Presented by Rich Tegge
It has been an exciting year so far. With U.S. markets dropping 15 percent in the first quarter before rebounding, and many international markets having done worse, the red flag has been raised for market risks. With Europe continuing to wrestle with economic and political challenges, the prospect of a breakup of the union via a British exit (aka Brexit) has never been more real. And with Chinese growth continuing below expectations, we see risk everywhere we look.
1. The U.S. economy continues to grow, and growth may well accelerate.
2. Headwinds to economic growth and corporate earnings are fading, and although valuations are high, resumed earnings growth could support current equity prices.
3. Real risks exist, primarily outside the U.S., but they are unlikely to show up this year.
4. Stock prices could trade around current levels for the remainder of the year, as earnings growth brings valuations back to more typical levels.
At the same time, there is lots of good news. U.S. hiring continues at a strong pace, despite recent weakness. European growth continues positive, and the European Central Bank (ECB) is finally fully committed to helping that growth along. The Chinese government has always had the resources, but recently it has also found the will to support its own economy again.
For the remainder of 2016, we may see neither boom nor collapse, just more of the same back-and-forth slow growth of the past two years. There could, however, be moments of exhilaration—the good; moments of depression—the bad; and moments of sheer panic—the ugly during that back and forth. Let’s take a look at where we are now and then look toward the future to see what some of those moments may look like.
Where we are now
Growth in the first quarter was anemic. The slowdown from the last quarter of 2015 continued, driven by continued weakness in oil prices, which hurt business investment; slow wage growth, which affected consumer spending growth; and general uncertainty, driven by troubles in Europe and Asia.
There are signs the slowdown is ending, however. The service sector remains in positive territory, after several months of weakness. The manufacturing sector has moved back into the positive zone after months in contraction. Europe and Asia have continued to grow, despite the uncertainties there. And even wage growth continues to trend up. Although it’s been a first half primarily characterized by slow growth, the second half is looking somewhat better.
Corporate America is showing the same trends. After suffering from a meltdown in the energy sector and a collapse in export growth due to the strong dollar, company earnings expectations were cut by the greatest amount since the financial crisis. The fact is, though, that even as earnings estimates have been cut, both of the negative macro trends have reversed. In addition, many companies have been doing their best to cut costs and become more competitive. With improvements both in general conditions (as oil prices rise and the dollar sinks) and in company competitiveness, the chances of profits beating these depressed expectations are better than is generally expected. We might not actually return to growth in the second half of the year, but we can see it coming.
Overall, the second half of 2016 has the potential to be one of economic growth here in the U.S. and around the world, based on a combination of organic growth in employment, demand, and global central bank stimulus. Although risks remain, they are largely outside the U.S. and unlikely to show up in 2016
With that said, here are the good, the bad, and the (potentially) ugly events we might see through year-end.
Much of the good is already on the table, but let’s consider how even known good news could continue to surprise to the upside.
U.S. jobs for the jobless
With employment continuing to grow, abundant job openings, marginal workers being drawn back into the labor force, and companies continuing to increase labor demand, it would seem that all of the good news has been priced in. But, in fact, two pieces are missing: wage growth and, stemming from that, growing worker confidence.
Wages have been increasing, but wage growth is still not at the levels that most people would associate with a strong economy. As such, consumer confidence has lagged. Moreover, even though income growth has been strong, spending growth has lagged significantly because people have been worried about whether the good times will last.
At midyear, however, wage growth is stirring again. Even given the weak past two quarters, the labor market has strengthened and wage growth has moved above the range seen so far in the recovery. With rising wage growth, we are also seeing continued healthy consumer confidence levels and increased spending growth. There is a real possibility that, as consumers earn and spend more, the positive feedback loop could kick the recovery to more normal levels of growth, which could further increase confidence and spending.
