January 19, 2016
Written by Nathan Erickson, CFA®, CAIA, Chief Investment Officer
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After 2015 ended with minimal to negative returns in most asset classes and in portfolios overall, investors were looking forward to beginning anew in 2016, only to be punched in the gut with the worst start to a new year in history. While we can’t ignore what the market may be telling us, we should consider what available data may be driving markets.
First, we should consider the first two weeks of 2016 in context. Although they may be the worst start to a year in history, they are not the worst two-week period in history. In fact, if we look back over the last twelve years since the beginning of 2004 there have been 14 worse two-week periods than our most recent experience, two of which occurred in 2010 and three of which occurred in 2011. In 2010 the S&P 500 ended up 15.1%, and in 2011 it finished up 2.1%. As investors it helps to remember that the media does not have our best interests in mind, and will create headlines out of data points whenever they can. Two weeks of returns have never been, and will never be, an accurate representation of what longer-term returns will be.
That being said, we cannot ignore the data that has been driving markets since the beginning of the year, which have really been a carryover from the 4th quarter of 2015. As we have noted in previous commentaries, the market is constantly trying to value future performance, not current performance. This is why you can have a company like Intel report better-than-expected earnings on Thursday, and subsequently see the stock price drop 10% on Friday because the company is forecasting lower profit margins. Even though current and historical performance has been good, future expected performance might be less favorable.
What we have seen over the last couple of weeks and during the latter part of Q4 2015 is a change in global economic expectations, primarily driven by activity in China. While China’s stock market is only 2% of the global stock market (roughly equal to Apple, Google, and Microsoft combined), it represents the world’s second largest economy. China produces a substantial amount of goods and consumes a fair amount of resources, including 12% of crude oil and 45-60% of most base metals. For years we have heard concerns over China’s growth rate, whether the data is legitimate, and if its growth can be sustained. While most outside observers could only speculate, a recent move by the Chinese government, as described below, has increased concern over China’s future growth.
In late 2015 the Chinese government began to weaken the yuan relative to other global currencies, which would make its exports cheaper in foreign markets and stimulate their economy. This overt action to stimulate growth was interpreted by investors as a sign that China’s economy may be worse than the Chinese government is reporting. It can be further interpreted that if China’s economic growth will be slower than expected, so will its demand for resources which affects oil markets, and so will global growth in total.
To absorb all of this information, we need to take a step back. First, China is currently reporting GDP growth of 6.9%, far below the 10% levels of 2010 and 2011, but much higher than most other countries in the world. If perhaps the number is wrong, it is unlikely to be wrong by several hundred basis points, which means China’s economy is still growing faster than most of the world. One of the challenges in China is that the Chinese government continues to play a heavy role in the economy. They clearly desire to play a leading role in the global economy, as reflected in their efforts to control the value of the yuan and invest billions in infrastructure to support GDP growth. Whether we agree with this level of government intervention or not, China has the resources to continue down this path for close to a decade. Until China’s massive population shifts to higher consumption and supports GDP growth naturally, we can expect the Chinese government to take necessary steps to maintain a level of GDP growth that supports their desired role in the global economy.
Undoubtedly the change in expectations of China’s growth and the world as a whole had some impact on oil prices dropping below $30 a barrel last week. It is possible that the removal of sanctions from Iran and their potential contribution to global oil production also had an impact; however, this data has been known for months and should already be priced into the market. It is important to clarify that the key driver of oil prices to this point has been an oversupply issue and not a demand issue. Oil producers in North America have already been responding to the change in price, with hundreds of rigs coming offline over the past year. U.S. production is expected to decline in 2016, with global production expected to increase less than 0.5%. Global demand for oil is expected to increase 1.5%, with China representing only 12% of global demand. As demand continues to grow and supply decreases, we should see some recovery in oil prices.
Finally, both China and oil prices have an impact on one other important measure, which is inflation. Many interpreted the Fed raising rates at the end of 2015 as a sign of confidence that the U.S. economy was strengthening. Now we are starting to hear that maybe the data didn’t support a rate hike in 2015, and doesn’t support the four projected rate hikes in 2016. This is primarily due to the fact that while the economy is at full employment by the Fed’s measure, inflation remains very low. An increase in oil prices would flow through to inflation, which would in turn lead to higher confidence in the growth rate of the U.S. economy and less concern about whether the Fed should have raised rates in 2015 or whether they should continue raising them in 2016.
The first two weeks of 2016 have not changed anything fundamentally. If growth is slowing in China, markets will adjust and reprice accordingly. However, neither China, the U.S., nor the global economy is entering a recession, and therefore adjustments should be moderate. We don’t know what 2016 will bring, but we do know that with this continued uncertainty around global growth, oil prices, and Fed policy, we can expect more volatility in markets.
As investors, we should not get caught up in comparing returns over certain periods of time or how many hundreds of points the Dow is up or down. The media will try to focus our attention on data points, but they are irrelevant to our long-term objectives. We invest because we earn a return for taking risk. Some investments have higher expected returns than others because they have more risk. That means in some years the returns in those investments will be higher and in some years they will be lower, or even negative. We increase the probability of success with discipline and time, not with speculation or trying to time markets. 2016 may turn out to be a bad year for markets, but we design our clients’ portfolios to respond accordingly, with proper diversification and risk hedges built into the portfolio structure. We cannot prevent a loss, but for all of our clients we have designed portfolios with an acceptable level of risk to meet long-term objectives.