Imagine going for an all-star movie, with the lead roles played by oil, a few monetary policy makers, and a handful of large technology and industrial firms. It turns out to be quite the film, ranging across suspense, drama, action, and a good dose of horror. Once you step out of the theater, however, you find that nothing much has changed on the roads.
That’s one way to put how investors felt at the end of Q1 on Wall Street. While the S&P 500 gained a seemingly nonchalant 1.8%, January had just delivered the worst US market open in history, alongside oil plunging over 20%, China over 15%, and Europe, Japan and the United States over 10% in a span of three weeks. And then, as quickly as things went down, it all reversed; in just over five weeks starting February 11th, all the losses were regained, and the S&P 500 ended March in positive territory. Wait, what just happened?
Q1’s drastic moves were heavily macro-driven. While we started January with modest earnings growth expectations (0.3% for Q1, per FactSet), China’s yuan depreciation kicked off a massive sell-off; it was compounded by oil’s continuing pursuit of a bottom, and a plunge in high yielding debt. Across the ocean, European bank stocks delivered arguably the greatest shock, with concerns arising around cocos and insolvency that very few had highlighted at the beginning of the year. The speed of all this unfolding was the most surprising factor; recession talk began filling the media waves immediately, compounding the fear.
The drama came to a head in February, when global monetary policy makers stepped in to save the day with a series of dovish remarks. Starting mid-February, value investors, alongside rebounding oil, led an amazing comeback story that lasted all the way through March. So, we’re good. Or are we? While things may seem normal, earnings expectations have kept deteriorating, and we ended March with Wall Street expecting a 9% drop YoY for Q1. In that case, was the rapid rebound of equities fully warranted? Here’s my take on why 2016’s market remains a work in progress, with two themes highlighted.
Central Bank Influence: In January, the Bank of Japan instituted negative interest rates – another milestone in expansionary monetary policy. The ECB and other peers weren’t too far behind; with more easing abroad, the Fed was essentially forced to back off from the original 4-rate hike projection for 2016. One has to believe that such unchartered territory, with easing all over, has to end someday. How will investors react when it does happen? In the United States, stock markets have essentially tripled since 2009, with labor markets tightening to near-full levels, and wages growing at a 2%+ YoY rate; core PCE is hovering around 1.7% as well, indicating inflation is alive and well if it were not for weak energy prices. However, today, we find over 30% of global government bonds (per the BofAML GG Bond Index) are now yielding negative, and there are valid concerns about an actual shortage of applicable debt left to buy, creating potential liquidity issues given so much has been bought up already by central banks abroad. While well intentioned, the effects of such policies remain up for discussion, given growth continues to remain weak – the United States is tracking at just 0.4% for Q1, per the Atlanta Fed’s GDPNow model; Japan’s tracking at -1%, and the yen and the euro have both strengthened in Q1 – the opposite of what policy makers ended. Could Q1’s results be indicating a central bank bubble for equities? I remain in the ‘no’ camp (for reasons detailed in previous posts, summarized in that there is no other alternative for investors looking for growth exposure), but what worries me is that the policy influence is stretching far across asset classes, beyond the extent of previous booms, such as the dot-com and housing bubble; today, currencies, bonds, equities and commodities are all involved, and global capital flows seem dependent on each word of policy and press conferences. The emphasis on structural changes, fiscal reforms, fundamentals and economic growth seems lacking; investors should be concerned about the direction of Wall Street if Q2 shows more of the same influence by central bankers.
