Following the post-COVID stimulus hangover in 2022, the bull market has continued to run. One of the key factors was the Federal Reserve’s decision to
Market Update from Sand Hill Global Advisors | February 15, 2016
Published Date : February 15, 2016
The markets are off to a rough start this year, culminating last week with a capitulation-like sell-off that left the S&P 500 Index down 10% since January 1st. The pull-back was triggered by many of the same worries that we experienced last fall: China’s slowing growth and their overvalued currency, the Federal Reserve’s decision to hike interest rates, commodity price weakness, and a string of global economic reports that cast doubt over the strength of the expansion.
Given the severity of the sell-off, we wanted to keep you abreast of our thinking at this decisive moment in the market place.
Stepping Back for a Moment
Our recent investment outlook has been predicated on the belief that we are in the middle of a moderate economic expansion. Our current expansion has averaged just over 2% annual growth over the last 7 years – and based on current indicators, will likely grow about 2% this year as well.
While a 2% growth rate certainly marks positive progress for the economy, it also represents the most sluggish of all economic recoveries throughout the modern period. This sluggishness has meant that markets have been highly susceptible to outside shocks as investors have suffered through a series of ‘fits and starts’ in economic activity, along with economic soft patches and their corresponding market consolidations. The reasons behind each of the market pullbacks during this recovery have changed, but the root cause has always remained the same – concern over the outlook for economic growth.
While the fundamental issues at play this go around are significant, it is important to put some perspective around this particular selloff’s primary drivers:
- The Chinese Economy: China, as the world’s second largest economy, has a significant impact on the world’s growth rate. Following years of extraordinary growth, the law-of-large numbers -combined with China’s widely-cited transition from a manufacturing-led economy to a consumption-led economy – has finally caused a substantial slowdown in the country’s headline growth rate. Complicating matters, China’s currency, which has historically been locked in a quasi-fixed exchange rate to the U.S. dollar, has appreciated significantly over the last year. This had created an overvalued Chinese currency, higher cost Chinese goods and a slower Chinese export economy. This in turn has resulted in several currency devaluations, leading to market dislocations and further slowing of global growth – a cycle that is likely to continue until our two currencies find a comfortable resting relationship in the coming year.
- Commodity Price Weakness: Meanwhile, China’s slowing demand for commodities, combined with OPEC’s deliberate oversupply tactics, has resulted in a dramatic fall in the price of oil over the last year. Historically, a pullback in oil was considered a ‘good thing’ as it led to improved consumer spending – as less money spent at the pump could find its way into other purchases. But not this time around. Technological advancements in drilling allowed the U.S. to access previously uneconomical oil reserves which led to the highest U.S. production levels in history. As oil prices fell, that reality acted as a countervailing economic weight, as energy and energy-related industries saw a drop in their corporate profitability; and many people in the industry lost their jobs. Further complicating matters in this sector, when oil falls a little bit, it’s considered a potential ‘tax cut’ to consumers. When it goes down a lot and it goes down fast, it can become a balance sheet issue for the weakest companies in the oil patch – and that has led to some isolated distress in the high yield credit markets. Encouragingly, there is some evidence that the consumption benefits of lower priced oil are beginning to come into play – and that the associated credit market stress is both isolated and quite possibly, overly pessimistic.
- The Federal Reserve: Finally, in the midst of slowing worldwide economic growth, falling commodity prices and little to no evidence of sustained inflationary pressures, the Federal Reserve still began the process of normalizing interest rates late last year. The change in liquidity trends caused by this admittedly modest initial hike were amplified worldwide as the U.S. dollar strengthened in anticipation of the move, adding further pressure on the overvalued Chinese Yuan, slowing growth and contributing further to the price pressure in oil. While widely considered to be a policy mistake today, the Federal Reserve marginally tightened financial conditions, further adding to global growth concerns. Based on recent testimony, we expect the Federal Reserve to effectively go on hold at their upcoming March meeting.