European growth: The ECB continues to push the cart up the hill
Although Europe has been the sick man of the global recovery so far, a combination of austerity measures and central bank actions seems to have started a growth cycle there. The hardest-hit countries, including Spain and Ireland, have been growing at surprising rates, and even France and Italy have moved back to growth. With the ECB set to continue its stimulative policies and the global economy showing positive momentum, growth in Europe could help mitigate political turmoil and maintain organic growth.
Chinese growth: The government turns on the spigot
Similarly, China is back in growth mode, in this case because the government has opened the stimulus taps again. Regardless of the catalyst, China’s economy has picked up, with housing markets rising, consumer spending increasing, and firms expanding. As the second-largest economy—and so far in this recovery the largest source of global growth—China matters. With growth resuming, China may move back from being a source of worry and instability to becoming a more positive economic influence over the rest of this year.
There are signs that the weakness of the first quarter is passing, and economies around the world seem to be doing better. Even so, there are substantial risks that could derail that improvement. The U.S. election is certainly one such risk, as there is more uncertainty than we have ever seen from a policy perspective. But the biggest risks are international—with the potential for real shocks that could shake the U.S.
The U.S. election: Uncertainty like never before
In this election season, most of the press attention has been on the candidates. But it’s the policies that really matter. Specifically, the possible outcomes of such policies—with Hillary Clinton being pulled to the left by Bernie Sanders and Donald Trump offering policies outside the current consensus—are more uncertain than we have ever seen. With investors waiting for more certainty around policy outcomes, and businesses doing the same, the potential for the election to cause slower economic growth and market tremors is very real.
Brexit: The first crack in the European Union?
Just as in the U.S., the economic situation in Europe is improving, but political uncertainty continues to rise. Tensions persist between Greece and the rest of the eurozone, with a difficult summer expected, and the Syrian refugee crisis continues to stress the open border agreements that provide much of the daily value of the European Union (EU). The immediate risk, however, is the so-called Brexit—the referendum in the U.K. over whether to leave the EU, which will be held in June.
Looking back to 2011 during the first round of the Greek crisis, the big worry was the precedent that would be set if Greece were to leave the EU. In theory, once in, a country is there for good. In truth, however, the departure of a small country such as Greece would not likely have a systemic effect. The actual risk is that once one country left, it would be much easier for other, more important ones to do the same.
We now have Great Britain quite possibly doing just that. Of course, it is not a small country; it is a major economy and military power within the EU. A British exit could certainly encourage others to do the same, notably France and Germany, both of which have active anti-EU parties with increasing political appeal. It could also change the entire structure not only of the EU but of each country within it.
What does it all mean? Although the U.K.’s June referendum on leaving the EU may rattle markets, significant disruption in 2016 is unlikely. When EU referenda threatened the union in the past, they were rerun until the desired (i.e., positive) result was obtained. So, even if Britain were to vote to leave the EU, this would simply mark the start of a multiyear negotiation about exactly what this exit would mean. Brexit certainly belongs in the bad group but likely not in the ugly.
U.S. corporate earnings: Growing but not enough
The final bad sign is the weakening trend in corporate earnings here in the U.S. With a likely fourth quarter in a row of declining earnings, declining margins, and market valuation levels still at exceedingly high levels, the risk imposed by continued weakness is very real and very likely. Rising wage growth, although good for the economy as a whole, is likely to continue to erode margins, as will the continued headwinds from low oil prices and a strong dollar.
Increased consumer spending growth could offset these factors, which could help the top line and help preserve profits even as margins decrease. Also, though they remain low, we are seeing oil prices start to rise—enough to help companies but (so far) not enough to hurt the consumer. Finally, strength in the dollar is beginning to abate, which may help the headwinds subside.
All of these factors could help, but it may be difficult for companies in the aggregate to grow earnings enough to justify current valuation levels, which could constrain appreciation through the rest of the year.
Overall, despite the challenges noted above, the global economy seems likely to improve through the rest of 2016. There are, however, several potential systemic risks that could derail that recovery.
