Stock market advances never proceed in a straight line, and in 2015 U.S. stocks paused for breath. While the U.S. economy continued to grow this past year, it did so at a slower rate than we had expected, due in large part to the drag on the economy from the energy and manufacturing sectors. The weakness in the price of oil and other commodities, along with a stronger U.S. dollar, caused corporate earnings, on average, to be more or less flat.
Within the 2015 stock market, there was an increasing divergence between a small number of large, aggressive-growth stocks and nearly everything else. These stocks rose strongly despite their already high valuations. At the same time, many of the more reasonably valued stocks, which we had already thought represented good purchase candidates, continued to trend lower in price as investors shunned them in favor of those few stocks with undeniable earnings growth.
What caused these negative trends to persist? Part of the answer is politics. Within OPEC there is a struggle between Saudi Arabia and some other members, resulting in the Saudis continuing to pump large amounts of oil, thereby keeping pressure on oil prices. Meanwhile, in China, the government has been dealing with the inevitable transition in that economy from infrastructure investment and a focus on manufacturing and exports to a focus on internal consumption. This evolution has produced a slowdown in growth, along with lower demand for the materials that go into infrastructure and industrial production. In Europe, sluggish growth triggered additional monetary stimulus measures by the European Central Bank at the same time that the U.S. Federal Reserve was telegraphing a gradual increase in interest rates. That combination pushed the euro down and the dollar up.
Does all this mean that stocks are nearing the end of a bull market? We think not. Significant bear markets for stocks are typically associated with economic downturns, usually the result of tightening monetary policy in response to an overheated economy. Signs of overheating would include too little capacity and rising rates of inflation. Such conditions are not present, nor do we think they will be soon. As it is turning out, this slow pace of economic growth is actually a positive for the duration of the advance. There is still room for the U.S. economy to grow before it gets to the overheated stage, and we think that small initial increases in interest rates by the Fed represent a “normalization” of policy from record-low levels rather than a tightening that will bring an end to the economic expansion. Meanwhile, we think that improving international factors will begin to help stocks in 2016 rather than hinder.
In 2016 – THE YEAR AHEAD we make the case for positive returns for the financial markets. We remind you, however, that while we are attempting to forecast the future, our investment success will largely depend on our ability to interpret and adjust to trends and events as they occur and as new information becomes available.
For now, the U.S. economy continues its below-average growth trend. Real (inflation-adjusted) Gross Domestic Product (GDP) looks to have increased just over 2% in 2015. Although consumer demand grew at a pace of 3-3.5% annually, lower energy prices and a stronger dollar affected the sectors of the economy related to commodities and manufacturing. For 2016, we think that 2-3% is a good estimate of real GDP growth. While still below historical expansionary trends, this is a rate good enough to support a reasonable increase in corporate earnings this coming year, as the sources of economic growth become more balanced.
Consumer spending is likely to continue its recent upward trajectory, with the unemployment rate continuing to decline and employee wages finally starting to accelerate modestly. As the Federal Reserve’s policy of gradual normalization (bringing interest rates more into line with underlying growth and inflation) causes short-term interest rates to rise slowly, this will also put more money in savers’ pockets. U.S. households are estimated to hold around $10 trillion of cash, presently earning next to nothing. The benefits of lower gasoline prices have not yet produced as much additional spending as expected (except perhaps for more and larger motor vehicles), but rather appear to have been at least partly added to savings or used to pay down debt. We think that with consumer balance sheets in better shape, these benefits will ultimately translate into more spending. Additionally, new household formation is finally starting to pick up, six years after the start of the current recovery, which should boost consumer spending as well.
Industrial activity should also see a gradual pick-up sometime in 2016, although not immediately. While worldwide demand for oil continues to increase steadily, the drop in oil prices has already caused oil production to decline in this country. Even if OPEC continues to produce as much as it can, global supply and demand should come more into balance this year. Similarly, while the U.S. dollar will likely continue to appreciate somewhat further against the euro and other currencies, this effect should gradually diminish as monetary stimulus helps European and other international economies grow again. The reduction in the headwinds from the dollar may reduce pressure on the currently weak foreign sales of U.S. industrial companies.
Government spending growth at the federal level is beginning to turn upward, as some bipartisan efforts appear to be taking hold. Defense spending looks likely to receive increased support in light of geopolitical uncertainty and concerns over terrorism, while severely overdue increases in funding for infrastructure projects are being considered. State and local government balance sheets also continue to improve in most locations.
