Apr 01, 2016
Something for Everyone:
Stocks declined over 10% in the quarter. They also gained more than 10%. Oil dropped 30% and gained almost 50% in the quarter. The Fed advised to expect four more rate hikes this year and then took that off the table. China both devalued its currency and strengthened its currency in the quarter. In the end, the broad stock market eked out a small gain, leaving investors relieved, notwithstanding symptoms of whiplash.
For the quarter, the S&P 500 gained 1.4%, while the NASDAQ, last year’s strong performer, declined 2.4%. Value stock indices performed better than Growth, as did higher dividend paying stocks, after both underperformed last year. Smaller-Cap company and non-U.S. stock indices continued to lag the broad market in the quarter.
Crude Oil (WTI)
From the charts above, it is probably no coincidence that the low point in stocks coincided with the capitulation in oil, to the day. The pattern for stocks and oil prices has been highly correlated for over the past year. Other worries around the February bottom included deteriorating U.S. corporate profits, emerging market turmoil, and increased default risk from lower quality investments.
There was one additional newer concern. Almost two years ago, the European Central Bank introduced negative interest rates (charging banks for holding excess reserves) in an effort to stimulate economic growth. In theory, this would motivate banks to make more loans, since their reserve balances would now be a cost to the bank. Negative interest rate policy (NIRP) has now spread to the Central Bank policies of Japan, Denmark and Switzerland. Rather than embracing the stimulative intent of this policy, investors feared that negative rates would pressure the profitability of the world banking system at just the wrong time, and possibly feed into another potential financial crisis.
As it turned out, the culmination of all these concerns marked the bottom. The bounce in oil was paramount, prompted by tangible signs of U.S. production cut-backs and talks of a coordinated production freeze among OPEC nations (wishful thinking). China provided more assurances about responsible currency management. Fed rhetoric began to walk back future rate hikes and Central Banks were responding to the backlash against negative interest rates. The turnaround reminds us of the wisdom behind the quote, “The bearish argument will always be most compelling on the lows.”
In Fed We Trust…Too Much
We have previously observed that our markets have become too dependent on the Fed as the ultimate safety net. Multiple sell-offs since the Great Recession have been rescued by additional monetary accommodation and Fed commentary. More recently, with interest rates already near zero, many have made the case that the Fed has fewer tools to work with and their rhetoric now is less effective in influencing investor sentiment. This diminished role, along with higher equity valuations, would help explain why stocks have become more volatile over the past 18 months.
The recent pullbacks over this period (characterized as panics and tantrums) show investors are still loathe to give up any monetary accommodation, especially when the economy continues to come in under growth targets. With the Fed’s latest backtracking on rate hikes, the markets have won another reprieve from the inevitable and rallied on that news. Probably just as well with the economy still operating at stall speed, but this limbo status would seem to have limited upside beyond how far investors are comfortable pushing up current equity valuation levels.
The way out of the woods for a smoother transition to more normal rates would be an acceleration of growth, but that has been elusive for seven years. More likely, the Fed will look for cover in any signs of improvement to offer the next in a series of rate hikes and chances are the markets won’t be happy. This mindset of looming rate hikes has been described as the “Yellen Call” on the market, distinguished from the “Bernanke Put” that was in place for many years.
What this means in plain English is that under Bernanke’s reign, there were some who believed that stocks were in a no-lose situation. If the economy performed well, that was good news for stocks. If the economy weakened, that too was good news because the Fed would be counted on to step in with more stimulus that also benefited stocks. This mindset works differently now, with interest rates already at historic lows. If the economy weakens, there are fewer levers the Fed can pull to provide effective stimulus. If the economy improves, the good news will be tempered because it will likely be accompanied by higher rates.
Under this scenario, the resumption of higher rates won’t be easy for investors, but in the end, a volatile transition accompanied by a stronger economy is preferable to one that avoids the angst of rate hikes but leaves us with stagnant growth, undermining the profitability of U.S. corporations. As markets are again cheering the deferral of rate hikes (granted for good reason this time) we should be mindful of what we ultimately wish for.
On that cheerful note, we’ll address a couple issues that we have come across in client discussions – why the decline in oil has not translated into good news for the economy and the impact of the current election cycle on the market. We’ve written previously about how the collapse in oil prices disrupted not just the oil industry but many other related parts of our economy. While the jarring impact of this reverse oil shock has weighed heavy on the market, it is reasonable to think there is an eventual windfall that will accrue to businesses and consumers alike. Early analysis shows that much of the saving from cheaper energy costs and gas prices is being saved and not spent. That is similar to how consumers have responded to tax cuts in the past. Not that anything is wrong with increased savings, but it will take more time for increased spending to work its way into the economy.
Another potential long-term dividend from lower oil prices has to do with the historic inverse relationship between oil prices and U.S. labor productivity. Investment Strategist, Don Luskin, observes that the peak in productivity growth coincided with the Arab oil embargo in 1973 and a subsequent peak occurred around the beginning of the war on terrorism in the 2000 decade. Both events ushered in a lengthy period of rising energy costs. He goes on to suggest that cheaper oil will mark the bottom of the current long-term decline in productivity.
Don makes the connection two ways – energy as a cheaper component to productive activities which will lead to an increase in those activities, and energy as a substitute for human labor that will increase the output, per hour of labor used. High cost oil has also had a stifling effect on innovation in areas that are more energy dependent. This doesn’t discount the growth in alternative energy sources, but cheap oil becomes additive in terms of expanding the opportunities for productive innovation. Granted, this topic is deserving of a much broader conversation, but we appreciate looking at this from a different perspective. The graph below shows this relationship using data on a 10-Year rolling average. It will take time to see if this relationship plays out as strongly as it has in the past.
Oil Prices and Productivity Growth
On the political front, our client discussions reveal a collective intrigue about going through a process that seemingly has no modern day precedent. Regardless of the outcome, it would appear that the “establishment” on both sides will have some real soul searching to do. With respect to the financial markets, the impact of Presidential election cycles are usually more indirect, but like everything else this year, that too may be up for grabs. Since we have another quarter before we will know the candidates and given the wide range of possibilities, we will save our thoughts for when the options have narrowed.
In the meantime, markets will brace for the upcoming round of first quarter earnings releases, for which analyst estimates have already been lowered significantly. There is no compelling reason to think that the recent above average volatility will subside, but with the recovery of oil from the $26 low, there is some relief that the contagion scenario (stemming from energy and financial-related stress) is off the table for now. We’ll put that in the good news column.