We’ll wrap up this year’s letter here with my views on the major themes that presumably moved markets in 2015, an assessment of each in today’s light, a breakdown of the results of major averages and sectors, and a teaser of what—in terms of future commentary, and discussions with clients—is to come.
The major themes in 2015 were China, the Fed, the dollar, and the amazing decline in the price of a barrel of oil:
The pace of economic growth in China—the world’s largest consumer of commodities, the home of 20% of the world’s population, the bullseye for U.S. multinationals like Apple—slowed this year. As I expressed throughout, the popular notion that China is about to implode under the weight of ghost cities and private sector debt was, in my view, faulty—or, at a minimum, untimely. Yep, the world’s second largest economy has its issues, but, nope, it’s not nearly ready to bring on the next great global recession. Not yet—not by a long shot! Here are a few snippets from my earlier commentaries:
I have received a few inquiries with regard to the recent volatility in the Chinese stock market, and whether it’s as big a worry as many in the media suggest. I counsel that, indeed, China’s crazy market of late has created volatility in other markets (U.S.’s included). My view regarding the Chinese economy, however, does not jibe with the consensus. A China slowdown was to be expected as the powers that be rightly move the economy to more of a consumption/services orientation.
China has issues, not the least of which is mounting private debt. And while, like any economy, it’ll experience fits and starts—exacerbated and aided by a regime that can’t help but try and control it—I don’t see a great Chinese recession occurring anytime soon ($3.8 trillion in reserves carries a lot of fire power) Although I do see continued volatility in the China stock market.
Well, there may or may not be a black swan (an unforeseeable event) lurking somewhere within the Chinese economy, but I can tell you with certainty that last week’s currency move was not an attempt to circumvent some impending cataclysmic event. While, granted, a cheaper currency may indeed help China’s slowing manufacturing sector—which I suspect was one justification for expanding its range—the following statements from the International Monetary Fund (IMF) speak volumes about another key motivation (the IMF is considering a bid to move the RMB closer to becoming a world reserve currency). I also included IMF commentary on China’s economy that reiterates what I’ve been reporting about its move to a more services/consumer-oriented economy and the resulting slower GDP growth—plus, the IMF’s view of where China’s present vulnerabilities lie:
The changes by China will help it gradually transition from a tightly managed system linked to the U.S. dollar to one that is more open and more flexible and more responsive to market conditions. The currency ought to move to free float within two to three years.
The Chinese government should put in place an effectively floating rate for the yuan before fully liberalizing its capital markets.
Moving to a free float is necessary for allowing the market to play a more decisive role in the economy, rebalancing toward consumption, and maintaining an independent monetary policy as the capital account opens.
China is moving into a phase of slower, yet safer and more sustainable growth.
Gross domestic product will expand 6 percent in 2017 before rebounding modestly. Growth should be allowed to slow to 6 percent to 6.5 percent per year to address vulnerabilities in the economy.
China’s reliance on credit-financed investment as the primary engine of growth since the financial crisis has created large vulnerabilities in the fiscal, real estate, financial and corporate sectors.
Thus, a key challenge is to ensure sufficient progress in reducing vulnerabilities while preventing growth from slowing too much.
As it turned out, the Chinese currency is now included in the IMF strategic drawing rights basket (along with the U.S. dollar, the Japanese Yen, the Euro, and the pound sterling), which, as I suggested, was clearly the primary motivation behind allowing the Yuan a greater trading range.
Were I to snippet for you all the seemingly pertinent commentary I offered up this year on the Fed, well, I suspect you’d grow weary and stop reading sometime between now and daybreak tomorrow. Suffice it to say that the market was more than a little focused on when the Fed would at last begin the next tightening cycle (raise the Fed funds rate for the first time in 9 years). So, it happened on December 16th, and, lo and behold, the ball will still drop on Time Square this Thursday midnight. The question is, will the stock market drop as the Fed pushes interest rates higher in the months ahead? Actually, a better question would be, will the Fed indeed push interest rates higher in the months ahead? Well, actually, both are good questions:
Starting with the latter, it depends on the economy. If the consumer continues consuming and if the employment situation continues to tighten, we should see the Fed continue to nudge short-term rates into 2016. If, on the other hand, the economy doesn’t exhibit continued strength—I’m guessing it will—then the Fed stands pat and tries to talk the economy to better health (promises to do whatever it takes with no intent [barring an actual recession] to dump additional liquidity onto the banking sector).