Inflation, Interest Rates, and the Bond Market
Headline inflation remained subdued in 2015, as the decline in energy prices held down the overall number, even as “core” inflation (which excludes food and energy) began to tick up very gradually. An expected bottom in oil will mean that the official Consumer Price Index will likely rise in 2016, approaching a 2% annual rate before the year is over. The stabilization of the dollar relative to other currencies may mean that import prices will begin to increase as well.
One of the main financial pastimes of 2015 was guessing when the Federal Reserve would begin to increase the short-term interest rates that it controls. After delaying a hike initially expected in September, the Fed decided that economic and financial market conditions were strong enough to warrant a one-quarter percent increase in the Federal funds rate on December 16. This announcement ended a zero-interest rate policy that had been in place ever since the Great Recession. However, the Fed also took care to emphasize that further increases in short-term rates will be gradual and will only occur if economic conditions are strong enough to warrant such moves.
The comments of the Fed Open Market Committee members indicated that they thought there might be as many as four quarter-percent increases during 2016, but we think two or three are more likely unless economic growth accelerates beyond the current rate. The Fed will be watching the level of employment and the rate of wage inflation, which tends to drive future inflation expectations more than the swings in prices of commodities like oil. In any event, we think that the increase in rates will be gradual enough that it will not have any major near-term negative effects on economic growth. Interest rates will still be very low by historical standards and borrowing for things such as housing and capital spending should not be impacted as considerable liquidity is still sloshing around the financial system.
Will the increase in short-term rates be enough to drive longer-term interest rates higher? The answer is probably yes, but those increases are also likely to be gradual unless it appears that the Fed is getting “behind the curve” by not raising rates fast enough, which we view as unlikely for at least this coming year.
Even gradual increases in longer-term interest rates will erode the value of existing bonds, so we continue to think it wise to keep our clients’ bond investments in short and intermediate maturities which will incur less price volatility. With rates on U.S. government securities so low, better value is still available in investment-grade corporate bonds, and it is not late enough in the economic cycle for the risk of financial stress to be significantly increasing for financially sound borrowers. In the bond arena, 2015 saw tax-exempt municipal yields decline more than those of taxable bonds, so we would be particularly selective investing there, although opportunities should present themselves as the year progresses and rates move gradually higher. Opportunistic bond selection often produces positive incremental results.
The Stock Market
The stock market advance stalled in 2015, as corporate profits disappointed expectations. Volatility also increased, and the broad market saw its first ten percent correction since 2011. The commodity-related and industrial sectors were among the hardest hit given their greater exposure to lower prices and the strong dollar. The price of oil, which began to recover in the spring of 2015, again reversed direction and is now sitting under $40 per barrel, contrary to our expectations of supply and demand trends. The consumer and healthcare areas, along with some technology stocks, saw the best results. While a small number of very expensive, high-growth stocks have done extremely well, the price of the average U.S. stock is down for the year.
We expect things will go somewhat better for U.S. stocks in 2016. Moderate earnings growth should resume, and valuations–while no longer as cheap as they once were–are not yet excessive, either. Federal Reserve policy, while beginning to normalize, is nowhere close to actually tightening, and when rate increases have been gradual the stock market has historically done well. Stimulative monetary policy in both Europe and China should also help brighten the world economic picture. Corporate cash flows remain strong, which should aid ongoing dividend growth and share buyback programs, and be supportive of continued merger and acquisition activity.
U.S. real GDP growth of 2+% should be enough to enable corporate revenues to grow in the mid-single digits, while revenues in the depressed energy and industrial sectors could even surprise on the upside as the trends of the last two years in oil prices and the dollar gradually begin to reverse. By one analyst’s estimate, the strong dollar trimmed headline earnings by over 3% last year, while energy prices took down overall corporate earnings by another 6%, for a nearly 10% total hit. Even if these factors don’t quickly recover, their stabilization alone should push overall corporate earnings growth into positive territory.
Corporate profit margins are probably about as high as they can get for now, since much of the easier expense cutting and efficiency gains have already been accomplished in this recovery cycle. Wage costs are beginning to pick up as unemployment continues to decline and companies compete more for skilled employees. Still, much of that expense gets recycled into increased consumer spending, keeping the wind at the back of revenues. Businesses continued to defer capital spending due to concerns about the demand outlook and a focus on shorter-term cost cutting goals, but some re-acceleration should occur here, especially technology spending focused on further productivity increases.
The overall stock market valuation, as measured by price-to-earnings ratio, is about 16 times next year’s consensus estimate for earnings of the companies in the S&P 500 index. This figure is about the same as a year ago and, while higher than earlier in this bull market, still not historically expensive. That said, a much higher valuation is probably not warranted for now either, given the rather modest rate of earnings growth we expect and the end of 0% short-term interest rates. However, stock market valuations also typically overshoot “fair” value before bull markets come to an end.