The Leaders Are Mixed: Moving on to the indexes, note that despite the iconic equity rebound, the S&P 500 sector leaders for Q1 were essentially the defensive ones; utilities and telecommunications were up nearly 15%, followed by consumer staples and energy. While a risk-off nature seems apparent, a rate-hike delay likely attracted investors, given these sectors’ dividend yields as substitutes for bond coupons. Industrials also gained, likely to good balance sheets, the desire for value and quality, and as they were beneficiaries from the dollar’s weakness given large international revenue streams. Financials disappointed, down 5%, largely due to their relationships with European banks – some of which were lower by over 20%, high yielding debt exposure worries, and rate hike delays. Alongside, gold gained, up over 16%; this was interesting, as while the safety trade was apparent, I still believe some portion of the rise was due to rising inflation expectations. The US 10-year Treasury yield fell from above 2% at the beginning of 2016 to 1.7%, and the 2-year, more sensitive to rate hikes, fell from 1% to 0.7%; again, explainable by rate hike delays and safety-seeking – and contrary to most investor expectations leading up to 2016. Alongside, crowded trades unraveled; Wall Street had heavily emphasized Europe and Japan as outperformers in 2016 against the United States. This fell flat in Q1; the Stoxx 600 was down 8%, and Japan’s Nikkei 225 was down 15% compared to the S&P 500’s 1.8% rise.
At the same time, investors were not entirely defensive. Emerging markets were up approximately 6% for the quarter, and after the near-apocalyptic jump in high yields in January, junk bonds stabilized, with prices rising over 8% within a month. Small caps also staged a comeback in March, with the Russell 2000 rebounding by 8%, and outperforming its large cap equivalent. So, we saw an interesting risk-on and risk-off blend. Also worth noting is that the sell-off in high yield bonds may have been overdone; spreads were at 7.5% as of March versus a historical average of 5.9%, but the default rate was just 3.2%, versus the historical average of 3.9% (JPM data). I find this to be a good sign, in that investors are being cautious. Overall, the S&P 500 finds itself trading at 16.6x forward earnings (FactSet Data), and the NASDAQ at 18.5x – slightly higher than historical norms, but certainly not stretched.
What to expect in Q2: As Alcoa kicks off Q1’s results on Monday, the markets will look for earnings and guidance to clear up the murkiness around oil and monetary policy influence. Expect the latter to remain in the headlines, especially if inflation does continue to tick up in the United States – a very likely scenario. The pressure on the yuan isn’t going anywhere, either; January’s market reaction to the depreciation greatly resembled August’s, and another episode later in the year shouldn’t be ruled out. Politics will also take center stage in late Q2; while the Republican convention will dominate, a Brexit potential may keep European stocks in check until the results come in. The bottomline? While the bar has been set quite low for earnings, investors shouldn’t hold their breath for good returns from indexes in Q2 – there are too many outside factors impacting returns. Selectivity will count, and Wall Street will remain a work in progress as it tries to find direction in the near term.
However, don’t let any confusion blind you; things are actually clearer regarding the longer term, and there’s a whole lot to be optimistic about. Innovation continues to amaze, and its relationship with Silicon Valley finds no barriers; Berlin, Sao Paulo, Bangalore, Sydney and others are rapidly positioning themselves as tech hubs with great reception. The world finds itself with an average demographic age of 29.7 (IndexMundi data), primed for consumption from emerging markets. And forget the market moves – the astounding number of Model 3 orders and excitement around Tesla was arguably the greatest highlight of Q1, showing that a revolution in transportation may have begun. Editas Medicine (EDIT), a gene-editing firm, had an extremely successful IPO in early Q1, and has delivered 122% since. Facebook’s Oculus Rift saw phenomenal demand, and Boston Dynamics’ robot running through the woods caused YouTube to go wild. Alongside, artificial intelligence continued to make waves, with machine learning and chatbots gaining significant attention. Argentina rejoined the global debt markets, and it was found that the Indian government’s recent banking initiative had created over 200 million accounts for citizens over the past year. Anyone who thinks that things are all doom and gloom is at risk of missing out on such amazingly positive developments. It may be wise to keep expectations low for Q2, but staying optimistic for 2016 and beyond is advised. Wall Street is at center of deploying capital to ideas that are transforming the world more rapidly than ever before, and patient investors will be handsomely rewarded with society’s corresponding progress.