As for how the stock market will respond if the Fed continues to raise rates into the new year; it depends on the economy and how aggressively they move. If the economy’s clicking along—and that translates into higher corporate profits—stock valuations can hang in there as the Fed gets us to an interest rate environment that we can relate to historically, as long as they proceed in, as they’ve promised, gingerly fashion.
The dollar (using the dollar index as my proxy) appreciated some 9% during the course of 2015—and that’s after rising by 13% in 2014. That’s gotta be driving the doom and gloomers absolutely batty! The thing about a strong dollar is that while it’s nice if you’re an earner and spender of dollars, it’s not if you’re an earner of another currency and want to spend it on U.S. stuff. I.e., if the dollar has grown 22% in two years versus what’s in your wallet, what’s in your wallet had to grow by 22% to buy the U.S. stuff it could’ve bought 2-years earlier. And that’s not great news for the U.S. companies—many of whose stocks occupy your portfolio—that effort to sell their goods and services into foreign markets. Of course those exporters’ inputs—that they buy from abroad (think the Chinese-produced parts in a Ford) —are cheaper when the dollar’s more expensive. However, if you believe their earnings reports, the weight on the foreign consumer (and the translation of profits earned in other currencies into dollar terms) often more than offsets the gain from cheaper inputs.
And now that the Fed has begun raising rates (we presume it’ll be more than one and done), the consensus seems to be that the dollar will just keep right on rising—as, surely, folks will exchange their foreign currency for U.S. dollars and earn a higher yield in the process. Well, that’s what the text book, and today’s currency analyst, says, but that’s not always what history says. Here’s my chart (the red arrows point to periods when the dollar was falling while the Fed was tightening, the yellows point to periods when the dollar rose while the Fed was loosening). click to enlarge
I’m thinking that the dollar may not be all that problematic going forward.
You’d think—based on so much of the high profile financial commentary of late—that the U.S. stock market has been perfectly correlated with the price of oil throughout 2015. If you’ve been reading my stuff, you know that that’s not my base case. Take a look (the green line is the S&P 500, the brown is WTI crude):
While there were definitely days here and there when stocks and the price of a barrel of oil moved in the same direction, the above is not what I’d call a picture of positive correlation.
In terms of whether it even makes sense that stocks—or, for that matter, the economy—should rise and fall with the price of oil, allow me to re-share something I wrote almost exactly a year ago.
Boone Pickens (famous oil man/expert) says oil will be back to $100 per barrel in 12 to 18 months. Others say it’s heading to $40. Again, that’s what makes a market.
Me, I don’t know where the price of oil is heading in the near-term. But I do know this, plunging oil prices first result in reduced, if not halted, investment in new capacity. Low prices that remain low will result in cuts to current production. Cuts to current production will alter the supply/demand equation, particularly when we’re talking about a commodity that, in one form or another, every human on the planet consumes. And one that when its price majorly declines becomes a major economic stimulus. And folks living in a majorly-stimulated economy feel good. And folks who feel good like to drive places and fly places and buy stuff with parts made from petroleum products. Yep, you get it, the price ultimately comes bounding back.
