Key Points
▪ Equity prices continue to face downward pressure and markets appear to be pricing in a 50/50 chance of a U.S. recession. We believe a recession is unlikely.
▪ Investor caution is warranted and we may witness additional downside, but we expect stock prices should trend higher over the coming months.
Equity prices fell again last week, with the S&P 500 Index dropping 2.6% despite a significant bounce on Friday.1 Investors continued to focus on downside risks and fears of slowing growth. Rising concerns over central banks adopting zero or negative interest rate policies also detracted from market sentiment, drove confidence lower and resulted in a sharp sell-off in banking sector stocks.1
The Negative Feedback Loop Will Take Time to Unwind
Financial markets appear to be caught in a series of intertwined and self-reinforcing negative spirals. Falling oil is dragging down inflation and economic growth expectations. As a result, general market sentiment sours and equity prices decline as financial conditions tighten. Given this backdrop, corporate management teams grow more cautious and actual economic activity slows. At the same time, consumers appear to be saving rather than spending their proceeds from the “energy dividend.”
Fears over the prospects of a recession are rising. We do not believe a recession is likely, but we acknowledge that it will take time for financial markets to stabilize and better data to emerge. Unfortunately, this means confusion and turmoil could be the order of the day for several more weeks or even months.
Weekly Top Themes
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The consumer sector of the economy remains solid. For the last several years, it seemed like the business sector was upbeat while consumer-related areas of the economy struggled. The tables may be turning. Retail sales were stronger than expected in January,2 while income levels and consumer sentiment seem to be improving.
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Ongoing financial turmoil may slow jobs growth, but any setback should be modest. Initial unemployment claims fell 16,000 to 269,000 for the week ended February 6.3 This suggests labor market fundamentals remain in decent shape and should be able to withstand downward pressure.
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The Federal Reserve must choose whether to focus on economic or financial signals. January’s jobs report showed that wages are rising just as financial conditions have been turning increasingly ugly.3 This puts the Fed in a tough spot, as it needs to balance the fact that the expansion is continuing with mounting investor fears.
4. Zero or negative rate policies may provide short-term relief but could bring long-term problems. In our view, the longer countries keep their interest rate levels artificially low, the more likely financial distortions will occur.
We Believe Equities Are in an Extended Bottoming Process
There are clear risks ahead. Slowing growth in China and commodity price weakness have long been concerns, and investors are now grappling with monetary policy confusion. Ultimately, we think improvements in economic data and stabilizing oil prices are necessary to improve sentiment. In the U.S., it may make sense to stimulate growth via fiscal policy measures since economic growth remains relatively slow. However, such a development seems unlikely since voters and politicians appear biased toward austerity.
It seems we are either at the forefront of a recession or investors are overreacting to the negatives. At its current level of around 1,860, the S&P 500 appears to be pricing in a 50% probability of a recession. If a recession does ensue, we think the index could drop to around the 1,600 range in the coming months. If the economic picture brightens (as we expect it will), the S&P 500 would be more likely to climb back to around 2,000.
Given the uncertainty, it would be reasonable for investors who are unable or unwilling to ride out the potential for further near-term losses in risk assets to adopt more conservative positions. We may see more damage and more volatility before conditions improve, but we believe investor pessimism is peaking. Last week, the S&P 500 fell back to the low it reached in mid January, before advancing again,1 which may represent an important test. This could suggest stock prices are at the beginning of a bottoming process.
1 Source: Morningstar Direct, as of 2/12/16
2 Source: Commerce Department
3 Source: Labor Department
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.
RISKS AND OTHER IMPORTANT CONSIDERATIONS
The views and opinions expressed are for informational and educational purposes only as of the date of writing and may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non- investment-grade bonds involve heightened credit risk, liquidity risk, and potential for default. Foreign investing involves additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. Past performance is no guarantee of future results.
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