Three Key Thoughts:
Recession? What recession…
Dollar bulls run out of steam
Europe: Opportunity in chaos?
On February 9th, we published a piece in this space entitled “Markets on Recession Watch.” In it, we noted that the US financial markets were strongly reacting to the possibility of an impending recession, induced by a credit crisis in the energy sector. Yet, as we noted, several key ingredients for a recession were missing: an inverted yield curve, a consumer pullback and high energy prices.
Three days after publication, on the back of stabilizing energy prices, stocks and credit spreads began a big reversal. By quarter end, stocks had more than made up the 10+% loss posted in the first several weeks of the year, finishing in positive territory for the quarter. Similarly, high yield bonds turned in a solidly positive quarter after an abysmal start.
As if on cue, subsequent economic reports showed solid consumer income and spending, supported by a strong employment outlook. However, oil prices have not been able to hold their strong rally. It is too soon to tell if this is just a “too far too fast” pause or a resumption of the oil bear market. Regardless, the negative impact of low energy prices on the credit markets will continue for some time, with the ever present possibility of spillover effects.
On the positive side, the employment picture continues to improve on several fronts. After falling consistently since 2009, the labor force participation rate has ticked up for the last few months, as a large number of previously sidelined potential workers rejoined the labor force. In addition, we are finally seeing some wage growth. This well could be the beginning of a stronger move up in employment costs, something the Federal Reserve has been predicting (too early) for some time.
Meanwhile, aggregate GDP growth for the first quarter will look somewhat weak but it will be positive and not materially out of the 1.5% vicinity that we believe is now normal. With growth this low, there is always a heightened risk that unexpected events could throw us into recession. We need to get accustomed to living with this risk.
Long time readers will recall our continued preference for non-US stock markets, primarily for valuation reasons. With few exceptions, this preference has brought much disappointment as international stocks have dramatically underperformed their US counterparts over the last several years.
The first quarter continued this trend, with the surprising exception of emerging markets. Higher oil prices, dollar weakness and potential political change in Brazil all provided sparks to both the currencies and the stocks. Further easing announcements by the European Central Bank and the Bank of Japan brought strength, not weakness, to the Euro and the Yen. Unfortunately, this reaction says more about the perceived impotence of central bankers than it does about the success of their policies.
China’s capital flight “crisis,” which naysayers were using to predict a major devaluation of the Yuan, has seemingly vanished as recent reports show a rebuilding of currency reserves. Add all of these developments up and the US dollar took a beating in the first quarter. We believe this was overdue, after a very long winning streak for the greenback. That said, we don’t think the dollar is in for prolonged weakness either, just some stabilization.
We have previously noted our concern about the long term effects of the Syrian refugee crisis on Europe and the resulting implications for managing the Eurozone economies. The recent, tragic terror attacks in Paris and Brussels have highlighted weaknesses in the open border system and the still strongly nationalistic views about how to respond. Unfortunately, also highlighted is the inability of the bloc to respond to the crisis in any unified way.
The Eurozone economy remains on fragile ground, still in the early stages of recovery from a series of small recessions after the Great Recession of 2007-2009. An upcoming referendum by Great Britain on its membership in the European Union adds to an already uncertain environment. For the last several years, reports of the imminent demise of common currency were overblown (often authored by those outside the currency regime cheering for its failure). We have believed that the central players (Germany and France, most importantly) would figure out a way to make the experiment work given their overarching objective of internal peace. However, the schisms laid bare by the refugee crisis and exacerbated by terrorism shake our optimism. We hope these challenges become a unifying, not dividing, force.
Last quarter, we summarized our outlook by saying that this “leaves us with lots of potential sources of volatility and not many sources of great prospective returns.” Little did we know how prophetic this would be of the first quarter of 2016! The combination of low expected future returns and high risk is not a hospitable environment for investors. Among individual stocks, we are focused on companies that can grow revenue and profits at healthy rates even in a slow growth environment. Finally, we are adding to investments in hedged strategies that control risk, as we expect the markets to continue to be volatile.
April 7, 2016 © Essential Investment Partners, LLC All Rights Reserved