After an extended period of complacency, markets have whipsawed in 2016. Will this level of heightened volatility continue? Does it signal an impending recession? We think the answers may well be "probably" and "we think not." Let's look at what could go right, what to watch, and what might be different in 2016.
What could go right?
Many macro components underpinning the solid nature of the U.S. and global markets remain in place, including reasonable retail sales, solid consumer sentiment, strong housing activity, high employment percentages, and improved corporate and consumer balance sheets.
Central banks outside the U.S. remain accommodative, encouraging exports and supporting business trends in the EU and elsewhere.
China's progression toward a consumption-based society is proceeding rapidly. Recent reports show consumer spending now makes up 65 percent of China's GDP (vs. 50 percent in 2014)--an amazingly fast shift for such a massive economy. A better balance between consumption and production is a more stable platform for continued long-term growth.
U.S .demographics, with Millennials now the largest contingent of both the general and the working-age population, have positive implications for a wide range of industries.
The majority of the negative impact to corporate earnings and capital expenditures from the steep decline in oil prices has already been seen. (Energy company earnings within the S&P 500 were down to $17.40 in 2015 for example vs. $41.40 in 2014.) Even if energy prices fall further, their impact on S&P 500 earnings will be muted by their relatively small representation. The bulk of the economy benefits from lower oil prices, though much of that benefit comes with a lag.
The sharp downtick in equity prices globally, even as earnings have come in largely as expected, has brought valuations down toward more reasonable levels. While not overtly cheap, they are in better alignment with current fundamentals than they were even late last year.
Areas to watch
Technical indicators still show that equities are vulnerable. Defensive sectors such as utilities and consumer stocks continue to lead (adverse), but short-term improvements can be seen in down-and-out sectors such as materials (positive). The bottom line with unfavorable technical trends during periods of market plunges is that equities could be one poor data point, headline, or awkward comment from the Fed away from another sharp retreat to the downside.
Should volatility remain high, it could begin to weigh on Main Street. If the pessimism grew widespread enough to pressure consumption and corporate capital expenditures, it could cause deterioration in the underlying fundamentals. Given that stocks/investments are more broadly owned now than they were a couple of decades ago, this issue bears close monitoring.
The fact that the U.S. is in the midst of an election cycle with no incumbent president to reelect only adds to the general sense of angst. Candidates have a vested interest in making each citizen disgruntled about the status quo, in an effort to be swept in on a platform promising change.
Capital, which had been on a worldwide search for yield, is seeking safer havens. The high-yield debt market suffered in late 2015, and the growth versus value equity tilt has reversed itself in early 2016 as investors seem intent upon hunkering down.
What's different this time?
Investment industry veterans are quick to point out that it's "never different this time." Yet secular trends take shape and play out over long periods. We are in the midst of a confluence of intersecting secular changes (technological, demographic, geopolitical, and social sensibility norms) that could influence investing and portfolio construction in the coming decades. While it's tough to accurately predict precisely how they will play out, they bear observation.
Central bankers in most developed and emerging markets have driven yields on government debt to below zero in an attempt to revive economic activity in the wake of the Great Recession. The degree of intervention in global capital markets has been so huge that few remember what life was like without this experiment in place. Having never been here before, it's tough to call what comes next when this intervention ceases.
Technological advances have picked up steam and the era of big data, machine learning, artificial intelligence, and everything connected to everything else is upon us. Most traditional business models are in some form of destruction.
Demographics: Japan (aging rapidly); China (one-child policy coming to a halt); and the U.S. (Millennials now the largest segment of population). As these trends take hold, changes--in consumption; in preference for ownership versus participation in the sharing economy; in comfort with technology; in spend down versus accumulation of wealth; and in the need for advanced medical care and solutions--will instigate changes to regional economies.
Daily noise in the markets, prompted by computerized trading, large pools of money invested through hedge funds and other blind pools, tighter restrictions on Wall Street firms' ability to take positions into inventory, and the dismantling of the specialist system is likely to continue. As we have noted, however, this interim volatility creates opportunity for those with a tight grip on fundamental value and an ability to move tactically.
While predicting markets is a frustrating and often fruitless endeavor, focusing on the aspects of portfolio construction one can control, and being ready to move tactically, can pay off in the long run.
Carol M. Schleif, CFA, is regional chief investment officer at Abbott Downing, a Wells Fargo business that provides products and services through Wells Fargo Bank and its affiliates and subsidiaries. She welcomes questions and comments at firstname.lastname@example.org.
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