Investment Outlook - Fourth Quarter 2015

Third Quarter Review

Stock Markets and Janet Yellen Get Spooked -- Happy Halloween!

For the first time in nearly four years the stock market took a serious tumble. There may be several explanations for the decline that occurred in the quarter ending September 30th, but topping the list would be that the sluggish global economic growth is at risk of slowing even more. Investors are also adjusting to the negative impact that declining commodity prices are having on emerging economies. These undesirable effects even caused Federal Reserve Chairwoman Janet Yellen to postpone raising interest rates due to "global economic and financial developments." If Dr. Yellen appeared uneasy about the outlook, investors could be as well. As a result, sellers outweighed buyers last quarter.

As the famous economist, Kenneth Galbraith, stated "the only function of economic forecasting is to make astrology look respectable." During the course of the recent economic recovery, investors have largely ignored the annual downward revisions in global growth by economists. However, they were not so complacent when the harmful effect of slowing growth hit revenues and earnings. Nowhere has this impact been more pronounced than in the commodity sector. When the current price of a key commodity like oil is one-half of what it was a year ago, it eventually becomes BIG trouble for companies and countries that depend on oil revenues. It also damages a significant part of the stock market. Energy stocks declined -18% in the quarter, and metals and mining companies were off -30%.

The decline in commodity prices started with the slowdown in China's growth. Several major economies that depended on China's thirst for commodities are now in recession territory. The economies most affected by lower commodity prices account for some 40% of global GDP, nearly twice what they did 20 years ago. The negative effect of these prices on emerging countries is rebounding to developed economies, such as the U.S., Europe and Japan. Although the U.S. Federal Reserve ("Fed") is primarily focused on the health of the U.S. economy, in today's interconnected global economy, negative trends reverberate across the world. Hence, Dr. Yellen pushed the pause button on an interest rate hike.

Low Interest Rates Help...Until They Don't

Low interest rates have been the major tool to prop up economic growth since 2009 as well as a major factor contributing to the six-year bull market in stocks. However, these low rates can also ultimately result in some adverse side effects. The Bank for International Settlements (BIS), a defacto central bank for central banks, has consistently highlighted the limits of a low interest rate monetary policy as well as the more negative consequences that the financial markets are now confronting.

The immediate benefits of lower interest rates are obvious -- lower mortgage payments, lower credit card rates, and higher stock prices. However, as the BIS points out, over time very low interest rates lead to financial instability and economic weakness through financial and property booms and busts.

Low interest rates have changed from being an unambiguously positive influence on economic growth to one with some unintended negative effects. One of the reasons for the slowdown in China is the weakness in housing and construction after a massive building and property boom. In the commodity producing countries, which are attached at the hip to China, both the countries and many companies there have dramatically increased their debt since 2011. Both parties could not resist tapping such low rates, causing debt levels to rise. High levels of debt, even with low interest rates, are problematic for those exposed to the collapse in commodity prices. The decline in their currency values has only made the problem worse.

In the midst of the 2008/2009 recession there was little to no dissent among central bankers to use lower rates to rescue global economies. Now some of the negative consequences of a prolonged period of low rates are evident, and the Fed appears paralyzed by international events that they did not anticipate. The Fed cannot raise rates in a sluggish global economy because it will worsen the heavily indebted emerging and commodity driven economies that binged on the low interest rates. And, it cannot lower rates more because they are already at zero. The BIS is pushing central bankers to broaden their focus from domestic objectives such as unemployment, inflation, and growth to the negative consequences of too much debt and currency depreciation. Central bankers are left literally scratching their heads.

Volatility Returns to the Markets

China has not only been at the center of attention for commodity producers, but has also ignited stock market declines around the world. Until June of this year, China's stock markets were sizzling:

  • The Chinese market was up +150% during the prior 12 months.
  • The public rushed in with over 50 million new accounts opened in the first half of 2015.
  • Trading on borrowed money had exploded.
  • Valuations on stocks doubled.

When it became clear that the catalysts underlying this spectacular rise were simply speculation, the Chinese market dropped precipitously. Global stock markets could not ignore China's issues, and dropped as well. Authorities and other market participants criticized China's leadership for promoting the upswing as well as their amateurish efforts to arrest the decline. On August 24th, the U.S. market resembled China's. In the early morning, many blue chip stocks declined more than -20% due to a lack of money (and guts) by market makers who historically have stepped in to cushion the markets.

Investors are now trying to determine the magnitude of the slowdown in China, and the duration of the slump in key commodities such as oil. If there is a consensus on oil prices, it is that they will remain in the current range through much of 2016, and perhaps longer. The logic behind this forecast is that although U.S. production is being cut, more supply will be coming from Saudi Arabia and Iran and the demand will remain under pressure due to China and the emerging markets. Like most forecasts, the current trend is the consensus forecast. As we know from decades of watching oil prices, they can turn on a dime and frequently in the direction few expect. In the past, we were programmed to think of lower oil prices as a positive. At this time, somewhat higher prices just might be welcomed.

The recovery in stock prices from the bear market of 2008 has been based on a recovery in global economic growth, incredibly low interest rates, and higher corporate profits and dividends. For several years markets benefitted from the unusual combination of an economic recovery and declining interest rates. The market stalled out this year as investors questioned the vitality of economic growth and whether the positive effects of low interest rates are exhausted. Investors continue to focus on pronouncements from our Fed, and they apparently are not in agreement on what to do. As a result, investors have pushed the pause button as well.

Bob Milnamow
President and
Chief Investment Officer
October 2015