Sound and Fury
Family reunions. Company picnics. Grade school field day – if you can remember back that far. Usually, these are fun gatherings. Usually. And sometimes you find yourself pulled into a friendly match of tug-of-war, whether you wanted to participate or not. You’ve got a bunch of people on one end of the rope, and a bunch of people on the other end of the rope, and then a lot of yelling, grunting and straining ensues until one side yields to other, often in exhaustion.
A tug-of-war may be the most apt metaphor to describe the markets in February, year-to-date, and even over the past 12 months or so. On one end, you have the bearish forces: China’s slowing growth, Europe weakening, Latin American economies in shambles, and weaker manufacturing all over the globe. But on the other end, you have the bullish forces: a seemingly resilient U.S. economy (which one might argue is debatable), but the most supportive factor is that every Central Banker the world over claims they’re willing to do “whatever it takes” to spur economic growth, even if that means implementing a Negative Interest Rate Policy (NIRP).
This market narrative reminds us of Shakespeare’s Macbeth and the line about life being “a tale/Told by an idiot, full of sound and fury,/Signifying nothing.” Heavy stuff, but indicative of the noise crowding our ears on a daily basis. Let’s start with a review of global events and finish at home, in the U.S.
The Icy North
We haven’t written much about our neighbors to the north in a while, but Canada is struggling mightily. The Canadian economy relies heavily on commodity exports, with one of its largest trade partners being the Chinese. Things were great when China’s economy was growing at break neck pace, but not so much lately. Canada exports oil, metals, and lumber, so the precipitous drop in commodity prices, which we’ve detailed in the past, made 2015 a rather bleak year for Canada. And 2016 looks even worse, with GDP growth estimates now under 1%. The Royal Bank of Canada—Canada’s central bank—expects their economy to pick up in the second half of 2016, banking on improving performance of the U.S. economy which is expected to spillover to the north. Canada’s weak dollar (yet another example of currency weakness outside the U.S.) should be a tailwind for exports, and it has also made Canadian real estate a desirable buy for wealthy Chinese looking to place bets on real property instead of the volatile Chinese stock market.
South America goes south
Things have been even worse on the continent to our south. Brazil is mired in economic and political woes. Standard & Poor’s recently downgraded Brazilian government bonds to junk status amid calls for the resignation of President Dilma Rousseff. A downgrade of credit to anything below “investment grade” is significant, as the parameters of many bond fund portfolios don’t permit holdings of anything below this standard. In addition to the economic and credit worthiness problems in Brazil, a possible pandemic is now an issue. The Zika virus outbreak has reached Ebola-like concern, but Brazilian Olympic organizers have declared that the summer games of 2016 will still be held in Rio de Janeiro in spite of the outbreak. Brazil’s southern neighbor and often bitter rival, Argentina, also struggles with debt-related issues. President-elect Mauricio Macri vowed to resolve the issue of $9b of government bonds which have been in default for 15 years. Macri recently met directly with a small group of the biggest creditors, including the managers of various U.S. hedge funds, and the parties agreed to essentially write off 25% of the defaulted loans. Poof! $2.25b evaporated just like that. The deal is subject to various conditions, and Argentina could still be on the hook for more cash, but the most interesting part of the deal might be that it was drafted on a single piece of loose leaf paper and signed by the involved parties. Talk about budget constraints.
More Troubles for the European Union
Things aren’t great across the Atlantic as the European Union (EU) is having a rough go of it as well. All of us remember how it was Greece’s crises that were going to tear the EU apart, but now it looks as if the United Kingdom (UK) is the biggest threat to euro-stability. UK Prime Minister David Cameron announced a referendum regarding Britain’s membership in the EU. Mr. Cameron seeks a package of changes in order for the UK to remain an EU member, including benefits for children, migrant welfare and immigration reform, protection for the City of London, and a host of other issues. Proponents for a “Brexit” argue that membership in the EU is expensive in light of the benefits garnered by Britain. Those that argue to retain EU membership say remaining in the union is good for business and labor. Uncertainties pertaining to a possible Brexit are high, and European manufacturing, inflation reads, and growth prospects have all been weakening of late. And in a response surprising no one, European Central Bank President Mario Draghi jaw-boned about more stimulus to promote economic growth.
Celebrating the Lunar New Year … and not much else
Asian countries celebrated the Lunar New Year during the first week of February. However, the return to work after the party only prolonged the hangover. Most Chinese and Japanese stocks extended losses right after the New Year. China continues to pump liquidity into its markets to stimulate confidence and consumption, and Chinese officials are in the process of replacing the Securities Chief whose stock market circuit breakers failed greatly at the onset of the year. Stock market mechanics aren’t the only thing not meeting expectations in China. Manufacturing data there continues to trend lower, although estimates for GDP are still coming in north of 6%. It seems that way above trend growth can only be sustained for so long, despite the efforts of central planners. China finished the month on a low note with the Peoples Bank of China (PBOC) guiding the Yuan to its weakest level in three weeks, which was then followed by a cut to the reserve requirement ratio by .50%—the fifth cut since last February, mind you.
