Equity Investment Outlook April 2016
During the first quarter, global markets experienced exceptional volatility. Markets began their nose dive on the first day of trading this year as investors worried about deflationary trends, turmoil in credit markets and the possibility of a global recession. Then, in mid-February, a rebound in oil markets and new data suggesting stronger than expected U.S. growth caused sentiment to reverse and markets to recover. We believe that similar ambivalence and mood swings will persist for some time. Odds seem to favor an extended period of sub-par economic growth both in the U.S. and around the world. Now that the China growth boom is over, we simply do not see any other engine of global growth waiting to take its place. This suggests that investors may suffer continued periodic anxiety over the possibility of global recession. On the positive side, continued low inflation and low interest rates would seem consistent with this economic environment. This may create trading opportunities for the adroit and reward longer term investors who can correctly identify companies that can sustain attractive growth rates in the current sluggish macro-economic environment.
There is a tug-of-war today between the slow but steady expansion of the U.S. economy on the one hand and strong deflationary trends emanating from China’s economy on the other hand. If one focuses solely on the U.S. domestic economy, one sees a slow growth, low inflationary expansion with rising employment, modest wage growth and accommodative credit conditions. Conversely, if one focuses on the mess in China, one sees an economy that over-spent on infrastructure, manufacturing and real estate and is now a) cutting back on such expenditures, b) coming to grips with the immense amount of red ink and bad debt that resulted from over-investment, and c) experiencing capital outflows and downward pressure on its currency. China’s demand for raw materials has collapsed and so have commodity prices around the world. This has caused widespread pain in commodity–dependent economies such as Brazil, Australia, Canada, etc. The contrast between relative stability in the U.S. economy and the turmoil and uncertainty in China and the rest of the emerging markets has driven up the value of the U.S. dollar. This upward pressure on the U.S. dollar has caused pain not just for U.S. companies with direct commodity exposure but to nearly all U.S. companies with large non-U.S. operations. The net effect has been a mild earnings recession for the S&P 500.
The flip side of all the anguish over lower commodity prices and weaker global growth is lower inflation in the U.S., lower input costs for U.S. manufacturers and lower energy prices for U.S. consumers and businesses. These should be a positive underpinning for growth in the U.S. economy. The risk, however, is that commodity deflation can also have a negative psychological effect on consumers and businesses. If consumers and businesses expect a sustained drop in prices and persistent low interest rates, they may very well become cautious and begin to save more, leading to weak consumer spending and lower business capital expenditures. The resulting lower demand would further depress prices, reinforcing people’s caution and so on and so on. We are not predicting this kind of deflationary spiral, but it is our biggest worry. It would lead to the sort of lost decades experienced by Japan in recent years or to a milder version of what the U.S. experienced in the 1930’s. Recently, the consumer has, in fact, been cautious and the savings rate has edged up.
Social Structure of the New Economy
One fairly clear trend in the new economy is a growing divide between the haves and the have-nots. As the nature of work becomes ever-more bifurcated between cognitively demanding and undemanding jobs, those with cognitive skills reap rewards while those without get left behind. The makers of robots get rich while the workers replaced by robots get fired. Technology and globalization benefit the cognitively skilled and devastate the unskilled. This has led to growing income inequality and a deep sense of frustration, which we see playing out in the current political arena as disaffected voters look to Donald Trump and Bernie Sanders to make things better. Neither one is likely to, even if elected. Nonetheless the political yearnings of their supporters are not going away.
As a result, one has to ask whether the social trends created by the new economy could engender a political response that ultimately has negative implications for future economic growth. Are we heading toward a negative feedback loop in which those people disadvantaged by technology and globalization gain enough political clout to demand policies that cause an economic slowdown rather than an economic acceleration? Nobody knows the answer to that question. One needs to watch how events unfold.
Oil: The New Supply/Demand Equation
Historically, the price of oil has correlated with the economic cycle. As a result, when oil prices resumed their decline from almost $50 per barrel in November of 2015 to below $30 in February, many investors feared that the collapse in oil indicated that recession had set in. Our view is that what ails energy markets (not just oil but natural gas and coal as well) is excess supply. Demand has continued to grow nicely both here in the U.S. and around the world. Weak prices reflect surging supply principally here in the U.S. from vast, newly accessed unconventional shale oil and gas deposits. Incremental supplies from Organization of the Petroleum Exporting Countries (OPEC) producers (Saudi Arabia and Iran) seeking to maintain their share of global markets caused inventories to balloon and prices to crater over the past 18 months.
We do not expect energy prices to sustainably rebound much above $50-$55 for perhaps another 12 months, and a retest of $30 is possible. There is, however, a growing concern that the length and severity of the current commodity downturn may sow the seeds of a much stronger recovery in commodity prices than would have been predicted just 6-12 months ago. The combination of massive underspending by nearly all oil producers in response to low prices and stretched balance sheets means that reinvestment levels have dropped well below those needed to offset organic depletion of existing fields and keep up with continued demand growth. The longer prices stay below the $50-$60 range, the longer the industry will likely underspend. This could lead to a supply crisis developing sometime in the 2017-2020 time period.
