Analyzing Despair; Restoring Hope

While I began this year with a cautious view of the financial markets, I did not expect the swift market declines that we have all experienced. At one point, the Standard & Poor’s 500 was down 10% year-to-date. The recent weakness is clearly supported by some serious economic problems which I will explore. My conclusion, however, is that we will not endure either a bear market or a recession this year, and I will try to defend that position in the course of this essay.

In the current investment environment, it is easy to give up hope. Stock markets around the world have fallen sharply since the beginning of the year because of many factors. Monetary accommodations by central banks almost everywhere have done little to boost economies or arrest the plunge in equities. Investors are so anxious to hide from risk assets that they have pushed yields in developed markets down to extremely low levels or even negative rates. Designed to encourage consumer spending and bank lending, negative rates have some positive effect in the short term, but the long-term benefits are not clear. While the data on the performance of U.S. and European economies indicate that modest growth is continuing, the fear is that turbulence in the financial markets will cause businesses and individuals to curb their spending and a global recession will begin later this year. The fact that manufacturing is already in a recession in key areas raises the question of whether other sectors of the world’s economies are strong enough to keep even slow growth alive.

Perhaps it all started with China. While official numbers reported suggest strong growth is continuing, almost every observer believes that a slowdown of some significance is taking place there. The negative view is supported by data on exports, imports of raw materials, electricity consumption, retail sales and capital spending. The good news is that the Chinese economy is rebalancing. Growth was too dependent on capital expenditures for state-owned enterprises and infrastructure. Debt incurred to fund those projects had increased to unsustainable levels and there was concern that the banks held many non-performing loans. The economy could not continue to move forward on that basis; consumer spending had to overtake capital spending as it has in most western economies.

This process is underway, but during the transition period and perhaps beyond, growth will slow. An expectation that the second largest economy in the world will continue to grow at seven percent is unrealistic; four to five percent is more realistic. China’s growth is critical. When it was growing at seven percent, it accounted for 25% of the increase in world GDP. China is still creating more than ten million jobs annually, bringing people out of the agricultural countryside and into challenging but more financially rewarding urban settings. Its current leader, Xi Jinping, is determined to purge corruption from the leadership ranks. The Chinese population is supportive of the current regime and that is an important positive. If the fiscal and monetary stimulus program falls short, a devaluation of the currency may be used to stimulate exports. Many, including myself, expect that to happen later this year, but lately the authorities have been using China’s considerable foreign currency reserves to prop up the yuan. This effort caused the yuan to rally sharply in February and, as a result, China’s $3 trillion plus in reserves is being drawn down $100 billion a month.

The decline in the price of oil may be the major factor causing the current financial market volatility. Initially, lower oil prices were viewed as an economic positive. Consumers would have more money to spend, retail sales would improve and real growth in developed economies that import oil would increase. As it turned out, only half of the money saved at the pump was spent elsewhere; consumers paid down debt with, or banked, the other half. The more worrisome aspect of the decline in the price of oil was its impact on capital spending and the credit markets. The rig count dropped by 70% and the bonds of marginal exploration and development companies collapsed. This raised questions about the financial condition of some of the major lenders to the energy industry, causing financial stocks everywhere to suffer declines. In Germany, Deutsche Bank stepped in to buy $5.4 billion of its bonds to prove its financial condition was “rock solid.” Still, investors expected some of the major established energy companies to cut their dividends.

Concerns about world stability may also be influencing investor apprehension. Since the Paris terrorist attack on November 13, people everywhere feel less secure. ISIS continues to be a threat to governments in the Middle East, and while the terrorist group’s military advances may have been arrested, it seems doubtful that they will be defeated by airstrikes alone. Even without the impact of terrorists, the governments of many Middle Eastern countries have been unable to establish institutional structures that would restore the confidence of their constituents. The Syrian civil war continues and refugees are flooding into Greece and ultimately the rest of Europe. Germany, which has taken in 1.1 million refugees, had hoped to set a positive example for the rest of the continent, but Angela Merkel’s political capital has eroded as a result of her refugee policy and her position as the leader of the European Union has diminished. The world needs her to keep the Union together during this period of economic and political stress. With the United Kingdom threatening an exit from the Union, the long-term prospects for the project are less certain, reducing investor confidence. While there may be more talk during the year of a European Union break-up and a British exit, I believe the loose alliance will remain intact. There is more to lose than to gain from a break-up now.

In Japan the economy has hit another pocket of weakness, forcing the government and banking leadership there to provide more stimulus to prevent the resumption of a deflationary recession and shaking confidence in Abenomics. The rising value of the yen has hurt exports. The China slowdown has caused recessions in many raw material–exporting third world countries. Brazil has been especially impacted and its internal political problems have deepened the crisis in this critical Latin American country.

