August 2015 Recap

Clarity

Investors are looking for clarity in the face of multiple uncertainties, more uncertainties than most typical investors can bear. What is going on with China? Exactly how strong is the U.S. economy? When will the Fed increase interest rates?   And when will oil prices stop sliding? These are all tough questions to answer. In this newsletter, we will start in the East and move West to reflect on market activity in August and our outlook going forward.

Red Scare

In August, markets were heavily influenced by both economic news and market activity coming from the Far East. Manufacturing and factory data came out early in the month suggesting economic contraction in China. News continues to shape a narrative that suggests China’s economy is slowing, and Chinese stocks have been hammered as a result. Year to date stock market gains in China were wiped out during the month, and Chinese officials continue to intervene in an attempt to prop up stock prices. For example, China’s market regulator recently suspended thirty-four accounts for trading irregularities, some of which belong to hedge funds and short sellers who were placing big bets on price declines.

The Chinese government ultimately controls the data they report to the rest of the world. Thus, the economic truth in China is difficult to discern. More and more economists, finance ministers, and investment strategists are calling into question China’s GDP reports. In recent years, China has continually reported economic growth anywhere between 7 - 10%, and a consensus is forming that China’s growth may now be in the 3 - 5% range. While most Americans would welcome that level of economic growth here in the States, this type of slowdown in China poses a new set of problems for the world economy.

China is now the second-largest economy on the planet, representing about 17% of the world economy in 2014, which equates to about $10 trillion dollars of economic activity. So if China tells us that they experienced 7% growth in 2014, the simple math tells you that economic activity from China this year may shrink by hundreds of billions of dollars.   Let’s pause to consider this staggering figure. That is hundreds of billions of dollars less in overall consumption of goods, services, and commodities that will also severely impact China’s trade partners. If you polled S&P 500 CEOs in the recent past about the growth prospects for their companies, they would likely have told you that they plan to expand into emerging markets, where the average person’s percentage of discretionary income is advancing. Remove that from those CEOs’ business plans, and you can see how falling commodity prices, weakening sales, and lackluster earnings can dampen the U.S. and global economic outlook.

China is a country in transition. They are in the decades-long process of converting from an agrarian and industrial economy to a service economy, like the U.S. and other developed countries. This change involves a mindset morph from being staunchly communistic to being more capitalistic. Obviously, this transition won’t happen without some growing pains.

Some of those growing pains are apparent, as evidenced by recent spikes in market volatility. Chinese markets trade hours ahead of European markets and a half-day ahead of U.S. markets, meaning selling in China can trigger selling in Europe, which can spill over to heightened selling in the U.S. . . . And with many market followers calling American stocks fully valued and even expensive, traders sometimes pounce on any reason to sell, which can trigger waves of algorithmic trading. Add to this the fact that market technicals have weakened so far this year, and we are not helped one bit by last month’s heightened volatility.

In a world with few certainties, one thing we can all be certain of is this: China will continue to do all it can to promote domestic growth. They have already devalued their currency, slashed interest rates, and injected hundreds of billions of Yuan into their capital markets. Time will tell if these measures will ultimately fix their economy and their markets, let alone convince the rest of the world that everything is going to be okay.

“There Will Be Blood”

The movie with the title above was met with critical acclaim when it debuted on the big screen back in 2007. It told the dramatic story of a ruthless oilman who monstrously built a small oil empire in California, and Daniel Day-Lewis won a well-deserved Oscar for Best Actor that year. Know that Saudi Arabia and OPEC seem to be almost as ruthless in their plan to cripple oil shale players whose oil output now accounts for a meaningful percentage of world oil production. OPEC is pumping oil almost as fast as it can to boost supply and drive down prices, hoping to damage the shale players enough to put as many of them as possible out of business. In fact, OPEC pumped more oil last month than any other month in the past three years as the summer comes to a close, a time when Saudi Arabia typically curbs its output. It’s been well over a year since oil prices started to fall. In August we watched as oil prices slipped to 6-year lows, but oil prices recovered some lost ground in the final stretch of the month.

The effect of low oil is apparent. The Energy Sector companies of the S&P 500 have seen sales and earnings decline by -32% and -55%, respectively. These declines are weighing heavily on energy company stock prices, and these companies have already started laying off workers and are canceling capital projects to expand production.

The big, integrated oil companies like Exxon Mobil, Chevron, and Conoco Phillips should be okay when this is all over. However, the smaller, sometimes highly leveraged shale players won’t be okay. Debt markets will likely be the first place we’ll see real signs of trouble. Some energy companies may start defaulting on payments to bondholders. Then we are likely to see rating agencies downgrade the credit quality on this debt and on future bond issuances as well. In fact, right now, roughly 15% of all junk (below-investment grade) bonds are energy-related debt issues. Eventually, the big firms may step in and buy up some of the distressed shale players that survive this period of low oil prices, but that has yet to play out. The future doesn’t look good for producers - the International Energy Agency has warned that oil stockpiles will not be diminished until the fourth quarter of 2016, or even later, if sanctions on Iranian crude exports are lifted. In short, the oversupply glut of oil isn’t going away anytime soon.

A date to mark in your calendars - September 17th

The Federal Reserve Board will conclude its regularly scheduled, two-day meeting in mid-September with a press conference. If all goes according to schedule, Fed Chair Janet Yelled will take a seat in front of a bunch of microphones, and she’ll defend either a Fed Funds rate increase or a decision to defer action until another date in the future. It’s nearly impossible to guess what the Fed will do at this point. Economic data is mixed. Inflation is low to non-existent. Unemployment data looks okay, but there are some concerning data points in the small print.   The Bureau of Labor Statistics reports a U3 figure of 5.3% unemployment. However, the U6 figure, which factors in those workers who are “under-employed,” is 12.6%. Under-employed workers are those that have jobs, but are doing work below their level of qualification. Also, real average hourly earnings (which takes into account the wage paid and the effects of inflation) have yet to show consistent, strong gains.

Uncertainties regarding China, Greece, and Puerto Rico, as well as the impact of low oil prices and below average economic growth are all reasons the Fed may keep rates right where they are at the conclusion of this month’s meeting. However, in dramatic fashion, Q2 GDP was revised up from 2.3% to 3.7% in the final week of August. A rise in spending has been cited for this sizable bump in domestic production during the second quarter.

There is a strong academic argument for a rate hike this year. Economists are starting to think that the present zero-interest rate policy (ZIRP) has run its course and that it no longer benefits economic growth. And if the Fed refuses to act now, will the fact that 2016 is an election year limit their activities then? Typically, the Fed has been less active in election years to dispel claims that it could influence the elective process by helping or hindering the economy. It’s difficult to say. Keeping rates low might be the cautious approach that might benefit the near term, but a rate hike now might be better for the overall economy in the long run.

Proceeding with Caution

In today’s interconnected and volatile world, there seem to be more questions than answers. However, this rock called Earth that we all live on keeps spinning. In previous newsletters, we have predicted economic divergence – an environment in which some economies would do better, while others would suffer. The same can be said for various business sectors. Big down and up days in the market are part of the world we live in, and this sort of volatility will likely be with us well into the future.  Should technical aspects of the capital markets break down or fundamental issues in the economy lead to deterioration in the markets know that we’ll continue to invest with discipline and patience, and we will take steps to limit risk, if and when warranted.