January was rough on Wall Street. Kicking off 2016, the S&P 500 ended down 5.1%, the DJIA ended down 5.5%, and the NASDAQ ended down 7.9%. That wasn’t all; oil had lost nearly 18% as of January 26th, and junk bond yields touched nearly 10% mid-month, highlighting an ominous 8% spread over treasuries – one that has indicated recessions in the past, per analysts. Similar quirky statistics continue to be circulated – it seems, with greater velocity – each day, in articles arguing why a US recession should or shouldn’t occur in the coming months. Here are my two cents.
To be or not to be…in a recession: Should investors fear a recession? Why not? Having caution and acknowledging risks is always useful. Consider recent economic data. We’re in an earnings recession, and corporate revenues seem to be following the trend down in Q4 alongside heavy foreign exchange headwinds, given the trade-weighted dollar is up 20% over the past 14 months. US industrial production has declined in 10 out of the previous 12 months, and profits last peaked in the summer of 2014. Alongside, the small cap Russell 2000 index is already well into a bear market alongside the Dow transports, and they’re in the fine company of numerous large emerging and developed markets abroad. Meanwhile, China’s debt ratios remain, to put bluntly, extremely scary, and Wall Street is gearing up for a battle with the yuan. If the hedge funds win, a depreciation would cause a turmoil potentially of proportions we have never seen, given China’s $11.4 trillion economy wasn’t nearly as big in the 1990s, when past emerging market currency crises occurred. So, yes, it would be wise to be concerned about 2016 for the economy.
Anyway, that’s the gloomy part. How about the bright side? The US has essentially full employment, unemployment claims are maintaining a healthy level, and the yield curve is pretty resoundingly upward. There’s no perceivable demand shock, given higher rates or credit crunches are nowhere on the horizon, and consumer debt levels are resoundingly solid; JP Morgan data shows debt payment as a percent of disposable income is at a multi-decade low of 10%. Cars are selling, houses are being built, and consumer confidence is high; household net worth is at all time highs, too. From a supply perspective, there’s essentially no inflation or commodity spike; rather, the opposite is happening with oil’s collapse. With the US being a net importer of oil, consumers, in theory, should have more to spend – and if they don’t now, that’s fine, because at least they save and can spend later. Importantly, services employ over 80% of the population, but with some data from Deutsche Bank, we see that 70% of the S&P 500’s earnings come from goods-manufacturing firms; as a result, a large-cap profit recession may not necessarily lead to an economic recession. American banks are also looking solid; per Barron’s, fewer than 5% of their loans have energy sector exposure, which means a collapse in junk bonds would remain muted; alongside, capital requirements have led to extremely robust balance sheets (and also a low return on equity, as we know well). Overall, there is no obvious euphoria – or, say, ‘irrational exuberance’ in the stock market; the S&P 500 is trading at roughly 15.2x forward earnings, per FactSet, while the NASDAQ finds itself at 17.1x – essentially in line with historical averages.
To summarize, the recession call is a toss-up – plenty of evidence to back up both sides. As you can probably tell, I’m in the no-economic-recession-upcoming camp. Bear in mind that bear markets are a different subject. Time will tell, but in the meantime, here are a few more curious points to keep in mind as February unfolds:
The Monetary Disconnect: The Fed is pricing in 4 hikes for 2016, while the market is pricing in essentially none. Where there’s a disconnect, there’s uncertainty, and where there’s uncertainty, there’s volatility. The BOJ’s negative rate decision last week, potential emerging market currency wars and weakness abroad is already leading to tightness in America, and until we have more clarity from the US Fed (perhaps when Chairwoman Yellen speaks next week), expectations from the market should remain low. We’ve highlighted earlier that QE led to significant equity gains, including multiple expansion; since it ended in October 2014, the markets have lost value. The relationship cannot be disregarded. Further tightening will uncover whether the market fundamentals are solid enough to withstand higher rates; right now, things look a bit dicey in the global context.
The Political Situation: Have you noticed Bernie Sander’s epic rise in the Democratic race? Likely, yes – and so has everyone else, including Wall Street. Despite all the rhetoric, it’s common knowledge that the markets would prefer, and were expecting, Hillary Clinton to be the Democratic nominee until a few weeks ago. If Iowa and New Hampshire feels the Bern, so will the markets. Watch this space. The election season is just beginning, and given the implications of oil, immigration, corporate tax, and foreign policy, there is no doubt that America’s votes will be closely watched by investors.
Earnings Season: Yes, and finally, the fundamentals. Foreign exchange headwinds, macro weakness, and iPhone saturation is hurting the markets; at the same time, Facebook, Under Armour, Google, and several other growth stocks have blown through the roof. Investors are starved for growth, and as a result, be prepared for continued major moves amid surprises in earnings. Innovation and structural trends don’t stop for market corrections, and investors that stick by the firms that define tomorrow will be rewarded; there’s plenty of phenomenal stuff going on in all sectors of the S&P 500 today. But more on this subject in the next post. As of Feb 1st, 40% of the S&P 500 had reported Q4 earnings, with 72% exceeding earnings estimates, and 50% exceeding sales estimates, per FactSet. The guidance from the remaining firms will be of particular interest as analysts dissect where the year is headed for corporations.
What it means for you: Would it help to have energy experts, geopolitical analysts, economists, corporate executives, and consumer representatives together to understand what’s going on? Perhaps, but there’s an easier option…and that’s Wall Street. The beauty of stock markets is that all the information comes together to drive value and returns; emotion, of course, adds to the charm in the short term. 2016 is proving to be an incredibly complex market environment – watch Q4 earnings and the January jobs report on Friday, and maintain low expectations regarding the direction the market takes as February unfolds.
