Market Update – January 2016
I usually like to use the Market Update to offer you reflections on events of the past quarter and observations of underlying trends looking forward. Unfortunately, the disappointment of 2015 and the disastrous start to 2016 defy most sound analyses. Namely, the first two weeks of 2016 gave us the worst opening to a year since 1929, and it is a fact that will cloud every analysis that you read, including this one.
The phrase that perhaps best describes the past year is “paradigm shift.” While the years 2010-2014 were characterized by massive monetary stimulus (an unprecedented $4.5 trillion of new money in the form of quantitative easing, augmented by a zero-interest rate policy), the removal of that stimulus has left us with a volatile, rocky market that is dealing with some unanticipated side effects. Recall that the Fed has purchased tens of billions of dollars of various debt instruments from banks over the past seven years, creating new money in the financial system in the form of Fed credits to these institutions. From the end of Quantitative Easing 3 (QE3) in October of 2014, volatility has spiked and U.S. equity returns have been flat or down. The global markets have fared far worse, as you’ll see from the charts that follow.
Financially, economically, and socially, we have never seen conditions such as these. Keep in mind that the Great Recession of 2008 exposed gaping holes in our economic foundation, bringing the global economy, as well as the financial markets as we knew them, to a halt. Certain things we held sacred — the safety of U.S. Government debt, the security of money market funds, the fundamental solvency of the banking system — were all destroyed. The U.S. Federal Reserve stepped into this void and, for seven years, pumped trillions into the economy to keep it growing. Now that the pump has been closed, we are in a new period of transition and the economy is struggling to find its footing.
Markets
The negative trend that began in the third quarter of 2015 continued through the end of the year and into the first weeks of this year. Domestic equities showed little progress: major indices were down, and dividend yields pushed them slightly positive. International equities were a veritable disaster: developed markets showed small losses while emerging markets blew through all sorts of support levels. The poster child for this was China, which witnessed a mercurial rise followed by a full collapse, followed by a second collapse this past week.
Bonds didn’t do much better. U.S. Treasuries, usually the safest bet, were able to generate a small gain of 1.3%, but didn’t manage to beat inflation. Any bond with some sort of risk associated with it, even small, showed some losses for the year. The biggest story in the bond market was the non-investment grade or ‘junk’ sector. After years of steady gains based on interest income and tightening corporate spreads, the decline in oil and other commodities caused a dramatic reversal. Company defaults for energy firms will rise in 2016 – it remains to be seen how far that will spread to other bond sectors.
In contrast, the tech and healthcare sectors performed above the norm. Amazon, Netflix, Google and Facebook showed growing profits despite significant skepticism from prior quarters. The big name in tech — Apple — wasn’t so fortunate. As one of the largest companies in the world, it is simply impossible to sustain the level of growth it has shown over the past few years. Despite their record-breaking profitability, this dampening of expected growth is beginning to impact its stock price.
The interesting movements mostly happened in healthcare. With the cost of debt virtually zero, and with slowing growth of top-line revenues, there were some amazing mergers that drove strong market returns. An interesting anecdote is Allergan; it announced in July of 2015 that it would sell its generics business to Teva, then later in the year, announced a “merger” with Pfizer with serious expected synergies and tax benefits. If you were an investor in Allergan, you would have seen swings of 25% during the year, with impressive gains along the way if you timed it correctly.
The biggest disruption in the markets continues to be China, where signs of trouble cause serious reverberations through the S&P 500 and the energy markets. The logic driving this is deceptively simple: if China slows down, we lose the growth equivalent of the European Union (as discussed in the October Market Update). But the reality is far less straightforward. China’s total market capitalization is $5.57 trillion, and volatility is driven almost exclusively by failed regulation and the dominance of domestic retail investors.
The link between these factors and U.S. equity markets is most likely a familiar theme: financialization, which drives short-term market dynamics away from fundamental values. We have seen it with gold, oil, the Swiss Franc, and a host of other assets that have been whipsawed by trading momentum. Once an asset or company gets into the trading spotlight, there is a pile-on effect that wildly drives the price, usually down.
Timing will continue to be important given these factors, particularly until there is greater clarity about the direction of the economy and the Fed. While we prefer to focus on fundamentals and long-term holds, our style of active trading is the only one that generated notable gains in the past year, and it is likely the same for this one.
Economy
The Fed rate increase has been a dominant news item for the entire year. The year started with the expectation that the Fed would increase rates pretty early on, which was followed by delays and ultimately doubts over whether it would happen at all. While the impact of the actual rate increase of 0.25% is negligible, the information communicated has a huge impact on the perception of the economy.