Increases in dividends can also be supportive of stock prices. We expect dividend growth in this more mature phase of the economic cycle to mirror earnings growth. Another positive factor can be stock buyback programs. While many companies have already bought in considerable shares in the current cycle, cash flows remain strong and we think further repurchases will be an additional benefit.
Adding up these factors of mid-single digit earnings growth, little or no P/E expansion, and a current dividend yield of around 2% provides an expected total return in the upper single digits for the average stock next year.
As the economic expansion and the bull market in stocks become longer in the tooth, market volatility is likely to increase. Investors got a taste of that in 2015. Given the uncertainties about the pace of Fed policy changes, the effect of the dollar and oil on the resumption of overall corporate earnings growth, and geopolitical concerns, it wouldn’t surprise us to see at least one correction of August’s magnitude or greater sometime during the coming year. However, we do not think it will be enough to derail the overall positive trend that we expect to continue as long as the U.S. economy continues to grow.
Within the market, we expect some unwinding of the valuation disparity between the faster growing companies and the currently out-of-favor economically sensitives. Although companies able to generate true growth in a moderate economic environment will still continue to see demand for their stocks up to a point, we would be wary of paying too high a valuation to chase this growth. We continue to look for good-quality companies with a competitive edge and reasonable stock market valuations. In this low-yield environment, stocks with growing dividends are likely to be in favor, as well.
Healthcare and technology should be sectors with continuing structural tailwinds. Energy and industrial stocks remain a contrarian play, and while possibly still too early, we should see recovery in the stocks of financially sound companies in these sectors. Consumer spending continues to drive much of the economic growth in this country. However, as the stock prices of many of the companies that serve these markets already reflect strong consumer spending, we look for company-specific successes here. Selected financial stocks could do reasonably well in a rising interest rate environment, depending on the pace of Federal Reserve policy.
For the last several years, we have viewed the U.S. as the “best house on the block” economically, and have thus focused most of our investments in domestic companies. We still believe this will be the case in 2016, although monetary stimulus programs in both Europe and China bear watching, as such efforts could lead to attractive opportunities in overseas stocks, especially if the strength in the dollar begins to peak.
Looking at the total picture, in 2016 we expect continued moderate U.S. economic growth, with healthy consumer spending, a bottoming in energy prices, and a gradual stabilization of the dollar relative to other currencies. This combination should keep our economy on the path to one of the longest economic growth periods on record. The Federal Reserve has finally ended its zero-interest rate policy, but the current policy is hardly restrictive. While growing more slowly than the U.S., overseas economies should also see a gradual acceleration thanks to their own expansive monetary policies.
With the increase in interest rates likely to be gradual, the effect on the bond market, while not positive, should be mitigated by owning bonds of short to intermediate maturities. Maintaining high quality while searching for specific undervalued situations will be important in aiding returns. And, cash investments–after seven long years at zero–will once again generate a positive rate of return.
The stock market should see a modestly positive year, although not one without continued volatility. Corporate earnings growth should be sufficient to support higher stock prices, but we do not expect much, if any, expansion of stock market valuations just yet. If, as we expect, stock price increases are indeed only moderate, dividends will be an important component of total return.
Longer term, the environment for investing is not without its challenges. While stimulative monetary policies have kept overall world economic growth in positive territory, the lingering effects of the last economic downturn have not totally dissipated. The amount of government debt required to finance the support of the world economic system has reached levels that at some point will have to be dealt with, which could reduce the future rate of global economic growth.
Technological advances in manufacturing and the need for fewer workers continue to put pressure on the U.S. middle class. Income inequality is a serious and growing problem, potentially leading to an increase in populist movements on both the right and left of the political spectrum. And, once again, geopolitical issues have moved to the forefront of the news. Terrorism concerns have justifiably risen, and regional military conflict and civil wars continue along with a dramatically increased flow of refugees. In our country, a contentious political election looms, with seemingly more political polarization than ever. It always seems that there is much to worry about, but we believe that our economy is wide enough and deep enough to weather a great deal. For the time being, we see the environment as still conducive to earning favorable returns on investment portfolios.
The last year has been a difficult one for investors seeking sound fundamental value. Periodically, long-term investment approaches such as ours can be temporarily out of sync with the action of the markets. At times like this, we recommit to our basic disciplines, but also continually review our strategy and process to see where we can improve. In the year ahead, we expect to continue our successful record of providing clients with favorable risk-adjusted returns.
We wish all of our friends and clients peace, joy, health, and prosperity in this New Year, and for many years to come.