Three Key Thoughts:
A bear hug for oil
Collision of the economic and political in China
Higher risk, lower return prospects call for caution
Energy prices remain firmly in the grip of a major bear market. In the near term, production is expected to stay elevated with OPEC not budging and Iran output expected to add to the glut. Meanwhile, demand is relatively stable as the world remains in slow growth mode. If US production begins to fall off in 2016, forced by the financial realities of low oil prices, then we could see some stabilization in the supply/demand imbalance.
Expectations of defaults on energy-related high yield bonds caused ripples across the entire high yield bond market late in 2015. This is certainly a warning sign that actual energy defaults could create problems across the credit markets.
Two other energy related matters are surprising. First, we have not seen much of an energy savings “dividend” in consumer spending. This usually takes some time to play out but we would have thought we would be seeing more of it by now. Second, rising tensions in the Middle East (Russia joining the Syrian fighting, open feuding between Iran and Saudi Arabia) should lead to stable or higher oil prices. That has simply not been the case as investors believe the supply/demand imbalance will continue despite these developments. Apparently, it will take an event that actually changes the supply situation to jolt the markets.
In China, the year started with a big drop in the A share market as concerns about currency devaluation and expirations of selling bans came front and center. Imposition of a poorly designed circuit breaker deepened the uncertainties and contributed to selling pressures in stocks around the globe. It’s important to remember that the A share market is primarily for locals and does not represent a major portion of Chinese wealth.
The Chinese authorities are trying very hard to balance four things: (1) a long term transition to a service oriented economy which means substantially lower, but more sustainable, growth; (2) a gradual transition to a freely floating currency, when the market is expecting a dramatic devaluation; (3) developing open stock and bond markets that can support a market based economy; and (4) cracking down on dissension and perceived corruption on the part of those who don't fully support the government’s policies.
Any one of these initiatives would be incredibly difficult in an economy the size of China’s. But trying to do all four invites policy mistakes. We have seen several missteps already and will likely see more. Our greatest concerns are at the point of intersections of the initiatives, particularly when “corruption” could be defined to include market-based selling of stocks, bonds or currencies at a time when the government wants them bought. This is a sure way to delay the development of the markets. We should expect continued bouts of volatility as authorities work through this learning process.
Halfway across the globe, we continue to be concerned about the impact of the refugee crisis on Europe. These concerns are heightened now that weakness in the immigration system has been linked with terrorism. All this adds to uncertainty against a weak economic backdrop. The European central bank is trying hard to stimulate growth and inflation but so far they have met with limited success.
Finally, here at home, our economy continues to muddle along at an expectedly slow rate. The employment picture remains pretty strong and so far inflation has been quite limited. At some point, we may see a pickup in wage inflation as employers are forced to pay more to hire a dwindling supply of available workers. That assumes the economy doesn’t stall before then.
The Fed is certainly counting on this return of inflation as it plans further rate hikes over the course of this year. But the Fed’s track record is mostly on the “too optimistic” side of things. Recognizing this, the markets don't believe the Fed will raise rates sharply, as short term rates have moved up modestly and long term rates have stayed stable after the Fed’s first hike.
Slow growth and low inflation leave us with low nominal growth, which means low growth in earnings for companies. And if inflation picks up because of wage pressures, that could hurt corporate profitability further. Bottom line, we expect corporate profits to be weak generally, particularly absent a bounce in oil. One possible bright spot could be a stable dollar, which would eliminate the large drag on revenues and profits that last year’s strong dollar had.
So where does all of this leave us? Quite honestly, it leaves us with lots of potential sources of volatility and not many sources of great prospective returns. The combination of low returns and high risk is not a hospitable environment for investors. Among individual stocks, we are focused on companies that can continue to grow revenue and profits at healthy rates even in a relatively weak environment. We continue to add to investments in the “alternative strategy” space, mostly in long short equity or debt strategies, seeking moderate returns with moderate risk. Finally, we are far underweight US small cap stocks as we view that category as high risk with quite uncertain rewards in the period ahead.
January 13, 2016 © Essential Investment Partners, LLC All Rights Reserved