Key Points
▪ Equity markets recovered ground last week, but volatility will likely persist.
▪ Investors appear to be ignoring most economic fundamentals, and we believe conditions are healthier than what the markets reflect.
▪ It may take time, but we believe confidence should improve over the coming months.
Equities remained volatile last week as the S&P 500 Index gained 1.4% following two weeks of sharp declines.1 The rebound didn’t appear to be driven by any fundamental shifts, although rising oil prices and expectations of additional policy support from the European Central Bank and Bank of Japan helped. In some ways, last week’s bounce may have been due to a reaction from oversold conditions, and we are not seeing technical signs that would suggest these gains will have sustained traction. Investors remain skeptical and seem to be looking for the next crisis.
Fundamentals Remain Stronger than Sentiment Suggests
The S&P 500 began the week at 1,880, dropped all of the way to 1,812 on midday Wednesday, and subsequently surged 5% to 1,906 by market close on Friday.1 As dramatic as those moves were, oil saw even bigger swings as prices plummeted early in the week before staging a comeback. Pessimism about the economy and risk assets has spread rapidly this year, with every downtick in oil prices triggering selling pressure, and (as we saw last week) the reverse has been happening as well.
We believe these wild gyrations are not in keeping with economic fundamentals. The weakening Chinese economy, falling oil prices and a slowdown in global manufacturing are dominating investor attention and are causing some to forecast a U.S. recession. We doubt that will occur. Consumer spending should continue to improve as a result of higher wages and lower oil prices. Government spending is also rising and should contribute to growth in 2016. The fourth quarter earnings season is still young, and while results are far from perfect, the numbers and forward guidance point to a decent economic outlook.
Weekly Top Themes
1. Economic data were mixed last week. Housing starts fell 2.5% in December,2 and unemployment claims surprisingly rose to a six-month high.3 On the bright side, preliminary purchasing manager index readings for January moved higher,4 and existing home sales in December jumped 15% after falling the previous two months.5
2. Despite rising anxiety about the corporate sector, it appears healthy to us. We see high profits, rising cash holdings, comfortable debt servicing ratios and solid net worth. Absent some sort of shock such as a recession or rapidly rising interest rates, we don’t expect these conditions to change.
3. We are not forecasting changes at this week’s Federal Reserve policy meeting. There are no expectations that the Fed will shift interest rates and we don’t anticipate any material changes in the Fed’s forward guidance. We expect the Fed will highlight recent turmoil and reference deflationary concerns, which will reinforce the sense that the bar remains high for additional rate increases.
4. Relative stock and bond yields may be a bullish indicator for equities. According to UBS, at last week’s low, the yield on the S&P 500 Index was 47 basis points higher than the 10-year Treasury yield. Since 1990, there have been 82 instances of yield spreads of this magnitude or greater. In each instance, the S&P 500 was higher four months later and the average gain was 9.5%.6
Markets May Remain Rocky Until Confidence Improves
Equity markets have been in full blown panic mode so far this year. Yet, as we indicated earlier, we think investors are ignoring fundamentals or exaggerating the negatives. There are a number of headwinds to global growth, but we think the global economy is still healing and expect the U.S. expansion to continue.
The key downside risks to the economy appear to be weak manufacturing and economic and policy issues in China. We expect manufacturing will gradually improve as inventories decline. If and when we start seeing manufacturing indices above 50 (indicating growth), that should go a long way toward quelling investor panic. Likewise, uncertainty surrounding China is putting stress on emerging economies and pressuring commodity prices. We think risk assets will remain vulnerable until investors become more confident that the Chinese economy is stabilizing. Our forecast is that confidence will slowly improve as fundamentals become more firm over the coming months. In the interim, however, investors will likely be in for a bumpy ride.
1 Source: Morningstar Direct, as of 1/22/16
2 Source: Commerce Department
3 Source: Labor Department
4 Source: Markit U.S. Manufacturing PMI
5 Source: National Association of Realtors
6 Source: UBS
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The Nasdaq Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market. FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. Deutsche Borse AG German Stock Index (DAX Index) is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange. Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. Hong Kong Hang Seng Index is a free-float capitalization-weighted index of selection of companies from the Stock Exchange of Hong Kong. Shanghai Stock Exchange Composite is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. MSCI EAFE Index is a free float-adjusted market capitalization weighted index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. Barclays U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market. The BofA Merrill Lynch 3-Month U.S. Treasury Bill Index is an unmanaged market index of U.S. Treasury securities maturing in 90 days that assumes reinvestment of all income.
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