In theory, the Fed assembles the country’s smartest minds to analyze the most timely and complete data on the economy available. If they see that we need a tighter policy, it implies strong economic expansion ahead. If they lower rates, it implies weak growth. How the market interprets Fed announcements has become a bit of a sport, with players and spectators wringing meaning from every move of the Fed.
Currently, the Fed’s plans to continue policy firming signals expectations of steady growth in the coming years. The dot-chart below shows the range of expectations of Fed participants on direction and pace. Unfortunately, the market has a different view. And as one trader recently joked with me, “[T]he Fed has accurately predicted eleven of the past zero economic recoveries.” The timing of its predictions have been consistently wrong, and we have yet to see success following a low inflation, low growth mode.
This leads us to share in the concern that the Fed could have it wrong again. Given the market action of the past few weeks and legitimate concerns over global growth, any moderate Fed tightening could risk pushing the economy into a recession. With no room to lower rates, we would be looking instead at somewhat draconian measures to stimulate the economy. Fiscal stimulus, for example, has been conspicuously absent in this recovery. Given current government debt levels and the political environment, increasing deficit spending is largely untenable. So in sum, a recovery is far from certain and there are few options to rely on in the case of another slowdown.
While concerns focus mainly overseas, the domestic figures we track — housing and employment — remain pretty stable. Jobs continue to grow at a steady clip: nearly 300,000 new jobs in December. It is important to note, however, that the overall employment ratio remains at historic lows. Most who lost their jobs in 2008/9 have yet to be re-hired into comparable positions. Millennials, on the other hand, have yet to achieve full-time employment at typical levels and are inhibited by $11 trillion in student debt, which has grown at 12% a year for the past 10 years. Given these nuances, job gains are far from enough to further economic expansion.
The housing picture is similar. Although there is relative stability and some growth, a large impediment here will be mortgages. With rates increasing, banks unwilling to lend in less-than-perfect situations, and regulation shooting up, further increases in the housing market will have to come from fundamental demand as opposed to increased leverage. Growth in the sector is critical to pushing forward the U.S. economy, with labor and raw materials heavily dependent on this dynamic.
So while the recovery is uncertain, there is enough strength in key sectors to believe we will avoid recession. There are dangers that continue — the strong dollar is a headwind for exports and the housing market might stall out — but the fundamentals are still sound. The major exception is the dynamic in the energy market, a major employer in this country and consumer of capital expenditures.
Energy
The factors that lead to sub-$30/barrel crude are myriad, but the most salient pieces of information are the lack of reliable data and complex political dynamics. As we have seen across asset classes since 2008, an asset can be destroyed by traders the second that cracks form, irrespective of fundamentals. A good example is gold, which rocketed up in 2011 to later collapse in 2013 over just a two-day trading period, and it has not recovered since.
We have seen a similar action on oil since mid-2014 when OPEC ceased defending the price just at the time that U.S. shale producers were ramping up to historic highs. Political dynamics play an enormous role in oil: from Libya to Venezuela, there are a range of governments — some more dysfunctional than others — that rely almost entirely on oil revenues, without which the leaders would struggle for legitimacy. The result is an irrational supply dynamic with each actor producing as much as possible to make up for lower prices, driving the oil to nearly worthless values.
A second storyline has emerged that places the focus on the hostility between the Saudis and Iran. Consider the fact that the price of oil is this low at exactly the moment that the Iranians plan to start new exports. While the two countries are partners in OPEC, they are regional enemies representing the competing Muslim sects and fighting their wars through proxies. Iran supports various terrorist organizations and Saudi Arabia unapologetically represses Shia rights and existence internally. It is possible that the oil market has become the Saudi’s latest proxy in ‘containing’ Iran’s influence in the region, despite its impact across the rest of oil producers and their own economy.
At this point, most every major oil producer is producing at or near maximum capacity. The only exception is Iran, which intends to increase exports starting this month but is unlikely to get to pre-sanction levels for years given the nature of their oil fields and their decline in productivity with disuse. Iran has already announced a need for $30 billion in capital expenditures by foreign corporations to restart their fields. In hard numbers, OPEC currently produces 32.6 million barrels per day (mmbd). While the U.S. production peaked at 9.3 mmbd in Q2 of 2015, that figure is starting to decline and has already lost 0.2 mmbd since then. Given the shutdown of two-thirds of the drilling rigs in the U.S. in 2015, that decline will continue for many quarters, even with the relative ease of drilling for shale.
