Watching the newest Star Wars release, many viewers felt they had seen this story before—the orphaned hero from a desert planet, the vile immensity of the Death Star, and the dashing Han Solo astride his Millennium Falcon. It’s a well-worn tale, and well-loved. The story’s echo of the original Star Wars strikes chords of nostalgia for many in the audience.
Witnessing this year’s market volatility, many participants fear that they have been a part of this story before, recalling both the stunning collapse of the dot com bubble in 2000-2002 and the even more violent financial crisis of 2007-2009. These recently experienced market extremes have become a well-worn story, burrowing their way into our collective cultural consciousness. As such, many market participants understandably possess a hyper-vigilance manifest by those who have been burned before and swear it will not happen again.
And yet, we know that outside of Hollywood, stories are neither inevitable nor simply sequels. Each era, each macro event is unique, with its own cast of actors, underlying conflicts, and distinctive resolution. So what is this story unfolding before us? Beyond the hype peddled by too many in the media and on the political stage, what is happening and what does it mean? To sort fact from fiction in this story of our global economy, let’s strive to identify at least some of the key drivers of our story so that we can better understand what is fact, what is fiction, and what to do about it.
A ROUGH START TO 2016
The first few weeks of 2016 have seen fairly widespread selling of risk assets with little differentiation across regions. As of January 20th global equities had declined (10.5%) while global fixed income had offered minimal protection to portfolios beyond capital preservation, rising only 0.9%. Real estate and commodities had suffered similar fates to that of global equities, down (9.2%) and (14.3%) respectively.
ANOTHER CHAPTER IN A LONGER STORY
While the concerns credited in the media for market declines are legitimate and should be incorporated into an ongoing portfolio construction process, we think the market sell-off year-to-date is overdone. The declines seen in risk assets and rhetoric via media outlets appear focused on a more significant negative scenario than what we expect as the base case. We do not anticipate a global recession nor do we foresee deflation taking hold of global economies. For the most part, developed economies are expected to continue a path of low positive growth with core inflation remaining low but stable.
There are, however, some areas of concern, such as China and commodities. That said, neither of these topics is new and both have been well-covered by many analysts for some time. Indeed, over the past few years, issues affecting both China and commodities have resulted in measured portfolio shifts for many investors. Separately, but related, concerns about the health of the US economy and markets also have been voiced due to weaker expectations for corporate earnings, the negative impacts on exports of a strong dollar, and the uncertain pace and size of Federal Reserve rate hikes.
We continue to aggressively monitor these concerns relative to our near-term sentiment and long-term forecasts in order to identify potential inconsistencies in our outlook and recommended allocations. As we move into 2016, emerging markets invite our sustained caution while commodities have yet to re-earn our confidence. Such views remain prudent given the multi-year trends in these areas as well as the recent validating volatility. We are regularly assessing the bigger issue of whether these concerns could turn into a much larger problem. What if changes in China’s economic growth and global commodity consumption shift from serving as merely a headwind to global growth and develop into a global recession with a protracted market selloff? At this time, while we are cautious, we do not think that the current situation supports such a negative base case. Some of the factors we are monitoring include:
KEY FACTOR: CHINA
Signs of deceleration in China are not new; they have been occurring for years now. As we have discussed several times before, the world’s second largest economy is attempting a transition to an internally driven economy from one dependent on investment and exports. Several events over the last few weeks sparked renewed fears over whether the Chinese government has the resources to manage this historic transition. In many ways, these events have been reminiscent of the China-inspired market selloff late last summer.
• China’s Transition
At the heart of investor anxiety resides uncertainty about how much China is actually slowing and the potential impact of that slowing on the global economy. Fears of an economic hard landing in China have been renewed due to weakness in Purchasing Manager Index surveys combined with continued deceleration in industrial production and fixed asset investment. Chinese retail sales were a bright spot in 2015, and only slightly moderated in December, but the numbers caused concerns about consumer sustainability as well. We continue to believe that China’s economic transition will be bumpy, that the old “heavy industry” will continue to shrink while areas such as technology, health care, and consumer products will be the future. We still believe China can navigate a soft landing and relatively effective economic transition but caution that the process will be volatile.
