The S&P 500 endured its worst-ever first five trading days to start a year, declining by about 6% and falling into correction territory for the second time since last August. With the correlation between stocks and oil prices recently hitting a 26 year high, it is likely that the decline in energy prices during the early part of the month played a large role in the market’s weakness. Moreover, we believe that this fragility reflects a market which is pricing in an elevated probability of recession for the U.S. economy, at a time in which the Fed has moved into tightening mode – altogether not an ideal combination for stock prices. While we too remain cautious, we see a U.S. recession as a low probability event. On the contrary, we continue to view the domestic economy as relatively healthy, despite some recent tepid data. Stocks were able to finish the month on a positive note, likely driven by oil prices which closed out the month with a 27% rebound from the 12 year low set on January 20th.
Despite the sharp rally to end the month, oil prices still declined by 9% during January. While we believe that falling energy prices are typically beneficial for most countries which are net importers of oil, the type of precipitous falloff which has ensued over the last several months can have negative consequences. In the U.S., domestic oil producing regions have been hit hard and industrial firms which sell products to oil and gas companies have been negatively impacted as well. In addition, corporations in a variety of industries have seen their capital costs rise as bond spreads have widened across the board in response.
While we were encouraged by the price action to close out the month, we see little in the way of fundamentals that would support significantly higher crude oil prices over the near-term. What might change our view in this regard? If the world’s major oil producers were to coordinate a production cut, we would expect to see materially higher prices. In fact, we believe that rumors of such an event were likely the key drivers behind the late January rebound. That being said, should this not occur, we could very well see a retrenchment back towards the January lows – a scenario which we anticipate would likely take stocks down as well. Looking out a bit further, we do think that a continued falloff in production from U.S. shale producers may eventually begin to support oil prices by helping to reduce oversupplied conditions.
Fourth quarter earnings season is underway, and in our view a key theme has been the extent to which the strengthening dollar has cut into profits of U.S. based multinational companies. This has been the case across sectors, though its impact has been particularly severe in the technology space, where companies tend to have a greater proportion of international revenues. With the continuing divergence in global monetary policies, namely the U.S. embarking on a tightening campaign while most other major central banks are firmly in easing mode, it is conceivable that the strong dollar headwind may persist. In our view, however, the Federal Reserve is highly cognizant of this risk factor. As well, we believe that the fragile state of global financial and commodities markets may give committee members pause with regards to their plans for rate hikes this year. Another characteristic of the current earnings season has been the precipitous share price declines for many companies that have reported disappointing results or provided a weak outlook. We regard this as a bearish indicator, and one which is suggestive of elevated levels of risk in the market.
Our outlook on the market remains cautious. We continue to view the potential for a meaningful economic slowdown in China as a major risk factor, and note that its equity markets are still exhibiting elevated levels of volatility. While we are encouraged that the People’s Bank of China (PBOC) has been proactive in ensuring sufficient levels of liquidity for the country’s financial system, we remain concerned about the opaque and at times confusing nature of its monetary policy strategies in aggregate. We are also keeping a close watch on the dollar’s value relative to other currencies. As noted, its appreciation has had a significantly detrimental impact on U.S. corporate earnings. It is conceivable that this headwind may persist should the Fed move forward with its tightening campaign, though at this point we think that committee members are already rethinking their most recent projections for four rate hikes this year.
We do see reasons for optimism. In our view the recent chatter about a possible U.S. recession seems premature. Economic contractions are typically preceded by material rate hikes by the Fed, a course of action which we see as highly unlikely for the foreseeable future. Recessions are also often heralded by drops in consumer confidence, an indicator which for now at least remains at relatively healthy levels. Moreover, consumption, the key driver of the U.S. economy, has been resilient. While December retail sales may have been tepid, overall consumption held up fairly well with a 2.2% gain for the fourth quarter, and grew a solid 3.1% for the full year. We believe that these numbers can strengthen if consumers begin to spend the savings they have accumulated from lower prices at the gas pump. With the savings rate currently at its highest level in three years, it appears that much of these savings have either been piling up in consumers’ bank accounts or used to pay off debt. That said, we do not expect the savings rate to expand much from here, and therefore believe that going forward we may see a bigger benefit to consumption from lower oil prices.
We continue to view global monetary policy as being firmly accommodative in aggregate. In December the Bank of Japan became to latest central bank to institute negative deposit rates in an attempt to spur lending, and the PBOC has been injecting copious amounts of liquidity into its financial system. The European Central Bank has also sent strong signals that it is ready to take further stimulative actions at its next meeting. In the U.S. the Fed did recently take its first rate hike in seven years. However, rates remain at historically low levels, and we expect when all is said and done 2016 will be yet another year in which initial Fed projections for rate hikes prove to be far too aggressive.
As risk managers in this environment of uncertainty, we continue to seek to build wealth over the long term by protecting the portfolio during severe downturns.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.