Did you know that 2014 was the warmest year on record? Most of the U.S. enjoyed a cooler start for the summer this year, but right now it’s pretty hot for us in North Texas. Still, it’s probably not a bad time to go somewhere even cooler in these last few weeks of the summer, a place like Europe where our U.S. dollar buys you more. Looking to the southern part of the Eurozone, great discounts are still available, whether you are considering a vacation there or investing in their markets which are crumbling like ancient architecture. But you won’t beat the heat. In this newsletter, we are going to spend most of our time reviewing last month’s themes, as they truly still applied to July.
The Default that Launched 1,000 Headlines
Christopher Marlowe, in Doctor Faustus, refers to Helen of Troy’s beauty by waxing poetically that hers “was […] the face that launch’d a thousand ships/ And burnt the toppled towers of Illium.” Similarly, the Greek default of 2015 is the default that launched a thousand headlines, however whether it will topple the Eurozone or the Euro remains to be seen. Let’s just hope this chapter of Greek history doesn’t last as long as their siege of Troy did in the Trojan War: ten, long years. To recap, our call was correct that Greece would default on their debt payment. The quarter started in the middle of the Greek crisis, with banks closed, their stock market closed, and the Greek people voting on a major referendum. They defiantly voted not to accept the creditor proposals requiring significant austerity measures, including pension cuts, spending cuts, and tax increases. However, as time passed, and their options dwindled, Greece eventually acquiesced to a deal that was essentially the same one it rejected only days prior.
As of this writing, Greek banks are open, albeit with capital controls on withdrawals, and the Athens Stock Exchange is open for trading as well, but suffered a massive sell-off in its first day back. To make matters even worse for Greece, the International Monetary Fund (IMF) dropped a bombshell on Athens when it stated that the country’s high debt levels and its current record of poorly implementing reforms would disqualify it from a third bailout. IMF staff members will participate in bailout negotiations with other creditors, but a new program could be months down the road, and even push into 2016.
The 800 lb. Dragon in the Room
From July 1st through July 8th, the CSI 300 (the Chinese version of the S&P 500 index) tumbled a whopping 26%. Through the end of the month, the CSI 300 recovered some, but not all of that loss. Going back to the index’s peak on June 12th, the downturn represented roughly $2.7 trillion of wealth. Let that number sink in for a second, that’s 2,700 billion dollars. However, the CSI 300 remains positive so far for the year, and is up more than 10% YTD (end of July). Still, despite the turbulence in its markets and banking sector, China presses on. In fact, this fall China will again lobby the IMF to become one of the world’s reserve currencies. However, there are many financial reforms that must be enacted before their currency can pass the IMF’s stringent tests for reserve currency status. The Chinese government retains effective control over almost 95% of bank assets. Chinese regulators did impose various restrictions in an attempt to dampen market volatility. Early in July, China’s biggest brokerage firms unveiled a government-endorsed plan to buy at least 120b Yuan ($19.3billion) of Chinese shares. Beijing also suspended the rollout of new stock via Initial Public Offerings (IPOs), and nearly half of all Chinese listed companies suspended their shares from trading on Chinese markets.
There are a growing number of analysts, economists, and investment managers in the community who have voiced their concern about what is happening in China. Recent revelations show that, as their stock market plunged this summer, Chinese regulators floundered on how to respond to the crisis in a coordinated matter.
As reported in a Federal Open Markets Committee (FOMC) Statement released on July 29th, every voting member of the Federal Reserve Board (“the Fed”) was in favor of keeping rates near 0%. The statement reported moderate expansion in economic activity, citing housing and job gains in a positive light. However, the statement also cited soft business fixed investment and net exports, as well as underutilization in the labor force, as detractors to economic growth right now. In addition to acknowledging that inflation has been running low, the statement noted that inflation will likely remain low for the near term. It should also be noted that second quarter GDP was reported at 2.3%, lower than the consensus expectation of 2.6%.
Some economists and strategists are predicting a rate hike in September, and that could certainly happen. Right now, if the Fed needed to stimulate the economy via “easy money” policies, it has very few tools left in the toolbox. The Fed Funds Rate already sits at near 0%, so a move downward is not an option. This is why getting rates up is desired so much by the Fed. They want to reestablish rates at levels with a downside cushion. The IMF renewed their call for the Fed to keep rates near zero until clearer signs of wage and price inflation are apparent. We believe that rates will remain low due to the issues we’ve pointed out in recent newsletters – namely low inflation, dollar strength, the dollar’s impact on earnings, and the possibility that a premature rate hike could send the economy back into recession.
Let’s spend some time looking at corporate earnings reported thus far. The last week of July saw 174 S&P 500 companies report, and 354 companies have reported to date during this second quarter’s earnings season. Of the companies that have reported, 73% have reported earnings above estimates, and 52% have reported sales above estimates. Those are good numbers. Low oil and gas prices are great for consumers and for the profitability of most of corporate America, but low oil prices have taken their toll on the Energy sector. In fact, the Energy sector reported year-over-year earnings declines of -57% and year-over-year sales declines of -32.7%. Energy-related businesses have suffered, some have shuttered their doors, and thousands of employees have been laid off. Also, there’s a good chance consolidation will occur with big oil getting bigger by way of leveraged shale players being acquired. It’s the little guy that gets hurt the most when profits tumble, and the big boys have the money to step in and buy up what’s on sale.
The recent nuclear deal between the U.S. and its allies and Iran will eventually add more oil to the world’s supply, which is likely to send oil prices even lower. With the Energy sector slashing jobs and reducing capital expenditures, the sector is likely to remain troubled for some time.
If the Energy sector were excluded from the S&P 500, we would see blended earnings growth jump from -1.3%to 5.4%. Simply put, the energy sector’s angst is muddying the water for the rest of the market. In the second quarter, we saw positive earnings and sales from several sectors including Healthcare, Consumer Discretionary, and Information Technology. So, there is good news out there! It’s just that the good news has come with negative guidance about future earnings, and the key numbers where we want to see growth are not quite there, at least not yet.
The “key numbers” we’re referring to are sales. Sales growth—organic revenue growth and business growth—will be key to stock performance over the second half of the year. Consumer spending, personal income, and core inflation will all be reported the first week in August. These critical data points will be major factors in the rate hike decision to be made by the Fed later this fall.
We think markets will continue to trade with increased volatility, but we encourage you to ignore the noise. The media will continue to yell at us about Greece, China, and the Fed. Or they’ll be hyping up the latest IPO, or talking about the latest stock trading at its all-time high. Remember, big headlines and high ratings make the media more money. (Don’t forget that they’re in business to sell commercial time.) Right now the all-time intra-day high for the S&P 500 is 2,134. Ultimately, 2,134 is just a number, a record to be broken. Eventually, every all-time high is replaced by another all-time high. No one knows when that will happen, and that is why you have to invest with a plan and have disciplines in place. It’s our job to put every data point, both fundamental and technical, in context, and from there the investment process dictates what we buy, hold, and sell.