burdens and a further drifting from rule of law as we have come to know it. The Fed will continue to do whatever & whenever the Fed does. And did we hear Rick Santelli speculate no hikes until after the election so as... and get this... the Fed might avoid politicizing matters?

What to do? We do anticipate more volatility as the market sorts out the earnings announcements, the state of the energy markets, and the Fed’s unfathomable clarity of so many dots & situational data dependency. Asset allocation determines most of your risk, so make sure you've got it right, and part of that  entails sufficient liquidity to manage through & recover from any downturn.  We would not abandon non-US investments as valuations seem to be more attractive than the domestic markets, but we concede the impact of the social & economic crisis that is now Europe & the EU needs time to be sorted out. No doubt costs will be incurred and budgets stressed by the security matters. Meanwhile we can witness the train wreck of Brazil (a must watch) and only dream of competent, ethical leadership and reform of rent seeking & other mis-behaviors, criminal or otherwise, within our political institutions. 

Lastly, we leave you with this little gem which will be the subject of our next posting and shortly so we hope.

...

“one-third of global government debt is trading at negative nominal yields” - Mohamed El-Erian