QUARTERLY MARKET UPDATE as of April 2016
After a volatile start to the quarter with many indices down more than 10%, stocks rebounded with the S & P 500 finishing slightly up while small cap, and international stocks remained in negative territory. The S & P was led by gains in the Utilities and Consumer Staples sectors, while the Healthcare and Financial sectors languished. There were no additional interest rate increases as the Fed held the Federal Funds rate steady after their initial increase of the short term rate in December. Longer term rates moved lower with the 10 year Treasury falling almost 1⁄2 percent to 1.8%. Recessionary concerns abated, although the growth rate for GDP was revised lower.
A wall of worry hit the market in the New Year. A combination of weak corporate earnings reports, uncertainty over additional Fed interest rate increases, slowing growth in China, and concerns about a strengthening dollar all led to the conclusion that the U.S. economy would be slipping into a recession. Corporate earnings declined for the third quarter in a row. This was heavily impacted by the sharp drop in earnings from companies in the energy sector. The consensus forecast for 2016 corporate earnings now shows an increase of only 2.4%. Per data from “FactSet”, earnings will not become positive until the second half of this year.
Economists disagree over the impact and timing of the Fed increasing rates. Uncertainty always plays a negative role in the stock market, and levels were high in January. As the quarter progressed the Fed softened its tone on future rate increases. Expectations for more rate increases this year are now down to two from four.
Headlines on the demise of China and its impact on global markets were overstated. Slowing growth in China has been an ongoing topic for the last two years. A lack of reliable and accurate statistics plays a role in the concern. But as a developing market, Chinese growth is still double the closest developed market. More importantly, U.S. exposure is rather small with exports to China representing only 7% of total U.S. exports.
Foreign sales represent about 1/3 of the aggregate for U.S. companies in the S & P 500. This is certainly a large enough percentage to have a meaningful impact on the bottom line. The fear of a stronger dollar and lower foreign sales weighed on the market in January. Fortunately, just the opposite happened in the first quarter. The dollar weakened against most trading partners and is range bound against others.
We have looked at the interest rate differential between countries as an explanation for the dollar’s strength. While U.S. rates are at historic low levels, rates in Japan are negative, as are the interest rates in several European countries. Investors have to actually pay the issuer of a bond rather than receiving an interest payment. The incentive is strong to invest those funds elsewhere, as in stock markets or in countries that still pay positive rates. Demand increases for the dollar as U.S. bonds appeal to global bond investors.
A better predictor for the direction of the dollar however, may be the rate of change of growth in GDP and explains the dollar’s recent weakness. Comparing the “Economist” poll consensus forecast for GDP from December to March shows widespread negative revisions to most country’s GDP forecasts. The forecasted growth rate for 2016 in the U.S. has now declined from 2.5% to the current 2.0%. This 1⁄2 percent decrease is more than our trading partners. As the quantitative easing programs are still going strong in the EU and Japan, that continued stimulus, counter to expected monetary tightening in the U.S., suggests further dollar weakness. This relationship to the stock market is complex but currently dollar weakness is favorable to stocks.
Other economic factors suggest growth will remain slow and inflation remains benign. Energy prices have stabilized. Oil prices rallied to $40/barrel but continued upside may be difficult with excess supply still a constraint. Last year’s decline in prices benefited the consumer, but the recent anemic increase in consumer spending suggests the benefit is waning. Manufacturing has been stagnant with broad based declines in production and orders. The housing market has been generally favorable, with low single digit gains in prices and sales. The unemployment rate is still a bright spot, although recently ticking up to 5.0%, it is expected to fuel the continued slow but steady expansion. It may cause a spike in wage growth, an important factor on future Fed rate hike decisions. The lower yearly trend in the employment participation rate adds to that concern.
The market P/E ratio using earnings one year forward is at 16.8, down from 17.3 at the start of the year. Valuations are somewhat more attractive, but continued gains in stocks will be dependent on favorable economic reports. Volatility has declined recently and it wouldn’t surprise us to see that increase. We will focus on higher quality investments with good long term prospects. Our managed stock and bond portfolios reflect this belief. Increased volatility in a slow but steady economy will make this strategy timely.