March 2016

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At our 7th Annual Investment Symposium on March 3rd, we discussed several long term themes in the context of the title of our program:  “Changes; Transitions & Transformations”.  Our presentations identified three forces for change:  a) global monetary policy divergence; b) demographic transitions; and c) the evolution of China’s economic model.  Several of these topics, particularly China, were sources of concern for investors during the First Quarter.  Uncertainty often manifests in heightened market volatility, and we pointed out that volatility was clearly pronounced during the quarter.  However, we also emphasized that underlying economic fundamentals were solid and improving, especially in the US.  Moreover, the US is not yet prepared to relinquish its role as the global economic leader, and its future competitiveness remains quite powerful in many aspects.

Given the market’s flat return for the quarter, somebody deprived of all market information from New Year’s Eve through April Fool’s Day would have assumed the First Quarter was uneventful.  The stock market’s performance was anything but uneventful as January witnessed the worst return since 1928.  The correction was driven primarily by two technical factors:  a) an extremely high, but likely unsustainable, correlation with crude oil prices and b) concerns over China.  Forecasts for an imminent recession, a repeat of 2008 market conditions, and “doomsday scenarios” involving currency devaluations among China’s trade partners grew in popularity.  The sharp decline in the stock market in January also created attractive valuations and favorable risk-reward conditions for long term investors that believed fundamentals remained intact.  Somewhat quietly, the stock market found bottom in mid-February, and its recovery since has been one of the strongest intra-quarter on record.

We have asserted repeatedly that short term bouts of volatility generally represent opportunity, provided fundamentals remain intact.  Further, over the long term, fundamental factors prevail over technical forces.  We acknowledge data that indicate a slowdown in manufacturing sectors, but these areas of contraction appear to be related to energy production and distribution.  Outside of the energy sector, there is growing evidence that the US economy is gathering momentum.  This is particularly evident in the labor markets.

There were several catalysts for the market’s recovery.  First, investors began to accurately assess the rather low probability of a “doomsday scenario” unfolding in China.  At our Symposium, we acknowledged the risks associated with China’s economic transformation, but our analysis led us to conclude the most probable outcome is a “muddle through” scenario.  Second, the collapse in crude oil prices precipitated expected production cuts in the US.  However, there had been reluctance among OPEC to help mitigate the excess supply problem.  During the First Quarter, several high profile nations with a heavy dependence on oil exports made overtures about greater cooperation going forward.  The market is unlikely to achieve equilibrium prior to late 2017, at the earliest, but the intense pressure on crude prices appears to have abated.  Finally, Federal Reserve Chair Yellen acknowledged global economic uncertainties in a recent speech to the Economic Club of New York and indicated a greater tolerance for inflation.  The market’s interpretation of these comments has been that the Fed would proceed in a more deliberate and cautious manner and that additional rate increases would be less likely for the next six months.  In our view, the Fed’s acknowledgement of the potential economic impact of several of the uncertainties that worried investors in January suggested greater support going forward.   The Dollar weakened on a relative basis, which contributed to a loosening of global monetary conditions during the quarter.  Consequently, commodity-oriented sectors have led the stock market’s recovery since mid-February.

Going forward, we continue to believe that data will increasingly support our view of a strengthening economy.  The US is a consumption-based economy, and the most important factor is a strong labor market and rising wages.  Given our economy’s dependence on consumer spending, the transmission mechanism of market volatility to economic underperformance is through a loss of confidence.  As market volatility has fallen, we expect consumer confidence will rise.  Rising confidence and relatively low energy costs should lead to improved retail sales.  Earnings growth for numerous stock market sectors are forecasted to accelerate in the second half of this year and could benefit from positive upside surprises to the extent consumption activity increases.  This should provide support for the stock market.

We expect China to represent the principal source of global economic uncertainty, but we also expect China’s economy will stabilize.  Investors will likely shift their concerns to the upcoming June referendum in Great Britain over leaving the European Union (i.e., “Brexit”).  The elections in the US also represent a source of potential investor anxiety.  However, the factors that contributed to the First Quarter stock market correction have become less relevant.  Oil prices are likely range bound until the supply-demand balance stabilizes, but we expect the impact of oil on market volatility to wane as well.  Negative rates in several important global bond markets and loose monetary policy in those markets will exert a “gravitational pull” on US yields and sustain our “lower for longer” thesis with respect to interest rates.  Fundamentals will increase in importance, and the markets should reward investors for selecting businesses with an ability to grow earnings in a challenging and changing global economic environment.