I’ve heard a number of pundits downplay the economic stimulus story of plunging oil prices. They cite the boom in states like North Dakota, and how the folks there will suffer if this keeps up: A good number of those jobs will go away and that’ll reverberate throughout the rest of the economy. Well, they’re right, and, well, they’re wrong. Yes, some folks could lose their jobs, but if “reverberate” means that a cut in U.S. oil production will effectively nullify the economic gains of lower oil prices, they’re wrong—on two fronts. One, the U.S. oil boom has been the result of newly adopted (i.e., it’s been around awhile, but it’s just now being used en masse) technology that doesn’t rely on human capital like the old technology did. Meaning, the productivity of today’s oil industry is way higher than yesterday’s. I.e., it takes substantially fewer man hours to fill a barrel of oil than it used to. Plus, the U.S. remains a net importer of oil. Meaning, the boon to the U.S. consumer and industrial user of oil overcompensates for the hit to the oil producing states.
So, I say we enjoy it while it lasts. Because, alas, it won’t last forever. And, yes, we’re still a ways away from the point where the alternatives take over. And the price of oil will traverse many cycles in the meantime.
Obviously, Mr. Pickens didn’t know OPEC like he thought he did. The cartel, at the behest of the Saudis, remains hell-bent on regaining market-share (putting some of the competition out of business) by keeping production high and, thus, the price low. But make no mistake, my little lesson of a year ago on the basic economics of oil (or, for that matter, any commodity) will indeed prove to be the story at some point going forward, despite the Saudis. You see, the social programs they ramped up in response to the democratic uprisings that sprung throughout the Arab world in 20011 (the “Arab Spring”) were ultimately unsustainable to begin with—pile on the self-inflicted hit their taking in oil revenue and this game ends sooner that it otherwise would have. Of course the question is, given the rest of world’s capacity to produce, to what extent these days can OPEC actually move the needle? I suspect some, but I wonder if Mr. Pickens will live long enough to see that $100/barrel again. Of course I’m not predicting anything!
So let’s finish up here with a brief synopsis of how the market performed in 2015, dispensing with the long sector-by-sector and regional dissertations (as we’ll be diving into those weeds in each weekly update going forward):
Here’s how major averages fared in 2015* (keep in mind, today’s the 29th [the following are as of the 28th}, so these won’t be right to the decimal point):
The New York Stock Exchange Composite Index: -5.74%
The Dow Jones Industrial Average: -1.65%
The S&P Global 1200 Index: -2.64%
The S&P 500 Index: -0.12%
The MSCI Europe, Australia and Far East Index: -0.73%
The MSCI Emerging Markets Index: -15.74%
Here’s a look, using index exchange traded funds, at the U.S. market by sector**:
IYH (healthcare): +5.09%
IYT (transportation): -17.75%
XHB (housing): + 1.00%
XLB (materials): – 9.84%
XLE (energy): -23.64%
XLF (financials): -2.99%
XLI (industrials): -5.73%
XLK (technology): +4.52%
XLP (consumer staples): +4.76%
XLU (utilities): -7.77%
XLY (consumer discretionary): +9.05%
Talk about your mixed bag!
And here’s how bonds faired**:
TLT (long-term treasuries): -2.96%
HYG (high-yield corporates): -10.70%
And, lastly, commodities**:
GSG (tracks the S&P GSCI Commodity Index): -34.80%
GNR (tracks the stocks of commodity producers): -26.07%
Along with my view on sectors and non-U.S. equities, there’ll be much more to come on bonds and commodities in the coming weeks.
In the meantime, you—if you consider yourself an opportunist—might be wondering if opportunity lies in the above numbers. Well, perhaps: I recently ran the charts on how the S&P 500, the EAFE (non-U.S. developed markets) and GSG (commodities) have fared over the past 40+ years of Fed intervention. The following summary covers the periods—like the one that ended two weeks ago tomorrow—between Fed tightening cycles (when the Fed was either reducing rates or leaving them alone), and the periods when the Fed was raising rates: click to enlarge…
As you can see, there may be some careful tweaking of allocations in order during the months to come…
On behalf of everyone at our firm, I’d like to take this opportunity to thank you clients out there for the opportunity to take the burden of managing your long-term money from your shoulders. We are truly blessed to work with such a wonderful group of people! Sincerely!!
For the rest of you subscribers, thank you as always for reading!
We wish you and yours a Very Happy and Prosperous New Year!