• Equity Market Impact
Local Chinese stock market volatility (e.g. Shanghai, Shenzhen, etc.) reemerged with significant declines causing temporary circuit breakers to stop trading on several days early in the year. It’s important to remember that less than 10% of Chinese households are estimated to have a brokerage account and less than 2% of Chinese consumer assets are in the market; yet, this small group of retail traders dominates daily trade volume. The volatility is a setback for the long-term development and liberalization of these markets, but is not likely to derail the economy. Indeed, we have not seen signs of damage to the Chinese economy or consumers as a result of the market declines in the summer of 2015. In the second half of that year, the pace of growth moderation did not meaningfully decelerate and consumer spending actually accelerated.
• Policy Miscommunication
Policy miscommunication around currency and market trading by the Chinese government also has upset global markets. Further declines in the yuan currency have added to fears that the government will start a prolonged devaluation of their currency to support the economy and spur exports. The knock-on effect has seen investors pulling funds from the region and further selling on fears of more devaluation. Some further declines in the local currency are possible but large scale devaluations are unlikely. Inconsistent policy on market circuit breakers has also contributed to market turmoil. The government seems to be moving towards a more liberalized economic model while intensifying political and social controls; given this unlikely blend of objectives, the risk of unforeseen policy adjustments remains a strong possibility.
Syntrinsic’s Sentiment: China
Market behavior over the last few weeks has not changed our fundamental view on the Chinese economy. We continue to expect a bumpy transition to more sustainable and higher quality economic growth. This transition is a near-term headwind to China as well as to other Emerging Market nations that have close trade ties with China. In contrast, most developed nations, including the US, have more modest economic ties with China relative to their economies and most are in positive economic shape, enabling them, we think, to effectively weather the changing nature of growth in the emerging markets, particularly China.
KEY FACTOR: COMMODITIES
The decline in commodities over the last 18 months has extended into early 2016, with oil prices falling to levels not seen in over a decade, currently below $30 a barrel. Over the past year, the broad equity markets have repeatedly declined in response to the relentlessly sharp declines in oil. Such a relationship implies the following two assumptions:
1. That falling oil is an indication of falling global demand due to a widespread recession; or,
2. That commodity producing firms will see elevated defaults and contagion effects from lower investment and layoffs.
With respect to the first concern, we think that the lower prices mostly reflect near-term oversupply rather than persistent shortage of demand. The second concern outlined above is one we share, but not to the same degree as the market today.
• Global Demand
While global growth is relatively modest, it is positive, with the International Monetary Fund predicting this week 3.1% global growth for 2015, 3.4% for 2016, and 3.6% for 2017, not particularly inspiring, but hardly statistics reflecting a global meltdown. We continue to believe that developed economies are healthy and will be supportive of demand. Oil demand is in fact rising, but—as with the global economy–at a slower pace than previous years.
• Global Supply
At this same time, the supply of oil continues to grow at a robust pace. For almost two years, oil supply has exceeded demand, leading to a significant inventory buildup. Additional foreign supply is creating uncertainty around the timing of the markets achieving a more balanced supply and demand condition. Under the current imbalanced scenario, there are winners and losers. The oil producing countries will see headwinds until this re-balancing takes place. Oil importers—which still includes the US, as well as China, Europe, and Japan—all stand to benefit from the reduced cost of energy.
• Energy Producers
Within the US, domestic shale and energy producers stand to continue losing in the face of the current oil price rout. We share the stock and bond markets’ implied concerns for commodity producing companies but think that the wider effects on the broader economy will be limited due to the positive benefit lower oil prices could have on consumers and companies. Still, defaults should rise for commodity firms and some headwinds should be expected from continued layoffs and reduced investment. We believe that these issues create only a modest headwind to US growth and profits; we don’t believe that they will disrupt the US economy given that oil and gas capital expenditures represent relatively modest percentages of Gross Domestic Product and total capital spending.
Syntrinsic’s Sentiment: Commodities
Weakness in commodities has been building for over a year now due primarily to oversupply in the face of moderating demand, particularly from China. We do not believe price declines are predicting an imminent recession but that current levels reflect the unbalanced nature of many resources, especially oil. There are real concerns for energy producing companies as well as countries, with economies highly skewed towards commodity exports. We continue to be highly cautious about these companies and countries, but only assign a minor discount to commodities’ impact on broader equities and global economies.
