Brouwer & JanachowskiDecember 28th, 2015
Asleep, tired or malingering. Nearly all major stock, government and investments grade bonds ended the year, at least to the night before Christmas, little changed in 2015. Ten-Year treasuries yield 2.2%, around where we left them in 2015. German Bonds, which drive European sentiment, hovered around 0.55%. Japanese bonds saw a flurry of mid-year activity as investors thought growth and inflation might take off. It didn't. They ended at around 0.2%. Japanese ten-year bonds haven’t yielded more than 2% since 1998. Stocks had a quiet year. Though it didn't feel like it in August.
Growth was tepid. U.S. GDP is stuck at around 2%. European growth improved but remains less than 1%. Japan came close to a technical recession following two quarters of decline. The final number, after three years of reform and stimulus, will be around 0.2%.
So not a great year for investing or the not-so-great recovery we’ve seen for eight years.
We saw three influences on capital markets in 2015:
- Fed Divergence: For most of the year, the Fed was in a “will they, won’t they” mind. We had weak economic growth in the first quarter and, while there was a rebound, annual growth failed to escape the post-crisis 2.0% to 2.5% range.
The Fed follows only two measures: job growth and broad inflation. Neither has been robust but unemployment rate fell to 5.0%. Inflation, specifically Personal Consumption Expenditure or PCE, has not risen much above 1.5%. So there was little compelling reason to raise rates except that expectations were to do something. So, they increased rates. By 0.25%. Markets yawned. Yellen failed her first big test.
- Energy, Emerging Markets and China: The three are linked. The slowdown in China, inevitable given the pace of investment growth in recent years, meant energy and commodity providers saw a rapid demand drop. Most of the large Emerging Markets are commodity exporters. Growth and corporate profitability plummeted. Investors quickly sold.
U.S. energy followed. Much of the resurgence in the U.S. energy industry was in response to high oil prices from 2010 to 2014. The result was oversupply. Oil prices fell over 50%. Energy companies capped wells, dismantled rigs and laid off workers. Investors dumped High Yield (particularly energy) and Emerging Markets bonds. The cyclicality of the oil industry returned with a vengeance.
- U.S. Dollar: the combination of rate divergence (low everywhere and rising in the U.S.) meant investors and central banks bought the dollar. The dollar DXY index rose 13% and 18% against the euro. Some 40% of S&P companies’ earnings come from overseas, so reported earnings fell. Over time, industry and companies recover from currency fluctuations but the hit to earnings meant that the S&P 500 in 2015 will earn 9% less than 2014. If earnings fall in Q4, it will mark the first time earnings fell for three consecutive quarters since 2009.
So, better in 2016?
Probably. Here are two charts that have to go right.
- Employment: forget the unemployment ratio. What drives confidence is higher participation among those in their peak earnings years. The chart shows the employment ratio for 25-54 year-olds. Some of this is demographics, such as fewer women in the workforce, and some exiting the workforce. But, not a great picture.
- Relief on Deflation: the strong dollar and falling oil price meant consumer and producer price deflation. While this continues, companies will struggle with top line growth. This may change in 2016. We’re seeing some upward pressure on non-core prices, a more stable year for growth and selective wage increases. If we get any of these, we’re likely to see faster sales growth. This will help consumer company profits enormously as the years of ever increasing profitability from driving down costs, financial engineering and share buy-backs are over.
So where are the investment opportunities?
- U.S. Equities: The S&P 500 has become expensive recently as earnings fell and the index remained unchanged. This is not unduly worrisome as part of the drop is due to the above reasons (e.g. energy, the dollar and global slowdown). Market leadership has been highly concentrated which suggests we will trade in a narrow range as valuations reason themselves out.
We like small and mid-cap U.S. equities. They are more domestic oriented and can grow faster. Here’s a chart showing the outperformance of Large Capitalization stocks in 2015 compared to the long term. We think small cap stocks, those with a market capitalization of under $2bn, will benefit more from a U.S. domestic growth rebound more than the international leaning S&P 500.
- Bonds: U.S. 10-Year government bonds may trade up to 2.5% in the first half of the year as higher front-end rates come into play. But we see limited downside for Treasuries. Supply is low and the strong dollar attracts foreign buyers. Credit will come under pressure and we have already seen both Investment Grade and High Yield spreads widen. We would maintain bond exposure at the highest credit level and expect coupon-like returns.
- International: the major drivers are i) quantitative easing from the ECB and Bank of Japan, which helps equities and ii) the low valuations of many markets. Global growth will remain slow but rising, at around 3.3% (from 3.1% in 2015) and European companies are well placed to take advantage of growth.
- Emerging Markets: the strong dollar and Federal rate hike played havoc with Emerging Markets equities and debt in 2016. But looser policies from Japan, the Eurozone and China are still in play in 2016. Markets are unloved and trade at a 40% discount to the S&P 500. In There are three interesting developments:
- “New China”: which is anything not state owned and industrial, should have a better year and benefit from any fiscal stimulus.
- Reform in India: especially at the local level. India overtook China’s growth rate in 2015.
- Brazil: the government is trying to undertake fiscal reform against the headwinds of a weak real, commodity prices and a slow brewing political crisis. Stay tuned.
Recommendations for your portfolio:
|1.||Increase U.S. Small and Mid Cap equities||Domestic earnings. Recent underperformance. Highly dynamic companies|
|2.||Increase high-grade bonds and Treasuries||Credit spreads wider and credit cycle deteriorating. TIPS provide the ultimate inflation hedge|
|3.||Lengthen duration of bond portfolio||It can take a long time for long term rates to rise after a Fed hike|
|4.||Hold infrastructure||A long haul. But there’s some yield. Capacity utilization up and the market is coming to terms with sub $40 oil|
|5.||Remain exposed to emerging markets||Relative valuation attractive|
--Christian Thwaites, Brouwer & Janachowski, LLC
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