Capital markets have had an inauspicious start to 2016. Concerns about China, the energy market, corporate profits, and the underlying path toward growth have resulted in widespread selling. In this Market Thoughts, we recap some of the recent trends and provide our thoughts on what it will take for markets to calm.
Today’s selling across global equities and parts of the commodity markets leaves investors longing for stability. In stocks, U.S. small-cap stocks reached two-and-a-half-year lows, falling 22 percent from their June 2015 highs. Their large-cap peers, as represented by the S&P 500, closed below the 1,900 level for only the fifth time in the past 14 months. Brent crude oil prices fell below $30 per barrel for the first time since 2004, and Treasury bond prices rose on increased demand for safer assets.
What is driving this adverse reaction? In a word: recalibration. Financial markets are forward-discounting mechanisms. Investors and traders buy and sell securities based on future expectations. Sometimes, future expectations match existing investor positioning, and markets are tranquil. Obviously, that is not the case now. The narrative appears to be shifting, and in an environment like this, investors are forced to digest information as it comes out.
Why is the narrative shifting? China is one key culprit. The country’s 2015 growth stumbles have spilled into this year. Amid weak manufacturing reports and stock and currency market intervention by the state government, Chinese assets have been under pressure. The energy market also reflects a changing narrative. The initial prospect of a consumer windfall provided by lower gas prices has turned into concerns about demand and employment of workers impacted by falling oil and gas prices. Investors worry about bankruptcies in the energy sector. Energy and commodity market pain has been felt in the high yield bond and emerging market equity markets.
The U.S. economy’s trajectory is also a bit unclear. The job market has shown improvement, as has wage growth. However, corporate profits likely fell for the second quarter in a row, indicating stagnation after years of cost cutting and only modest revenue growth. High yield bond prices signal that lenders are demanding more compensation. Many investors worry about the U.S. economy’s ability to grow while major economies like China, Japan, and Europe are stagnating or slowing.
What could stabilize markets during this recalibration process?
- Steadying Oil Prices. For oil prices to regain their footing, producers need to take capacity out of the system. The U.S. produces 87 percent more oil than it did eight years ago. In fact, at the end of December, the U.S. exported oil for the first time since the 1970s. With improved drilling technologies and newfound exploration sites, the world is awash in oil. Oil demand is unlikely to turn higher in a sluggish global growth picture.
- China: No News Would Be Good News. China’s Leaders are attempting to transition the centrally planned, communist country from a manufacturing and export-driven economy to one driven by consumer spending. Their currency and stock market interventions have not worked to date, and with each additional step, markets get more concerned about China’s underlying health. No news or, even better, a positive growth surprise would be well received.
- Healthy U.S. Earnings. With fourth quarter earnings season beginning, equity markets would like to see positive or at least glass-half-full outlooks from U.S. companies. Past earnings are not as important as forecasts, so credible claims from CFOs and CEOs would be welcome.
- Help From Japan and Europe. Both of these major economies remain in full central bank stimulus mode. Evidence that market-friendly policies are helping stoke consumer activity would help allay growth concerns.
- A Successful Hold of 1,867 in the S&P 500. The market held this level on three occasions dating back to August of 2015. An S&P 500 bounce around that level would instill investor confidence. Breaking through that level to the downside could mean more short-term turbulence.
We do not know how long this recalibration period will last. While the market has recently chosen to focus on negatives, several positive outcomes remain possible. We feel that the capital markets are in “show me” mode, waiting for positive news to offset the negative sentiment enveloping the markets. A sound asset allocation strategy and a clear view of one’s time horizon are an investor’s best friend in this, and any, market environment.
As always, we are here to help ensure that your unique situation is in sync with the current capital market tenor. If we can address any questions or concerns, please to not hesitate to let us know.
Eric J. Freedman
Chief Investment Officer