Before August 11, the popular perception was that the United States economy was growing at about a 2% annual rate and the Standard & Poor’s was locked in a trading range between 2040 and 2125. After the Chinese revalued the renminbi by 2%, the trading range was lowered to 1875–2025. Perhaps the key reason for the equity market’s inability to work its way higher is the belief that earnings for the index are likely to be flat in 2015 compared with last year (the view that we are in an earnings recession). The strong dollar and lower oil prices have contributed to this situation.
But there are other factors in the background that may also be influencing the lack of enthusiasm for equities. Even though the earnings outlook for 2016 is favorable, investors are reluctant to expand their portfolios in the face of so many uncertainties.
The “will she or won’t she” ambivalence about increasing short-term interest rates by the Federal Reserve is clearly one factor confusing investors. That the Fed failed to raise rates in September, while indicating they will do so before year-end, is puzzling in the face of the fundamentals. The economy is growing modestly, but there are important areas of weakness, and inflation is not a problem. While unemployment is down to 5.1%, you have to wonder how many people who would like to have a job have given up looking for one, given that the participation rate is at 62.4%. My view continues to be that there is too much attention paid to the issue of Fed policy. If they raise rates, it will be by a small amount and they will do so gradually. With the dollar strong and economic weakness throughout the world, the Fed is likely to delay any policy change. When and if a rate increase finally happens, it may knock the equity market down for a while, but it won’t cause a bear market. Another factor which may be unsettling investors is the reaction to the end of the Federal Reserve’s bond-buying program last October. Equities generally perform well when the Fed is accommodative and poorly when it is not. The broad market entered its trading ranges when the Fed stopped easing last fall. Because I believe that three-quarters of all the $3.5 trillion the Fed pumped into the system since 2008 went into financial assets, keeping interest rates low and pushing equities higher, I feel that the lack of bond-buying by the Fed has been a drag on the stock market’s progress.
The recent Russian military involvement in Syria has revived concern about the beginning of another Cold War, albeit on a lesser scale. Russia is backing the current government under Bashar al-Assad and opposing the rebels, while the United States has been supporting the efforts of those who want a regime change. We have been hesitant to provide arms to the rebels because of concern that these weapons and equipment could fall into the hands of forces opposed to us. The possibility of a confrontation with Russia has caused us to change course in Syria, raising questions about our strategy in the region.
Another regional issue confusing investors is the decision to leave troops in Afghanistan beyond 2015. The American people want U.S. military involvement ended because they believe it has been costly and ineffective. The admission that we must maintain a presence in the region to prevent chaos is a significant disappointment. Our inability to contain ISIS and the Taliban may be argued, but there seems to be little question that if we withdraw, tribal forces with policies that oppose our interests, including Al Qaeda, will take over the region. Add to that the question of whether Iran will adhere to the recent nuclear agreement and you have plenty to worry about. Given that the region is a major oil producer, the lack of stability could have an important impact on the world economy. So far oil has reached consuming markets at reasonable prices without a problem, but that could change if the social order breaks down. You can argue that the oil will be sold in world markets no matter who is in control, but enriching terrorists is something no democracy wants to do.
Related to the problems in the Middle East is the refugee crisis in Europe. Every effort is being made to control the flow of migrants. Europe has an aging population and the integration of a controlled number of younger, educated people from Syria and other troubled countries could help the continent deal with that problem, but the number of people who want to leave the region is overwhelming. The present surge is causing problems in Greece, Hungary and other countries, resulting in desperate living conditions. So far, any negative economic impact from the host governments providing essential services to these displaced people has been hard to measure. Europe’s recovery was modest at best, and the potential drain caused by coping with the refugee influx could cause a loss of momentum.
Europe isn’t the only place facing economic challenges. The emerging markets, which including China represent 40% of world Gross Domestic Product (GDP), are generally suffering recessions. Their currencies have declined and those dependent on commodity exports, like Brazil, have been particularly hard hit. Political problems have surfaced in a number of countries, exacerbating the fundamental issues. Countries like India and Indonesia are, however, doing well. World growth is projected to be 3% in 2016 with China providing about a third of the increase. The developed world will account for a part of that, but we will need to see some recovery in the developing countries for the target to be reached.
Over the past month, concern about a hard landing in China has receded. There is no question that China is slowing and probably will not grow at the 7% target rate, but the shortfall may be less than was feared in August. The country is using aggressive fiscal and monetary policy to arrest the slowdown. Recent data on house prices, foreign direct investment and bank loans supports the view that a reasonable pace of growth will continue. This is the primary reason why the developed country equity markets have recovered since the end of August.
The main problem for China’s trading partners is that the Chinese leadership is trying to rebalance the economy away from investment in infrastructure and state-owned enterprises and toward the consumer. Recent data shows this is happening, but progress is slow. The consumer sector includes services where workers are paid less than in manufacturing and which use fewer industrial raw materials. As a result, this shift has hurt those countries that ship commodities to China. I don’t expect that to change any time soon, but the fact that China is continuing to grow at a moderate pace is reassuring to investors. This is one piece of positive news in the background.