Of course, as markets fall, negativity thrives and additional issues seem to gather, including European Bank concerns, geopolitical concerns, presidential primary concerns, technology stock concerns, aging bull market concerns and even negative global short-term interest rate concerns. Combined, the sum total of all of the above has created a pretty negative environment for stocks as we start the New Year.
The Markets versus the Economy
The market is a discounting mechanism as the old saw goes. And as such, it is in the process of stepping back and recalibrating expectations for lower worldwide economic growth in the first half of the year. There is simply less growth in the world today than people had recently thought – and that has translated into the world economy being a riskier place right now than previously thought. And perhaps not surprisingly, investors have sold riskier assets and hunkered down. However, we believe the underlying economy remains resilient if somewhat battered. We also believe the macro forces driving the recovery do not often change as dramatically as the emotions of investors – and the speed and magnitude of this correction are disproportional to the evidence at hand.
Consider the current state of the bond market. Long bond yields have fallen sharply as the markets have given way to this particular growth scare. As a result, the current yield curve is the flattest it’s been in almost nine years. What that means is the bond market is essentially calling for near-zero growth and near-zero inflation for a long-time out into the future (almost a decade actually).
While we will slow slightly in the first half of the year, the economy should return to a 2% or better growth rate by mid-year. While the near-term slowdown is not ideal, we don’t need 2% growth to prove the bond markets wrong. We don’t even need 1%. It’s assuming zero.
To be sure, some parts of the economy have started to show strain, particularly the manufacturing sector. However, most economic indicators show no sign of a recession looming on the horizon. Job growth in January was healthy and employers are having trouble filling vacancies. Retail sales have recently trended higher. Housing remains strong. Wages started to rise in January. Bank lending is not slowing and consumer confidence is resilient. The fear, of course, is that these economic data points will falter as the year progresses, but based on current readings, the U.S. is projected to grow just north of 2% in 2016.
Your Portfolio
The question at hand is whether the market today is over-discounting and over-extrapolating near-term trends well out into the future. Based on the resilient strength of the economy, we think it is.
While we are not looking at this moment as a ‘back up the truck’ buying opportunity, it does feel like we are close to a possible inflection point for the markets. Yes, there can always be more downside, but we don’t see the conditions present to create a systemic event from this particular growth scare. Again, the economy rarely changes at the same pace and with the same volatility as the underlying markets.
Beyond the short-term, we still see a positive outlook for stocks, helped by a combination of relatively attractive valuations compared to bonds, slowly normalizing global monetary conditions and a continuation of moderate economic growth. Over time, China will continue to be the greatest consumption story the world has ever seen, the Chinese currency will find its equilibrium and their growth story will move forward. Oil prices will stabilize as supply and demand characteristics normalize in the second half – as all cyclical industries tend to do. And of course, signs that global growth is more constrained in the near-term will have the effect of ensuring the Federal Reserve alters its stated plans and remains very gradual in its approach. Investor emotions will eventually calm.
We are fully cognizant of the rapidly evolving environment and the toll that these world events have taken on the economy and on investor confidence. We are aware that these economic soft patches are a part of the investment landscape from here as this subpar recovery moves forward. Although there are no assurances in the market, volatility usually creates dislocations and as confirming data points present themselves, we have begun to take advantage of those opportunities on your behalf.
Specifically, we are concentrating on (i) taking advantage of the dislocation in the markets and the price opportunities observed in certain securities and asset classes; (ii) maintaining our commitment during this most recent mid-cycle slowdown to our longer-term moderate economic outlook, and (iii) seeking to emphasize higher dividend paying strategies, now that many dividend stocks have yields twice the current yield on the 10-year Treasury bond. Ultimately, we expect the U.S. recovery will continue to trudge forward, albeit with less spring in its step in the immediate term than when we entered the New Year just six weeks ago.
We hope this update helps put the current state of the markets, the economy and our view in better perspective. Please don’t hesitate to contact us to speak specifically about your own portfolio and strategy.
– Your Sand Hill Team
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