Global oil markets may not start to reflect this for another 12-18 months given the remaining spare capacity from Iran, Saudi Arabia, Kuwait, and United Arab Emirates (UAE), as well as the startup of a few large deep water projects from the majors, but once the supply crisis hits, the only part of the global supply chain that has the ability to respond with new supply within a 12-24 month time frame is the U.S. The size, complexity and long lead time nature of the mega offshore, Arctic and oil sands projects that the super majors focus on means that they will not be able to get new supply to the market until 2020-22 especially now in the wake of massive downsizing that they are all engaged in. The super majors (Exxon Mobil, British Petroleum, Shell, Chevron, Total, etc.) are licking their wounds from overinvesting in the 2008-2014 time period and will need to see much tighter markets and higher prices for an extended period before they sanction any large new projects. The national oil companies from Petrobras to Petronas to Statoil are also reeling for many reasons. In summary, oil and gas prices today are well below levels at which nearly any oil and gas producer will sanction major new growth projects even after the bounce off 15-20 year lows earlier this year. This is true from the super majors all the way down to the smallest, fleetest of foot exploration and production companies.
How high could oil prices eventually rebound? Our fundamental view is that new drilling and fracking techniques have unlocked vast new supplies not just here in the U.S. but around the world. The result is that when prices do rebound back to and above the $55-60 level, U.S. players will likely ramp up drilling and completion activities to get production growing again. Thanks to dramatic improvements in efficiencies, U.S. shale producers will not need prices to return back to the $80-100 range. The combination of lower corporate cost structures, less capital per well, more output per well, in-place infrastructure, delineated fields (low cost, prolific sweet spots are now known) and better understood drilling and completion techniques should mean that oil prices will not need to return to levels seen in the 2011-2014 time period. This should be a positive for global consumers of oil.
Monetary Policy: Any Bullets Left to Fire?
Given low growth and low inflation around the world, monetary authorities are flooding the system with money in an attempt to stimulate growth and create higher inflation. As a result several countries now have negative interest rates and the U.S. has extremely low interest rates. The monetary authorities are very afraid that low inflation could morph into actual deflation. Deflation is really bad for economic growth. First, it leads people to spend less and save more. Second, because debts are in nominal dollars and represent fixed obligations, debts become more onerous as the general level of prices declines. Thus in a deflationary environment, more companies cannot earn enough to repay debt, bankruptcies increase, banks suffer, credit contracts and the economy gets trapped in a deflationary spiral. (See Irving Fisher’s seminal piece: Debt Deflation and the Theory of Great Depressions.) This is what keeps central bankers up at night. It is not clear that further monetary easing can or will stimulate growth at this point.
Shifting Competitive Landscape
Over the last couple of decades, the competitive landscape of the U.S. economy has gradually shifted in favor of large, entrenched companies able to dominate their respective industries. It has also favored newer companies, such as Alphabet (formerly named Google), Amazon or Facebook, which have been able to create, define and then dominate newer industries such as web-search, e-commerce or social media. Once in place, these companies are hard to displace.
Numerous factors have contributed to this trend. Technology and globalization together have enabled better managed, aggressive companies to drive down costs and thereby create a sustainable advantage versus their competition. Growth in market size (i.e. global vs. regional) has enabled companies to achieve scale economies that smaller companies would struggle to attain. The result of all these factors has been to enhance the position of market leaders at the expense of weaker competitors. Recognizing this trend, we have refocused our attention onto more of these market-leading companies.
Our Current Positioning
Given the present level of uncertainty, we believe it is prudent to maintain a somewhat larger cash position than normal. The stock market has enjoyed seven-plus years of a bull market and stocks are no longer dirt cheap. At the same time there are clear earnings headwinds in certain sectors, so keeping some extra dry powder seems sensible.
Second, we are very focused on companies that can continue to grow despite the current headwind from a strong dollar and weak non-U.S. demand. These tend to be more U.S.-centric companies, particularly those that dominate some niche, industry or sector. In a stressed environment companies with strong balance sheets and better cost structures can gain market share and grow at the expense of their weaker competitors. We are trying to avoid weak also-rans like the plague.
Third, we are emphasizing companies with very strong or rapidly improving balance sheets and companies able to generate copious amounts of free cash flow. These are the companies to own in an uncertain environment.
Despite all the negatives we have touched on in this Outlook, the fact remains that the U.S. economy is still expanding, inflation and interest rates remain low, and numerous companies are still growing their earnings. To the extent we can correctly identify and invest in companies able to persistently grow earning and whose stocks sell at reasonable valuations, we believe we should be able to produce favorable investment returns over time. Even in a challenged environment, really strong, market leading companies continue to grow and continue to increase dividends over time. Our job is to identify them and exercise discipline in how much we are willing to pay for them.
Sincerely,
John Osterweis, Matt Berler
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Past performance is no guarantee of future results.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 Index is an unmanaged index which is widely regarded as the standard for measuring large-cap U.S. stock market performance. This index includes the reinvestment of dividends. The index does not incur expenses and is not available for investment.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
As of 3/31/2016, the Osterweis Funds did not hold Exxon, Mobil, British Petroleum, Shell, Chevron, Total, Amazon or Facebook. The Osterweis Fund, Osterweis Institutional Equity Fund and Osterweis Strategic Investment Fund held 4.91%, 5.31% and 2.59% in Alphabet respectively.
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© Osterweis Capital Management
© Osterweis Capital Management