In Japan, stocks are also suffering as it seems the fiscal policies implemented by Prime Minister Abe Shinzo are failing. Japan has tried desperately to stimulate growth via low interest rates, quantitative easing, and now Japan has become the largest economy to deploy a Negative Interest Rate Policy (NIRP). For those of you unfamiliar with NIRP, essentially account holders are charged for carrying reserves. That’s right, bank depositors aren’t paid interest; they pay interest for the “privilege” of holding money at the bank. If it seems crazy, that’s because it is. The rationale behind the policy is—in effect— to punish savers in order to promote spending which will, theoretically, promote economic growth. Yet another means of manipulation from central bankers that may look good in theory in a textbook, but it may not work as planned in the real world. We’ll have to wait and see…
Past is Prologue at Home
The same headlines from 2015 apply to February and 2016 so far… focus on the Fed, oil is probably lower for longer, and both company earnings and the economy slowly stumble along. Two notable events during February for the Federal Reserve Board were the publishing of the January meeting minutes and Fed Chair Janet Yellen’s congressional testimony. In each, the messages were the same. Fed officials are concerned about weakening global growth, specifically slowing growth in China, and are therefore exhibiting extreme caution in interest rate policy decisions this year. Even hawkish Fed member James Bullard reversed course in recent statements. The long-time proponent of raising rates sooner rather than later is now stating that the Fed must be very cautious in doing so.
Oil prices and equity markets have interestingly started to move in tandem, exhibiting what’s known as higher correlation. This behavior isn’t typical for oil and stocks, but there have been periods in history where it has happened before. Right now, here’s where we stand: 1) the U.S. is sitting on a historic amount of surplus reserves due to ease of production and lack of demand, 2) despite a rapid cut in rig counts, reserves have increased nearly every week in the past year, 3) Iran’s oil sanctions have been lifted, which will add even more to global supply, and 4) OPEC shows no signs of changing its production plans although the cartel seems to be talking about it an awful lot. The banter is much of what’s moving oil prices. One day Iran says something to the effect of “sure, we’ll play ball and limit production”, and the following day they say “actually, why should we play ball when we’ve been held out for so long; we don’t need to play ball.” And the Iranians aren’t the only ones creating headlines on what seems to be a daily basis. In the U.S., we’ve seen S&P 500 energy company earnings go lower year-over-year to the tune of -73.7%. Ouch. The result of all this is plenty of volatility in the price of oil.
U.S. corporate earnings, on the whole, don’t look that great right now. So far about 87% of S&P 500 companies have reported, and the blended earnings decline is about -3.6% so far. Blended earnings are earning based on actual reports for those that have reported, and the consensus estimates of Wall Street analysts for those who have yet to report. Blended sales are showing a decline of -3.7%. Also not good. In addition, 78 companies have provided negative guidance for Q1 of 2016. There is some good news, however, provided by solid research from the people at FactSet. Companies who generate 50% or more of their sales in the U.S. show blended sales growth of 3.9% and blended earnings growth of 6.9%. What does that mean, exactly? Well, businesses doing business in the U.S. are doing well, but the strong U.S. dollar is hurting multi-national companies whose profits come from abroad. Their goods are too expensive for foreign buyers, so sales and revenues have suffered, and thus earnings as well.
“All the world’s a stage”
A typical Shakespearean drama spanned five acts. Act 1 was the Prologue, which introduced the characters and setting. In Act 2, the Conflict was unveiled, and in Act 3 it continued, rising to the Climax. Act 4 wrapped up the story, revealing unknown details and sometimes plot twists. Finally, Act 5 was the Denouement or Resolution, revealing the final outcome and possibly a lesson. Economic and market cycles are not too dissimilar — a series of plays dealing with various conflicts, all eventually resolved with the great equalizer that is a bear market, only to start again. We’re probably somewhere in Act 3 right now, prior to the climax, with far too many characters drawing our attention in different directions.
Recently, finance ministers and central bank governors from the world’s leading economies have gathered in Shanghai at the G20 Summit to discuss a response to the darkening global economic landscape. Among the many issues facing them is the plunge in commodity prices, market volatility, exchange rates, and the slowdown of China’s economy. While we don’t know how this story is going to unfold exactly, we do know that uncertainties and down-side risks are elevated right now.