QUARTERLY MARKET UPDATE as of January 2016
Stocks rebounded in the fourth quarter. Most sectors were up led by Healthcare, Materials, and Technology. U.S. equities, as measured by the S & P 500, finished slightly higher for the year, while small cap and international markets were still in negative territory. After much anticipation, the Federal Reserve Bank raised short-term interest rates ¼ of a point, the first increase since 2006. Yields for two-year Treasuries moved above 1% for the first time in 5 ½ years, and longer-term rates were marginally higher. This year the yield curve should continue to flatten with more rate increases, as the spread between short term and long term rates will narrow. For stocks, corporate earnings are expected to grow by 7% which should provide for a more positive year, if the dollar stabilizes.
We expect economic growth (GDP) for 2015 will be a moderate 2.2%, and to pick up slightly to 2.4% this year. That is just below “The Economist” consensus forecast of 2.5%. A slow but steady growth rate should allow room for the Fed to gradually raise interest rates as they move toward a policy of normalization. Growth in the Euro zone and Japan is expected to improve but will still be less than in the U.S.
The dollar’s strength against the Euro peaked last March but continued to move higher against most U.S. trading partners. This has made for a challenging manufacturing environment in the U.S., as it raises the prices for U.S. companies’ goods and services and lowers the prices for our trading partners. Our concern is to the extent of that trend. The sharp market correction last August was driven in part by a swarm of devaluations around the world initiated by China’s devaluation. Both the higher growth rates in the US and the lower interest rates abroad suggest this trend could continue. Moderate dollar strength is tolerable, but a big move would likely disrupt the markets.
While manufacturing has been hampered by the dollar’s strength, the consumer has benefited. Prices of imported goods are lower and commodity prices, especially lower energy prices, have allowed consumers to pay down debt and increase spending. The consumer represents 70% of the economy and has been the main driver of growth. Consumer confidence is high, and housing markets while slowing lately have steadily improved.
The Fed’s key inflationary indicator, core Personal Consumption Expenditures, remains below the 2% target. The other main objective, to maximize employment, remains healthy. The unemployment rate has stabilized at 5%, and continues to improve on an annual basis. The goal to normalize interest rates and bring rates up gradually will be impacted by ongoing growth. The expectation is that if rates are normalized, lending will improve, which in itself will boost growth. We expect to see more rate increases this year, but only if growth stays on course. A slowdown in the rate of growth of GDP will likely hold off the Fed from further increases.
Stimulus efforts in the Eurozone and Japan should allow the small increases in their GDP to stay on track, but we do not expect to see any significant changes. This is especially evident in the EU which still needs to tackle labor reforms to improve long term growth. In the Emerging Markets, stocks have been hurt the last few years from declining prices of resources and the dollar’s strength. As commodity prices are not projected to climb anytime soon and debt typically is paid back in dollars, we see this year as continuing to hold back the emerging market economies.
The bullish U.S. stock market while in its later stages has room to grow. Typically at the end of a bull market there is a high level of euphoria and valuations are expensive.. Currently we have neither. Most market sentiment indices are neutral or even leaning towards pessimism. The P/E ratio using earnings one year forward is at 17.3. That is above an historical average of 15, but below the 20+ level we had in past peaks, and more justified in our lower interest rate environment. As alternative asset classes do not offer better prospects it makes sense to stay the course on stock market exposure.