After six years of attractive returns, markets proved frustrating for investors in 2015, as neither stocks nor bonds outperformed cash on a price basis. A flat market does not imply the past year lacked excitement. Quite the contrary as China’s currency devaluation, the collapse in the price of oil, and several geo-political incidents prompted spikes in volatility. A “treadmill” market leaves one exhausted with seemingly no progress, and there seems to be a sense of trepidation among investors as to what the New Year might offer.
There are reasons for concern, to be sure. The stock market narrowed around a few select companies in 2015. Its valuation, while not excessive when compared with prior periods, is no longer compelling. Retail sales were disappointing. Industrial production also failed to meet expectations. For these reasons and because of an onslaught of negativity proffered by the primary election campaign season, the “bunker mentality” that we have described in previous missives seems firmly entrenched.
When prevailing sentiment is at a negative extreme, we become excited as this condition invariably suggests opportunity. For example, a recent survey conducted by the National Association of Realtors indicated that 44% of households believe the economy is in recession. We consider that statistic amazing as there has been clear evidence of significant economic growth over the past seven years. Granted, the pace of growth has not been as robust as in past cycles. Nevertheless, when one considers improvements in the labor market, wages, and personal income, our conclusion is that the economy is actually quite strong.
One year ago, our outlook included an expectation that lower energy prices would result in an increase in discretionary income for US consumers, prompting a surge in spending. For much of 2015, we were perplexed that the windfall from low energy prices did not manifest in greater retail sales growth. Further analysis suggests, however, that consumers did spend the windfall. Americans drove a record number of miles this past year. Restaurants, airlines, and regional travel & leisure companies all experienced growth in sales. The spending occurred, in other words, on services and experiences instead of durable goods and apparel. As expected, lower to middle income households, those for whom energy represents a larger percentage of monthly expenditures, increased spending considerably. Ironically, higher income households, those with greater sensitivity to the financial markets, cut back on activity. Heightened stock market volatility and unusually mild weather during the holidays likely contributed to the recent disappointment in retail sales.
The most encouraging development was the passage of two pieces of legislation that should provide stimulus to the economy. The Highway Bill totals $305 billion over five years. The omnibus spending bill provides funding for other sectors, including infrastructure and defense. Initial estimates indicate that this fiscal stimulus could contribute substantially to GDP growth, and more importantly, it could partially offset tightened monetary conditions. For the first time since the ill-conceived Fiscal Cliff and the Sequester, our Congress has enacted a set of measures that should prove stimulative. The stimulus could also encourage companies to invest more in plant and equipment. This provides additional benefit to the economy in the form of a pronounced multiplier effect that is far superior than investments in the services sector.
Infrastructure, particularly investments in energy, was the driver of global economic growth since the Financial Crisis. It is widely acknowledged that China represented a disproportionate share of investment, and given its dearth of natural resources, emerging markets benefited from its seemingly insatiable demand. Additionally, the massive windfall from $100 per barrel oil prices accrued to the benefit of oil producing nations, many of whom increased spending on domestic programs. Since the Financial Crisis, this accumulated wealth created by high oil prices (i.e., “petrodollars”) contributed to global liquidity and helped finance growth, with some estimates in excess of $2 trillion. In addition to the loss of monetary stimulus from the Fed, the decline in wealth among oil producing nations has served to offset gains in consumer discretionary income. Therefore, the “key” to the market remains the price of oil, and ironically, investors appear to desire a return to high prices.
To the extent oil prices remain depressed, which is our central view, investors will need to be much more selective. Portfolio adjustments should increase the allocation to sectors that benefit from low energy prices. That said, we believe there is significant value in the energy sector, particularly for income. Therefore, we are not inclined to abandon any sector entirely, but instead, our focus will be on careful and opportunistic security selection.
While oil prices might remain lower for longer, there is growing evidence that might require an end to our view that interest rates will also remain lower for longer. Upward pressure on rates could be derived less from policy adjustments by the Fed and more from rising unit labor costs. Increases in the cost of labor suggest tight labor markets, which is a positive indicator for the general economy. Therefore, we remain cautious and defensive toward the bond market. Our base view is that yield curves should flatten, but we are vigilant with respect to factors that would challenge this outlook. Finally, from a long term perspective, we are optimistic that India could fill the void created by China’s evolution to a more consumption-based economy. It is unlikely that the market will produce two successive years of flat returns, and we are quite optimistic that positive economic developments will be better recognized by investors. Happy New Year.