2016 Midyear Update
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.
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 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, moments of depression, and moments of sheer panic. 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. With that said, there are risks that could derail the recovery.
What are the risk factors?
The U.S. election is certainly one risk factor, 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. In this election season, most of the press attention has been on the candidates. But it’s the policies that really matter. 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. Just as in the U.S., the political uncertainty in Europe continues to rise. Although the U.K.’s June referendum on leaving the EU may rattle markets, significant disruption in 2016 is unlikely. 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.
U.S. corporate earnings. 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. Increased consumer spending growth, as well as higher oil prices and a weaker dollar, could help offset these factors, which could help the top line and help preserve profits even as margins decrease.
Chinese currency devaluation. This is the big one. Much of the global uncertainty in late 2015 came from China’s surprise currency devaluation, which threatened to create a vicious downward cycle of cuts to spending and investment. That risk has subsided for the moment, as the Chinese government has increased fiscal and monetary stimulus to kick-start growth again. Unfortunately, the stimulus is no longer as effective as it once was. If stimulus fails, further currency devaluation might be China’s 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, and it would encourage other countries to do the same, potentially starting a worldwide currency war.
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.
Higher oil and commodity prices. For all the concern about the negative impact of low oil prices on the world economy, the effects have been quite positive overall. Benefits for American consumers have been offset by a decline in energy-sector employment and investment, but elsewhere in the world, the benefits have been more pronounced. Europe and China, for example, import two to three times more petroleum products as a percentage of gross domestic product (GDP) than the U.S. 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. Again, we would be less exposed to such damage here in the U.S., but the damage of a price spike could be widespread and the benefits limited.
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.
What are the expectations 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.
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.
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:75 percent–1.00 percent at year-end after two rate hikes
- 10-Year U.S. Treasury rate:50 percent
- S&P 500 average: 2,050–2,100
A possible 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. Although business has suffered from lower oil prices and a strong dollar, it 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 also benefit from this faster growth. Still, corporate earnings are not doing as well as the larger economy. Even the expected resumption of earnings growth will be hard pressed to match current valuation levels. As such, 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 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. Authored by Brad McMillan, CFA®, CAIA, MAI, senior vice president, chief investment officer, at Commonwealth Financial Network. © 2016 Commonwealth Financial Network®