KEY FACTOR: THE UNITED STATES
Lower commodity prices and lower global growth have increased concerns for US companies. Corporate earnings have hit a rough patch and continue to disappoint to the downside. Meanwhile the Federal Reserve initiated a rate hike cycle in December 2015 amidst concerns about global growth.
• Strength in US Dollar and Profit Margins
Much of the recent relative negativity in US corporate earnings is due to a stronger US Dollar as well as weakness in the energy sector. Energy companies are struggling but other areas of the US economy remain healthy. Much of the impact of currency translation on earnings due to a strong US Dollar already has occurred. And while the US Dollar is expected to remain strong going forward, it seems less likely that it would experience a repeat of the almost 25% gain of the US Dollar Index over the last 18 months. Corporations still have healthy profit margins despite the energy sector’s skewing margins lower; therefore, earnings are expected to improve and revert to positive growth in 2016. While strong margin expansion is unlikely, we believe margins can be maintained as US corporations remain competitive relative to global peers.
• The Federal Reserve
Some analysts have expressed concerns that the Federal Reserve initiated rate hikes too early and in the face of moderating growth. We do not believe that the raising of rates by 25 basis points (0.25%) from historically low levels will increase borrowing costs to the point of derailing growth. Uncertainty about the future pace of rate hikes is arguably the greater concern. The Fed continues to indicate that future rate hikes will be dependent on macro economic data, specifically, inflation and employment levels. US employment has improved dramatically since the Great Recession and is supportive of a positive US growth environment going forward.
• Inflation and Deflation
Inflation is likely the larger worry and concerns over global deflation complicates the Fed’s decision-making regarding raising rates further. Despite inflation remaining low, we do not believe we are on the cusp of a deflationary environment within the US. Current inflation continues to be strongly affected by commodity price weakness; however, this source of deflation is not sustainable as there are limits to how low commodities will go. Other areas of the US economy actually have seen a pickup in other components of inflation, including housing, education, and medical care. The services industry continues to see stronger inflation than the broader economy while wage inflation has begun to tick upward. The Federal Reserve claims to be taking a balanced approach to raising rates, attempting to avoid a potentially stronger pickup in inflation down the road. Initiating rate hikes early enough stems this risk while a slow—rather than fast—pace of rate hikes would be supportive of growth.
Syntrinsic’s Sentiment: The United States
The fears over the US economy are important to discuss, but the recent market sell-off appears overdone. There are legitimate areas of concern such as energy sector spending and employment. A strong US Dollar and future Federal Reserve rate hikes also should be factored into portfolio decisions. Still, our overall belief is that US consumers and companies alike are healthy and able to handle these headwinds better than at any time since the last recession.
THE STORY CONTINUES
We continue to believe that modest positive global growth is likely for the near future and that a global recession is not on the near-term horizon. This outlook is best supported by healthy economic data in domestic and foreign developed nations. We are more cautious on emerging markets, but do not expect the region to cause a global collapse.
Declines are never easy to stomach, especially sharp ones like the beginning of this year. We fully agree that the cause of much of the selling should be part of the conversation, but think that the market is overreacting and pricing in a much more negative scenario than our base case.
The impact of an evolving China, commodity oversupply, and Fed policy have been main characters in our shared economic story for several years now, and will continue playing outsized roles going forward. They have driven renewed market volatility over the past six months after years of abnormally low volatility and unwavering positive equity gains; whether we like it or not, that volatility is likely to stay with us and must be accepted in order to achieve returns above the risk-free rate. That doesn’t mean that the volatility always will be negative, as we saw last October-November; however, it means that we must understand the environment, focus on fundamentals, and invest accordingly.
This story may not be the most dramatic one to tell, but it’s authentic, and over time, those are the stories that last.
Written in collaboration by:
Ben Valore-Caplan, CEO
Mike Duffy, CFA®, Chief Investment Officer
Alex, Haun, CFA®, Senior Analyst
Akasha Absher, Consultant