Market Update – July 2, 2015
The first half of 2015 has been marked by some surprises, but at the end of June, the markets were in neutral, without any clear directional trend. While events such as the Fed move, oil price stabilization and disappointing economic indicators in the U.S. are all worth exploring, the Greeks are currently stealing the summer headlines. This update will address the current events in brief, while focusing on the prospects that we see for the second half of the year in what I’m calling the “durable economy.”
Thus far, the financial markets in the U.S. have generated negligible returns. Although there are some bright spots over the past six months, the collective S&P 500 is hovering around 2%, and the Barclays Aggregate Bond index remains slightly negative. Overseas markets are better in some areas, such as developed European markets, but with the prospect of a Greek exit from the euro, those returns just got halved for the year. The drag on overseas returns is China, which just entered a bear market this week after a series of missteps and miscues around sustained growth.
We don’t see this as all bad, and in fact, we are fairly optimistic about the prospects for the second half of the year. In a sense, the pause that the past six months have provided is beneficial to the markets over the long term. Keeping in mind that we’ve had a raging bull market for many years now, a breather in the climb gives the economy a chance to catch up to market expectations. In addition, we are also experiencing a significant shift in the manner in which the domestic economy generates growth.
I will address these factors in a longer Research Note this month, but for now, we appear to have shifted into a domestic economy that is resilient to a recession, yet unlikely to grow at the four to five percent pace that we have come to expect in past expansions. Two percent growth is all that the Fed projects for the next couple of years – not one of the most reliable predictors, but a good proxy. Given our heavy reliance on consumption for growth and a movement away from manufacturing, the modest expectation is reasonable. We appear to be shifting away from consumption as the primary driver of new growth and creeping into an innovation economy that would provide for a durable expansion over many years.
The downside to two percent growth is the threat of recession should there be any significant shock to the economy. Global events such as those in Greece, or conditions in Russia ranging from erratic military action to a decimated ruble, all have the ability to be that shock. Other possible shockwaves could emanate from increased occurrence of financial dislocation in markets driven by financialization (explained later), such as we experienced in the 2008 collapse. Similarly, more recent events, such as violent movements in the price of gold, the Swiss franc or oil could have an impact. But, we view the domestic economy at this time as stable enough to withstand most shocks.
With this in mind, we are looking at a variety of investment areas for the second half of the year. Energy, with the halving of oil prices last year, is one of the brightest spots in the durable growth scenario. Carbon-based sources and other alternative energy sources, plus the combination of an innovation economy with the dramatically lower energy prices this year, have stoked demand globally. That demand is translating into economic stability in some regions, and unexpected growth in others. We are incorporating the perspective of Mike Rothman at Cornerstone Analytics, which posits that demand for oil will outstrip supply by the end of 2015. While this prediction is counter to prevailing market sentiment, the growth in demand combined with a dramatic slow-down in drilling in the U.S. and declining well production in all other regions makes a strong case for this inversion later in the year.
Aside from energy, the disruption from Greece could present some interesting opportunities in Europe. Despite their market rally in the first quarter, the earnings multiples of European equities are still relatively modest, and the prices are even cheaper in dollar terms because of the devalued euro. If the region slips into another recession, then those valuations are too high; if the current situation resolves without significant economic damage to the broader continent, then the prospects are strong. Add to the picture the extensive exports by Europe to the U.S. and China — both of which are growing at a substantial clip on an absolute basis — and there is important upside for the European companies that operate globally.
Market Review
The context for the markets is fairly consistent with our discussion back in January: we’ve seen a relatively flat market with noted volatility around specific events. The flat markets in the U.S. are striking — equities have struggled to improve their gains for the year, while bonds are showing losses. Although some of the chronic underperforming markets had a strong start to 2015 (Europe in particular), the perpetual Greek crisis has already derailed many of those gains.
The chart below shows the three major asset classes in the US: the S&P 500 equities, Barclays Aggregate Bond Index, and the Deutsche Bank Commodities index, our rough benchmarks for most accounts. They are not ideal reference points, but here they show you the general trend for the markets this year, keeping in mind that we’re seeing a very narrow trading range in all three asset classes.
Chart 1 – Market Total Return 2015. Source: Bloomberg
As you’ll see in this chart, U.S. stocks have had a year of relative quiet with gains of 1% – 4%. Bonds, with the anxiety around Fed policy and interest rate movements later in the year, have moved only slightly. The stock and bond indices combined, on a 60/40 basis that is typical of a diversified asset allocation model, yields a return this year of about 0.8%, depending on the week.
Also note the relatively tight range of trading on these assets – stocks have moved in a total range of 6% from high to low. Even commodities, a volatile asset class this year, has stayed within a 9% range.
Despite the perception of turmoil for the year, the volatility measures have been remarkably quiet. In fact, the equity markets have had their narrowest range of movement in the past two decades. According to Bloomberg, the range of movement from highest to lowest points for the year is just 6.5% a very modest move where the range is typically 10% – 40%. Add the VIX to the picture — the measure of expected future volatility in the S&P 500, which has not traded above 20 since January — and the realized and expected volatility is the lowest it has been in a very long time.
The key exception to this flat market with a narrow trading range is energy. Oil, in particular, has been all over the place. Starting with a 50% drop in crude prices going back to last fall, we saw a 30% jump in the early spring. The short-term impact of trading dynamics on oil prices far outweighs the impact of the supply and demand situation. Specifically, the amount of financial products that are traded daily on oil is roughly twenty-four times the actual demand for oil. This financialization is not new to the asset class. The phenomenon is a function of both growing derivative markets and the computerization of trading strategies, and drives many of the market dislocations across asset classes that we experience on an annual basis.