While a military confrontation with China is unlikely over the intermediate term, China’s growing economic strength and stepped-up expenditures on defense have to be of concern. China’s values and goals are different from ours, and we are already facing disagreements in the area of cyberspace. The South China Sea also represents an area likely to produce tension in the U.S./China relationship.
The way the 2016 Presidential race is shaping up may also be troubling portfolio managers. With the exception of Donald Trump, the Republican field seems uninspiring. While Trump continues to rank high in the polls, most believe he will drop out before the convention. If he does become the candidate, his radical positions on several issues would be difficult for most legislators to support. The other candidates are more acceptable to investors, but their adherence to the concept of improved growth mainly through deregulation and reducing taxes seems to recall themes from earlier campaigns. As a result, the concern is that the Republicans will not win in 2016 and a Democratic candidate less friendly to investors will be in the White House. Given the probability that the Republicans will retain control of both Houses of Congress, we will continue to get very little done in Washington. Three-quarters of Americans polled believe the country is headed in the wrong direction, and the prospect of only insignificant change in current policy is discouraging.
As for the Democrats, little excitement exists there as well. With her strong performance in the October debate, Hillary Clinton strengthened her position as the front runner. Voters continue to be concerned about her trustworthiness and her tendency to make self-serving decisions (e.g., regarding the private e-mails), but she seems informed, decisive and energetic. Her policies, however, make many investors uncomfortable. The popularity of Democrat Bernie Sanders and Republican Donald Trump shows the dissatisfaction of potential voters with traditional candidates. A survey of the issues important to investors belonging to both major parties showed that Washington experience was most important to Democratic voters, but “being an outsider” was a major plus for Republicans.
Moving over to some of the larger issues facing the economy, productivity has to be near the top of the list. According to McKinsey Research, in the fifty years prior to 2014, overall world growth was 3.6%, made up of 1.8% population growth and 1.8% productivity improvement. For the next fifty years, McKinsey projects population growth to be .9% and productivity the same, for an overall growth rate of 1.8%, half of the rate of the previous half-century. A different study shows growth for the U.S. based on hours worked and productivity. In the immediate post-war period, both hours worked and productivity were strong (1.4% and 2.8% respectively) but over the period 2005-2015, hours worked has slowed to .5% and productivity to 1.3%. Productivity is enormously important to both corporate profitability and our standard of living, and the prospect of a lower level going forward on a secular basis is disturbing. There is, however, the possibility that we don’t know how to measure productivity accurately in the age of technology. We know we are more productive as a result of the smartphone, the computer, the Internet and other products and services that have come into use during the past thirty years, but we don’t know whether those improvements are picked up in the traditional ways of measuring productivity.
Recent tepid data for retail sales has again raised the issue of overall demand. Technology eliminated a number of higher-paying manufacturing jobs in the 1980–2000 period and this is still going on. We also know that computers have the potential through Artificial Intelligence to eliminate a number of white collar jobs. The hollowing out of the middle class has definitely had an impact on spending. In addition, those who have good jobs have shown a preference for “experiences” rather than goods. Apparently they have only a modest need for additional possessions. This is favorable for travel, hotels and restaurants but a negative for retail establishments.
Looking at demand on a global basis, you would think that the growing middle class in the developing world would create a higher level of demand for goods that would improve a family’s standard of living, and, indeed, this has been the case. The problem is that countries like China are producing quality goods at attractive prices and crowding out manufacturers in the developed world. The result of this is that wages in the developed markets have stagnated since the end of the recession in 2009 and this has reduced overall demand.
There are also some issues related to the investment environment itself. Many investors became cautious as a result of the 2008-9 bear market. Some of that unwillingness to hold equities endures. Data on the proportion of bonds in institutional and individual portfolios confirms this observation. High-frequency trading has also created apprehension among investors. While volatility over the past several years has been aberrationally low, it has spiked up sharply in periods when a surprising event has taken place, like the Chinese revaluation in August. There is a feeling among professionals that algorithmic trading has increased the risk of the traditional fundamental approach based on economic and earnings factors. These concerns have caused investors to scale back their equity exposure.
If you ask typical portfolio managers about their view of the market outlook, they are likely to cite traditional factors like monetary policy, economic growth and earnings. I believe, however that some of the issues I have raised here are lurking in the back of investors’ minds, reducing their willingness to pay up for stocks. Because virtually all of these factors are negative, they could have a dampening effect on the market multiple. You can take the position that there is always plenty to worry about and the current period is no different, but there have to be brighter prospects on the horizon for conditions to improve, in order to recharge confidence in the market outlook. Unless the economy strengthens and either earnings begin to show a sharp improvement or some of the problems I discussed diminish in importance, investors are likely to remain cautious. Despite my concerns about uncertainty, I still think the S&P 500 will end 2015 comfortably in positive territory in anticipation of a better earnings environment in 2016 and in light of current reasonable valuations.
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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