Chinese currency devaluation: Could rock the global economy
This is the big one. Much of the global uncertainty in late 2015 came from China’s surprise currency devaluation. Up to that point, the Chinese government had been known for its ability to keep its economy growing and to manage shocks. The stock market crash there, the government’s bungled response, and the sudden currency devaluation called that competence into question. Reduced confidence affected not only world markets but the Chinese economy itself. As companies and citizens became less certain of the future, they cut spending and investment, which threatened to create a vicious downward cycle.
That risk has subsided for the moment. The Chinese government has increased fiscal and monetary stimulus to kick-start growth again, and the general mood seems to have improved. The problem is that the stimulus is no longer as effective as it was in the past, and it’s not at all clear that China can continue to rely on it. If stimulus fails, further currency devaluation might be its only course.
Such a devaluation would export deflation to the rest of the world, making an existing global problem worse. It would also hurt other trading nations by stealing their exports (already a bone of contention around the globe), and it would encourage other countries to do the same, potentially starting a worldwide currency war. For the U.S., for example, a cheaper Chinese yuan would likely raise the value of the dollar (the effects of which have already been substantial), make U.S. exports more expensive and less competitive around the world, and rock financial markets—again, as we saw in late 2015 and early this year. Other countries would stand to suffer as much or more.
China appears willing and able to continue its current stimulus policies for at least the rest of 2016. But the political winds could change at any time, with potentially serious consequences.
EU breakup: Ugly if it happens
The upcoming British referendum is a short-term risk and could certainly be disruptive. What it likely will not be, at least in 2016, is a systemic risk event. As mentioned previously, when referenda in the EU have gone wrong before, the powers that be have tended to rerun them until the desired result is obtained. That is probably what would happen if the British vote to leave the EU. Even if the referendum held, it would likely spark years of negotiations rather than an immediate exit. The effects would be real but not necessarily disastrous.
On the other hand, a British decision to leave could set off a chain reaction, prompting the anti-EU parties in other countries to demand the same kind of action. The effects could also rock Britain itself, as Scotland might try to revive its independence bid in an attempt to remain in the EU as its own country.
Given the current political environment—the Greek debt talks this summer, rising anti-EU parties in many countries, major disagreements about how to handle borders and refugees, and pending elections around the region—the possibility that a British exit could metastasize is very real.
Japanese debt markets: The Bank of Japan doubles down
While growth is resuming in the U.S., Europe, and China, Japan remains the missing link. The Bank of Japan’s attempts to stimulate the economy have now reached the point of desperation. Negative interest rates are not helping, and the central bank now owns a material share of all government debt, suggesting that Japan’s ability to stimulate growth is approaching an end.
Although markets are largely ignoring Japan’s woes, the rising imbalances there raise the risk of massive disruptions at some point. Considering the long-running nature of the problem, however, and the fact that the Bank of Japan continues to purchase assets, the likelihood of a crash this year does not look high. In fact, the risks have been substantially reduced by the central bank’s acquisition of so much government debt, leaving the market less exposed. Who would sell? Nonetheless, the risk does remain meaningful—especially the possible psychological disruption that could ensue if a major government like Japan were forced to default.
Higher oil and commodity prices: Be careful what you wish for
For all the concern about the negative impact of low oil prices on the world economy, the effects have been quite positive overall. Here in the U.S., those positive effects, though still material, have been felt least, with the benefits for American consumers offset by a decline in energy-sector employment and investment. Elsewhere in the world, the benefits have been more pronounced. For example, compared with the U.S., Europe and China import two to three times more petroleum products as a percentage of gross domestic product (GDP), with correspondingly greater benefits. Economic growth in those regions likely would have been substantially worse with higher oil prices.
Therein lies the risk. Much of the recovery we have seen can be attributed to the effects of low oil prices. As prices rise, that recovery may be in jeopardy. Although we are seeing increasing growth around the world, a spike in oil prices (or, to a lesser extent, other commodity prices) could well dampen it. Again, we would be less exposed to such damage here in the U.S., as the domestic energy sector would stand to benefit. Even so, the damage of a price spike could be widespread and the benefits limited.
