“Now is the winter of our discontent, made glorious summer by this sun of York.”
— From Richard III, by William Shakespeare
Financial assets of all kinds had a difficult time in 2015. Little seemed to work, with equities, fixed income, and other alternative asset classes either little changed or down in a volatile year. Though some individual stocks did well, most did not, as the overriding themes of a weakening China – and emerging markets, in general – and plunging oil prices plus other commodities, as well – weighed on companies with direct or indirect exposure to either cause. Bond returns were also mixed, with most Treasuries and municipal bonds up slightly while high yield “junk” bonds performed poorly. The fourth quarter did feature a sharp rally in October, but there was no follow through. Though many seemed relieved that the Federal Reserve Bank finally stopped equivocating by raising interest rates in December, concern soon surfaced that the tightening would continue in 2016 amid weakening U. S. and global economies.
The New Year has begun with China and oil continuing to dominate investor psychology. There are things that need to occur before both negatives turn into positives – or at least move to neutral. For one, Chinese leaders need to regain the confidence of global investors by stabilizing their economy and currency. This will take time, and the Bank of China might assist the process by consulting resources such as the World Bank, International Monetary Fund and other central banks for advice. Genuinely pursuing needed reforms and removing subsidies to industries with excess capacity would also help. Since it is obvious now that the Saudis and other major petroleum producers will not cut their output, the oversupply will only go away when enough weak oil companies go out of business. Rather than an event, this will likely be a drawn out process lasting at least several months. The debt of many secondary companies is already trading at distressed levels.
The upshot to all this is that the first half of 2016 is likely to remain difficult, with relief coming later in the year. Chinese real GDP growth, although not in the 6.5-7% range that the government has predicted, will probably be in the 4-5% range. That will be considerably slower than it has been, but not recessionary. Keep in mind that China is an oil importer, so lower oil prices are a net positive for the economy, especially the consumer. Also, once enough excess supply is wrung out of the oil market, prices should finally stabilize, though few predict a rapid recovery. Even so, the fact that a bottom will have been reached should help repair market sentiment. Crucial to all this is the stance of the Fed, which seems to favor two to four more interest rate hikes this year. However, any additional weakness due to China, oil or the markets could slow U. S. growth to a level that keeps inflation from increasing back to the desired 2% rate, and force the Fed to delay any further rate increases until conditions improve.
We still believe U. S. stocks are in a longer term bull market because, even with growth likely to be moderate, our economy is nowhere near a recession. The economy is still producing jobs, housing is improving, consumers are still spending and the Treasury yield curve is positive. For 2016, U. S. GDP growth may average around 2-2.2%, a little slower but still in the same range that it has grown for the past five years. Though we continue to be cautious regarding energy and other commodities and remain underweighted regarding emerging markets, we also see opportunity in select consumer discretionary, information technology and industrial stocks. Once the negatives mentioned above are resolved, markets could rally substantially. The best market opportunities occur when extreme pessimism ignores positive economic fundamentals. We presently are approaching such an environment.