On the demand side, cheap oil and gasoline does only one thing: increase usage. Cornerstone estimates that global demand moved up by 5.0 mmbd since 2014, to 97.0 mmbd, and shows signs of steady increases on an annualized basis. Even demand from China, with their supposed slow-down, increased 2.7% through 2015. With the supply figures stagnant at best, and demand increasing, we will soon flip to net shortages. The problem is that most oil statistics are generated by econometric models, rather than actual measurements. As a result, the data is subject to changing market conditions, taking months and sometimes years to get accurate measures.
We will also see changes in inventories, which reached historic highs in 2015 and are now seeing slow but accelerating declines. The challenge going forward is not low oil, but the shock that is building as all these dynamics develop into unmovable trends. About forty companies in North America have gone into bankruptcy protection because of the fall in prices, and investment by the survivors has come to a virtual halt. It takes years to develop new reserves, far slower than what will be needed to meet the expanding demand for oil. While there are many steps between here and an energy-induced recession, the price becomes disconnected from the fundamentals when one barrel of oil is traded 26 times in one day, as it is now. In short, we are “priming the pump” for a nasty whiplash in oil prices that could create an entirely new set of dynamics in the years ahead.
COP21 and the Climate Agreement
Ironically, the major highlight to 2015 is the complete antithesis to the oil situation. While oil producers have created a situation in which oil consumption will reach historic highs, 195 nations agreed to find ways to reduce carbon emissions to avoid global warming beyond 1.5ºC. While this limit is unlikely to be enough to prevent dramatic change to the environment, it is projected to be enough to allow the planet to be habitable beyond the next century.
The dynamics here are complex and difficult. It took over 20 years to reach this consensus, during which time most of the damage is already done and not reversible. Getting all the countries to agree was a herculean effort, but the compromise is that this is not binding and not funded. It is also unclear what each country needs to do to get there.
But despite the shortfalls, the ramifications will impact the economy and the markets for decades. The changes today are nascent: solar and wind companies have started to grow in market cap and are investable sectors, but they have yet to generate the sorts of returns one would expect from disruptive technologies. Energy has dominated the equity and debt markets for decades, as one of the core growth drivers and income producers. Going forward, as we shift away from a carbon-based energy infrastructure, those market fundamentals will have to find a new home, presenting significant challenges to asset managers. At the same time, the opportunities that open up will be enormous.
Despite the bottoming out of oil, coal and natural gas, renewables saw more money invested and capacity added in 2015 then ever before. And of all champions of renewables to emerge, China spent a record $111 billion on clean energy infrastructure in 2015. But an unintended consequence of this investment is that it has wiped out profitability. Take the solar industry as an example: back in 2008, First Solar soared in value to $300/share on the prospect of panels on every home and building. But after the Chinese entered the market in the way that a rhino enters a swimming pool, the profitability of that industry disappeared. With the help of extensive government subsidies, Chinese manufacturers reached massive scale driving down global prices on panels. Now First Solar trades at $60/share.
How this all impacts the investing community is still unclear. But given the burst of new capacity, it is global agreements such as COP21 that will foster increases in demand necessary to restore profitability. In time, investment opportunities will become clearer, whether it is direct manufacture of alternative energy components, delivery systems or enabling technology to improve existing systems. All companies need to adopt sustainable business models that balance the needs of environmental stability with those of society. Without that balance, revenues will be challenged and profits will diminish. Businesses able to strike the balance will not just survive, but thrive, in the next economy.
Summary
We are in the most difficult period since 2008, and it is not clear when the next recession will hit this country, or if we are insulated from the next global slowdown. But despite the emotional anxiety of the markets, the fundamentals in the U.S. are still strong. What we haven’t experienced in a long time is a domestic market devoid of government stimulus.
Adding to the anxiety and uncertainty is this backwards dynamic of plummeting energy prices at a time when the global community acknowledges that our energy infrastructure needs to be radically different in the future. With this layered on top of a growing global population, it is no wonder that the markets are unclear. The world is changing dramatically, and that can be frightening.
We will continue to invest in this market with some risk assets (such as equities), but will continue to be very selective about these areas. The balance needs lean towards predictable, stable investments, which are plentiful yet only marginally better than cash in some instances. The resulting mix emphasizes that returns will be muted in this period of transition, until there is greater clarity on the sources and sustainability of economic growth.
We are staying patient, and expect many interesting opportunities to emerge. In the mean time, the volatility and uncertainty will continue to spook the markets and investors. A steady perspective, and a keen eye on identifying value in the rubble of market volatility will continue to be the basis of our management of the situation.
Regards,
David B. Matias
Managing Principal