Finally, in the United States, the current race for the Presidency has to be unsettling. Outsider candidates in both parties are gaining traction, which should be no surprise when you consider that more than 70% of the population believes the country is headed in the wrong direction. Investors are fearful of radical change, and all of the “outsider” candidates represent a major policy shift. Younger voters seem to be flocking to the oldest of the candidates, Bernie Sanders, and giving large sums of money to him in small amounts. The general tone of the debates is confrontational and insults have shaken the dignity of the discussion. All of this may be entertaining, but it does not build confidence. Hilary Clinton believes Bernie Sanders’ plans for the economy would increase the budget by 40%. A panel of former Chairmen of the Council of Economic Advisors says his program exceeds the most “grandiose predictions of Republicans.” The Trump and Cruz plans for tax reduction would create similar budget problems if their expectations of improved growth don’t develop as they see it. There is a reassuring belief that Congress would prevent financially irresponsible bills from being passed, but if one of the outsiders were to win the Presidency, Washington would become a chaotic place and the financial markets would not react well to that. The passing of Supreme Court Justice Antonin Scalia and the prospect of a battle over his successor present another uncertainty to the market.

The economic situation in the United States is, however, generally positive. While the labor report for January showed only 151,000 jobs created, less than expected, other data on employment are more favorable. Initial unemployment claims are low at 269,000, average hourly earnings are increasing at a 2.5% annual rate and job openings are at five million. The readings on the willingness of employees to quit their jobs in hopes of getting a better one are high and this shows confidence in opportunities available in the workplace. Over the past twelve months, the average monthly job increase has been 225,000, so the overall employment conditions are favorable. In January, the participation rate increased to 62.7% from 62.4%. Payroll employment is well above the 2007 peak.

The increases in people finding jobs and in average hourly earnings should be reflected in retail sales, and the data for both January and December were good. Since prices were down in those months, the gain of .2% was impressive. Real consumer spending should show a 2.5% increase in the first quarter.

The other positive in the outlook continues to be housing. House prices were up 7.7% year over year in December and nothing encourages a prospective home buyer more than the fear that waiting to buy is going to prove costly. Mortgage rates are a low 3.53% and employment in the 24–35 age bracket (the principal range for the household formation) is strong. Mortgage applications for purchase climbed 9.3% as a result of the lower rates, but the National Association of Homebuilders survey of sentiment dropped to a nine-month low in February. The reading of 58 still indicates favorable market conditions. January housing starts were down 3.8%, but bad weather may have caused the shortfall.

The two big worries I have about the economy are capital spending and productivity. Weak oil prices have brought energy exploration and capital projects to a halt. With overall operating rates at 77%, there is little reason to expect companies to build new plants to increase production in most other industries. Investors are aware that profits will be weak in 2016, although recent data on manufacturing and consumer goods output were more favorable. The question is whether the consumer and housing can keep the economy from falling into a general recession. So far it looks as though we will be able to pull through with about 2% growth this year.

The productivity problem is more troubling. The latest reading was .2% and the last five years have averaged .5% on a year-over-year basis. Because overall growth is a combination of increases in population and increases in productivity, the latter may be one reason why growth since the recovery began five years ago has only been 2%. Many believe that productivity measurements fail to capture the impact of technology on manufacturing and service efficiency and I have some sympathy for that view. The fact is, however, that productivity improvement is a key factor in raising the standard of living and corporate profitability. Right now there has been meager progress toward both of these goals, and I believe poor productivity must have something to do with it.

Another worry is the action of the credit markets. Junk bond yields have risen sharply to over 9%, indicating a sharp increase in investors fearing defaults. Low-quality non–investment grade debt is yielding 15%. Bank stocks in the United States and Europe have suffered especially during the decline. The concern is that a number of oil companies will be unable to meet their financial obligations and this will weaken the whole credit system. Investors are reminded of the sub-prime crisis in 2007 when these loans were less than 20% of all bank loans but they left us vulnerable to a potential meltdown of the commercial banks. I do not think bad energy loans will do the same damage, but that is the concern of the market.

From a valuation point of view, equities do not seem to be frothy. Standard & Poor’s earnings estimates of $125 are clearly too high, in my opinion, but even if you use $120 or $115; you come up with a multiple of 15.5 to 16, in line with the historical average. Technically, the market is very oversold and the Ned Davis Crowd Sentiment Indicator, which has proven helpful to me in the past, shows levels of pessimism comparable to 2012, but not 2009. We have still not seen outright capitulation, which might be ahead and would mark an important bottom for the market, but we are certainly in rally territory. I stand by my view at the beginning of the year that we will have negative performance for the major indexes and no bear market or recession, but I will be watching closely over the next few months to see if that assessment is right. Oil may have to reach a definitive bottom first.

The views expressed in this commentary are the personal views of Byron Wien of Blackstone Advisory Services L.P. (together with its affiliates, “Blackstone”) and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the current views of Mr. Wien as of the date hereof and neither Mr. Wien nor Blackstone undertakes to advise you of any changes in the views expressed herein.
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