The take-away from financialization is the fragility of many markets, which are influenced by perceptions on any given trading day. Whether we are discussing gold, Swiss francs, corn, oil, or even Apple stock around a product release, the disconnect between fundamental value and trading price can be severe. Despite the anxiety that can arise around these fluctuations, financialization also creates enormous opportunity when actual value is separated from perception.
Economic Review
The factors that we continue to monitor for predictive market behavior are employment, GDP, and housing. We have gradually added energy to this discussion, given the volatility in the energy markets and the skewed dynamics it has created.
The U.S. economy is again expected to show slow growth in the past quarter, somewhere in the 1.8-2.0% per annum growth rates. Unemployment dropped again over the quarter, and the jobs creation picture is holding steady and promising. With close to 300,000 new jobs created every month, we are slowly mending the employment picture. But labor participation rates hide the broader story, as many folks simply are not participating in the trend. This causes a drag on domestic consumption, but also gives us tremendous room for growth before serious inflation is triggered.
Chart 2 – Labor Participation Rate in the U.S. 1945 – 2015. Source: Bloomberg
While our labor market has shown tremendous tightening in the past two years, the broader employment picture is masked by the historically low participation rate in the U.S. Driven by a combination of changing worked demographics (retiring boomers, for instance) and the perception of poor opportunities, we are at a level not seen since before women entered the labor force in earnest.
The part of the picture that I am most optimistic about is housing. New home construction (housing starts) have reached the one million annual level again – and are holding that level – after a dismal slowdown in the Great Recession. With a long-term average of roughly 1.5 million new homes per year, we have a long way to go. The competing factors here are housing stocks, which decline every year as homes are demolished, and the growing population, the impact of which has been partially offset as retirees team up with Millennials to consolidate households. Doing some simple economic math, an extra 500,000 new homes a year with the associated jobs, materials and durable goods purchases can add 1.0 – 1.5% to the annual GDP figure. In an economy still in need of consumption for growth, that could prove to be a tremendous stimulus for economic stability and market gains.
Chart 3 – Housing Starts 1970 – 2015. Source: Bloomberg
Housing starts hit epic lows after the Great Recession, bringing that sector of the consumption cycle to a virtual standstill. We are seeing significant gains in housing prices, and with eight years of contracting housing stock, we are poised to see a return to healthy housing starts. Between the jobs, materials and consumption that go into each new home, this recovery would add significantly to the GDP.
Turning to energy, U.S. “energy independence” threw a theoretical monkey wrench into the oil market. Lower prices have caused supply growth to decelerate with the prospect that OPEC might be fully tapped out. U.S. oil producers may be headed for annual declines in production by Q4 2015 due to a halving of capital expenditures and the high depletion rate of fracking wells. Yet demand growth seems to be picking up faster than economic surveys would suggest. Interestingly, this latter fact points to increasing economic activity in many emerging markets, even though traditional commodity prices have yet to show the correlated movement.
Overall, we are monitoring the energy picture extremely closely given the manner in which it can impact global demand and domestic inflation. Factors such as ISIS or the Iranian nuclear talks are just a few of the wildcards in this equation, with the ability to derail all of the models described above. It also continues to prove the case for alternative energy sources and inventive ways to use energy, stimulating innovation that will ultimately change the way our economy grows and how we live.
We are weighing all these factors as we rebalance our commodity exposure for the second half of the year. In recognition of the volatility in the commodities market driven by financialization, we are shifting to companies that profit from increasing demand as opposed to futures-based ETFs. The shift on specific commodities is also changing, with a heavier emphasis on energy and a movement away from metals and some agricultural commodities. On agriculture, our view is that the middle class growth will continue to drive food demand, but that going forward, we will invest in that area in a way that avoids the vagaries of temporary oversupply and political intervention.
Greece
The biggest risk as of this writing to the global growth scenario is Greece. We have never seen a country exit the euro, and the last time that a major borrower defaulted on their debts was the Lehman collapse of 2008. Back then, the global markets came to a freeze, with the prospect of a collapse in the financial system, as a trillion dollars of assets were wiped from the system and dozens of institutions teetered on the brink of failure.
Today, the situation is very different. Institutions have had years to assess the prospects of a Greek default, shoring up balance sheets and putting risk management tools into place. Most important, key institutions have trimmed their holdings of Greek sovereign debt to nominal levels. That said, someone is holding the debt and will suffer the consequences. In many cases, these are the hedge funds that once played this gambit with tremendous success. A Greek default would most certainly torpedo these funds, either through complete insolvency or a gradual rush of redemptions over the coming months.
The Greek financial system, however, would be in tatters. Aside from massive financial failures, the basic system of currency and payments will go into a tailspin. As one analyst put it, the Greek voter will be sorely disappointed when the supermarket is out of food and their ATM card no longer works. For these reasons, we don’t expect Greece to take themselves over the cliff. The political posturing is dangerous, yet the uncertainties of a break would do so much damage to their domestic situation that it would amount to national suicide.
Conclusion
“May you live in exciting times,” my Chinese cookie fortune recently told me. What we are seeing today is unprecedented, potentially dangerous, but rife with opportunity. The resilience of the capitalistic model is being tested, and at the same time, the benefits of technology are expanding in ways that are beyond comprehension. Many social issues need to be addressed now and for the long-term, but with the right perspective and an ability to see past the fears, we see this as a time to be thoughtful, cautious, and creative in our investment strategies.
Regards,
David B. Matias
Managing Principal