With production declining somewhat and the supply/demand balance getting closer to even, the potential for a spike in oil prices is real. Such a spike is unlikely to happen in 2016, due to very high levels of oil stocks in storage and ongoing overproduction. On the other hand, given wars in Syria and Yemen, unrest in Libya, and the potential for a difficult Iranian reentry into the market, a supply shock and subsequent price spike isn’t out of the question. Despite high stocks and current overproduction, a sharp shift in the supply/demand balance could force prices upward faster than anyone expects.
What Might This Mean Going Forward?
Given all of the above risk factors, what are the expectations for the global recovery?
- The world economy is likely to continue to grow slowly. With signs of organic growth continuing in the U.S. and emerging in Europe, substantial stimulus continuing in the U.S. and on the rise in Europe and China, and energy and currency markets returning to normal, much of the damage has already happened. It would likely take a substantial external shock to derail the global recovery in 2016.
- The potential for such shocks, however, is very real, particularly in Europe. On balance, the bad possibilities substantially outweigh the good ones. It is hard to see what might generate an upside surprise and all too easy to see what might knock us down.
- Still, the base case is that we will continue to grow slowly.
What might investors expect?
- With growth slow and downside risks high, don’t expect central banks around the globe to tighten substantially, or at all, during 2016. Even in the U.S., any tightening is likely to be limited. Moreover, at the long end of the market, rates in the U.S. will still be held down by low rates elsewhere. Interest rates are likely to increase only modestly, if at all, and may well decline.
- Stock markets are, in general, not cheap, but there is a wide range of valuations. With growth likely to stay low, market appreciation will probably come only from organic growth or multiple expansions. And, although U.S. markets may benefit from higher growth, they will have a much harder time showing multiple expansions.
On balance, we believe the following are reasonable expectations for the rest of 2016:
- GDP growth: Around 2.5 percent for the rest of 2016 and 2.2 percent for 2016 as a whole
- Fed funds rate: 0.75 percent–1.00 percent at year-end after two rate hikes
- 10-Year U.S. Treasury rate: 2.50 percent
- S&P 500 average: 2,050–2,100
A Repeat of the First Half?
There is quite a bit of good in the global economy and particularly here in the U.S. Employment continues to grow, and although consumer spending is not growing as quickly as it could, there are signs that this trend may be changing. In any event, the fact that savings continue to rise makes the recovery more sustainable, albeit slow. Business has suffered over the past couple of quarters, with lower oil prices and a strong dollar, but has largely weathered the challenge and is now poised to potentially benefit as those headwinds abate. The foundations of the economy—total employment (growing), consumer spending (increasing), and the service sector (expanding)—remain reasonably stable, and the rest of 2016 may see faster growth than the first half.
Financial markets may benefit from this faster growth as well, but the fact remains that corporate earnings are not doing as well as the larger economy. With declines over the past several quarters, and valuations at very high levels, even the expected resumption of earnings growth will be hard pressed to match current valuation levels. As such, while the economy could continue to grow, markets are likely to bounce around current levels and show limited, if any, appreciation through the end of the year.
For both the economy and the markets, then, we expect the second half of 2016 to look somewhat better than the first—with continuing, and perhaps accelerating, growth but a volatile stock market. Over that time period, the risks appear generally balanced, with the possibility of accelerating U.S. growth offsetting, at least for the U.S. itself, the systemic risks in the rest of the world. Moving into 2017, global risks could become more meaningful, but we are not there just yet.
Disclosures: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results. Diversification and asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s. Emerging market investments involve higher risks than investments from developed countries and also involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation.
Rich Tegge is a financial advisor located at Wealth Strategy Group, 300 S. Front Street Ste C, Marquette MI 49855. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 906-228-3696 or at email@example.com
Authored by Brad McMillan, CFA®, CAIA, MAI, senior vice president, chief investment officer, at Commonwealth Financial Network.
© 2016 Commonwealth Financial Network®