Countdown to Liftoff
With 38 days to go before the Fed’s September rate decision, we see some signs of risk aversion in markets and continued signs of weak growth outside our borders. Here are just a few examples. Credit spreads spiked last week, as the difference between the Moody’s Baa Corporate Bond Yield®, which acts as a credit index, and the long-term U.S. Treasury bond spiked above 230 basis points (it was 180 basis points back in April). There is a growing number of declining equity issues across the various U.S. exchanges relative to advancing issues.
A good portion of this turbulence can be traced to growing concerns over global growth along with a pickup in currency and commodity price volatility. The latest leg down for commodity prices, for example, are seen in oil (which broke below $50 last week and is down from $110 a year ago), and industrial metals, including copper (-26% year-over-year), steel (-36% year-over-year), and aluminum (-21% year over year). In many cases, slowing growth in China is contributing to already weak non-U.S. demand for commodities. In addition to importing less, China is also shipping more commodities into already oversupplied world markets, further lowering prices, and hurting both commodity producers and those countries whose economies rely heavily on revenue from commodities. Higher-risk stocks are now lagging lower volatility shares as a style preference for investors. The Treasury curve has flattened modestly as expected real rates are rising sharply and inflation expectations priced into the TIPS market have again begun to fall.
Where This Gets Complicated
Latin American economies, such as Brazil, Chile, Columbia, and Uruguay, are all experiencing mounting trouble from the commodity price collapse, China’s slowdown, and the impending Fed rate hike. Making matters worse is the fact that Latin American growth is essentially 0% and inflation is accelerating. Brazil, whose currency has fallen by 25% this year, is experiencing inflation near 9%. All of this increases the complexity of policy decisions for these countries, as hard choices need to be made between supporting weak economies and risking higher inflation or attempting to reign in inflation while risking an even worse economic downturn. The flip side of this is that the U.S. becomes even more appealing by contrast for global investment and capital flows. This could have the effect of further strengthening the dollar and accelerating investment in U.S. real and financial assets. This, too, could complicate the Fed’s efforts, as they seek to dial back ulta-accommodative monetary policy on their own terms and timetable.
Although China continues to rebalance its economy with more Gross Domestic Product (GDP) coming from domestic consumption and services, China is downshifting to a much lower growth rate than what we saw since 2000. As this happens, we think China will struggle with a variety of issues. The property sector will remain a drag, for example. The combination of a stronger currency and higher wages will chip away at some of the country’s manufacturing competitiveness. Elevated corporate leverage following a long credit cycle exposes a variety of potential risks. Fiscal constraint likely will continue to rise. In addition, recent issues including a falloff in non-U.S. demand and a sharp pickup in stock market volatility will also pose drags and risks as we move toward 2016. China’s troubles are obviously contributing to the pickup in global risk aversion this year and dampening year-to-date returns for equity indices such as the Dow Jones Industrial Average (Dow) and S&P 500.
Looking for A Pickup
We are hopeful that growth will pick up toward mid-year. On the positive side, we are happy to see the 0.9% drop in the unemployment rate since this time last year, as it suggests that final demand here should be able to continue apace. Of course, the steady improvement in jobs is not lost on the Fed either, which seems intent upon moving forward with their first rate increase in over a decade despite the aforementioned pickup in financial market jitters and the challenges still confronted by our trading partners. Just last week, Dennis Lockhart, a typically centrist member of the Federal Open Market Committee (FOMC), commented that the U.S. economy would have to suffer a “significant deterioration” for him not to support a September 17 rate hike.
Overall, our view has not changed despite continued progress on the domestic economy. We still see a mixed bag of data once we incorporate real-time market based indicators and foreign inputs to our data analysis process. First-half growth was weak, and our base case calls for an improvement in the back half of the year. From a tactical perspective, we need to see further evidence of improvement before increasing our equity allocation, however. From a security selection perspective, we are noticing that companies with higher-risk profiles are now exhibiting signs of fatigue after a two-year “risk on” environment. Consequently, we have been making select substitutions where we can find better quality at still-reasonable valuations.
S&P 500 companies are tracking toward a 1% earnings decline for the quarter. Currency issues, weakness in Europe and China, and commodity pressures are all contributing factors toward the weakness. Still, there is hope that earnings will pick up from here as the dollar’s advance fades, commodity prices find a floor, and global growth picks up into 2016. Analysts are looking for $127.40 in earnings over the next 12 months, putting the forward P/E ratio at 16.3x — 15% above the 10-year average. Net income margins are also elevated (but falling) with 9.7% expected versus a 10-year average of 8.7%. Mean reversion of both of these measures would drag on returns which will rely more on underlying growth, dividends, and buybacks as drivers of return.
Asset Allocation Portfolio Posture
LONG-RUN STRATEGIC POSTURE: Strategic allocations are set to reflect our long-run forecasts for key asset classes. We expect policy rates to remain low as central banks continue to push lower-for-longer rate strategies. Eventually, rates should rise back to more normal levels, but this is expected to happen gradually and unevenly. Fixed income returns are expected to lag current yields as rates rise. Equity returns will track moderate growth in global GDP with little to no further lift from margin expansion (margins are already elevated). Equity valuations appear reasonable and in line with historic multiples, so no additional return is being attributed to margin expansion.
The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.
Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small company stocks are typically more volatile and carry additional risks, since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.
August 10, 2015
Kevin Caron, Portfolio Manager
Chad Morganlander, Portfolio Manager
Matthew Battipaglia, Analyst
Suzanne Ashley, Junior Analyst
The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Indices are unmanaged, and you cannot invest directly in an index.