The Markets: Past and Future
As we flip the calendar to 2016, it’s a great opportunity to think about the future. Or maybe we want to think about 2016 simply because 2015 wasn’t a great year for the markets. Unfortunately, the S&P 500 was basically flat for the year. The average stock actually decreased in value while the S&P 500 index was buoyed by a few large tech companies (particularly Amazon, Netflix, Google and Facebook).
For bond investors, treasury yields changed little during the year (hovering around 2.3%), meaning that investors were left clipping small coupons which resulted in a below-average total return. Almost all commodities, including oil, dropped in value and there was no relief gained from investing overseas since most markets were weak. Even the overseas markets that had positive returns saw their gains wiped away when converted back to the appreciated dollar.
The markets spent much of the year waiting for the Fed to finally start increasing rates. In late 2014, Fed officials suggested they would raise rates by mid-2015. As summer arrived and the Fed’s rate increase didn’t, the markets started to anticipate a September rate increase. Labor Day came and went, as did Halloween and Thanksgiving – still no increase in rates. That all changed in December when the Fed finally raised rates after seven years of a zero-interest-rate policy.
Clearly, we are at an inflection point with Fed policy. While some observers try to diminish the importance of the Fed, we’re reluctant to do so. It’s hard to deny the impact of quantitative easing and the Fed’s accommodative monetary policy when you examine the chart on page 3. As you can see, the Fed borrowed money (from 2008 to 2014) so it could buy additional bonds in order to keep interest rates low. The chart shows a strong correlation between stock prices and the Fed’s balance sheet.
With that quick summary of 2015, let’s turn our attention to some of the issues to keep in mind as we enter 2016.
Interest rates – According to the Federal Open Market Committee participants (the decision makers at the Fed), the Fed funds rate will be in the 1.25% to 1.50% range by the end of 2016. Yet, the market (based on the Fed funds futures contract) is expecting the Fed funds rate to be in the 0.75% to 1.0% range by the end of 2016. Regardless of who is right, interest rates should remain low by historic measures.
Our view tends to be more consistent with the Fed funds futures. The current low unemployment rate (5%) is a sign of significant improvement in the labor market from the 10% peak in 2009, but it’s also misleading. We’ve seen a tremendous drop in the labor participation rate, and we still have an unusually high number of people who are working part-time even though they want full-time jobs.
More importantly, inflation has been weak. The Fed’s primary gauge of inflation (the PCE Price Index) is the lowest that it’s been in the past 50 years, with the exception of a brief period during the Great Recession. Even when oil prices stabilize and we lose that deflationary influence on the index, inflation will likely be below the Fed’s 2% target. This will make it difficult for the Fed to raise rates quickly.
While low inflation may sound like a good thing to those of us who remember the problems caused by high inflation in the 1970s and early 1980s, it’s not. First, remember that prices are the best indicator of demand, meaning that low inflation is typically an indication of a weak economy. Second, when inflation is low, it creates the risk of deflation. Lower prices mean that employees don’t get meaningful raises, home prices stagnate and consumers defer consumption (“why buy today when it will be cheaper tomorrow?”). The Fed also loses its ability to influence the economy since the Fed doesn’t want to take the Fed funds rate below zero.
Credit spreads – Interest rates on high-yield debt have increased significantly in the past year while U.S. Treasury rates have been flat. This is particularly onerous for highly leveraged energy firms as there is a fear that low oil prices will make it difficult for industry participants to repay debt. Higher rates will make it difficult for some companies to roll over their debt and will also make acquisitions more expensive. Of course, while many people expect significant acquisition activity in the energy sector, it’s difficult to put a deal together when buyers value a target company based on $35 oil, but sellers value their company based on $60 oil.
The rising dollar – The dollar has appreciated more than 20% over the past 18 months versus most foreign currencies. The higher dollar has hurt our ability to export since it makes our products more expensive when sold overseas, lowers the dollar value of foreign profits and makes foreign imports more competitive. The majority of the dollar’s upward move is likely behind us as the market has been anticipating higher U.S. interest rates.
Wage growth is below average – Wage growth is just above 2%. And, after excluding inflation, it is even lower with the result that it’s difficult for consumption to grow. Low wage growth is likely attributable to low productivity growth and the increase in service related jobs (i.e. retail and restaurants) versus manufacturing.
Low oil prices – In 2014, the price of oil was well above $100. As everyone knows, oil traded below $35 in December 2015. Many factors have resulted in this price decline, including increased supply (due to the use of fracking and other technologies), slow worldwide growth (below average demand) and the appreciating dollar. While many economists have argued that $35 oil would spur consumer spending, that hasn’t had much of an impact from an aggregate perspective since some of that money has been saved or used to pay off debt. More importantly, lower oil prices mean that we’re losing many high-paying jobs and creating fear in a sector that has been responsible for much of our growth over the past few years.
Equities – Equities are currently trading at 18 times trailing earnings. While this is higher than the historic average of approximately 16 times trailing earnings, multiples are typically higher during periods of low interest rates. As described above, we expect rates to remain low which should be favorable for equity markets going forward. We’re also hopeful that oil prices will stabilize at higher levels and that the dollar’s appreciation is complete. Finally, we’re optimistic that investors are not complacent and will use pullbacks in the market as an opportunity to buy additional stocks.
These are some of the issues that we at Trust Company are thinking about as we look at the market today. Many of these issues have the potential to create bouts of short-term volatility: situations that will likely give us the opportunity to increase our allocation to equities at more attractive prices over time. We will continue to monitor the markets and adjust portfolios to best position you for whatever the market and the Fed send our way.