Global Imbalances Temper U.S. Growth: TGC Q1 2016 Market Update
In what seems like a bad remake of Groundhog Day, we expect stock market volatility to continue throughout 2016. As a result, portfolio valuations will fluctuate greatly from quarter to quarter depending on where in the volatility cycle we are. However, what should really drive domestic market movements, whether Equity, Fixed, Alternatives, or Real Estate, is the actual strength and depth of growth in the US economy, which at this point seems to be lacking. As we mentioned in our Year End Markets Review, over the last few quarters, markets have been driven by fear of the unknown, including the ever-changing possibility of a Fed Funds rate increase. So, the burning question investors should be asking themselves is: Is the economy as solid as some, including the Fed, say it is?
Often cited are the low unemployment numbers, moderate inflation and recovery in the housing markets. Here at Tidegate Capital, we believe there are some decent underpinnings to the recovery; however, there is still room for significant improvement before the all-clear signal can be issued. Thanks to Janet Yellen and the Fed, in the U.S. we have a strong dollar versus other major developed market currencies due to our higher relative interest rates. More recently, the dollar has been under some pressure as the Fed appears to have become slightly more dovish in their stance. Notwithstanding that, as we get closer to the next potential rate hike, whether in June, July, or some other meeting date in the future, we don’t expect significant changes to dollar strength as long as the U.S. continues to lead the developed world in terms of attractive interest rates.
A strong dollar certainly provides benefits for U.S. consumers as imported goods often offer a better value versus domestically produced products. As the largest group of consumers in the world, Americans will find that it is a great time to locate bargains on their favorite French wine, Swiss chocolates, electronics, clothing (which thanks to outsourcing has been a bargain for a while), and international travel, for example. What should be concerning to investors, however, is the impact a strong dollar will have on U.S. corporations who compete in the domestic and international marketplace for shelf space.
Firms focused on services in the US should generate the best returns, and some examples of industries that may be insulated from a stronger dollar would include hospitality, health care, accounting, and financial planning. While the automotive industry may have done well in the last few years we expect some challenges ahead. The concern is that in the U.S. we bought a record number of cars in 2014 and 2015, and such lofty vehicle sales often precede a downturn in that industry. Only so many new cars can be absorbed by consumers before demand trails off.
With overall corporate earnings projected to decline this year in part due to the strong dollar, we are concerned about the current high levels of the equity markets. The Energy sector has clearly been beaten up with the stronger dollar and lower oil prices, though that, too, has moderated recently with some upward pricing movement. We question whether there may truly be opportunities there or are alternative energy sources the next great investment theme? Whenever the wind blows, the sun shines, and rivers flow alternative energies make more and more economic sense, which will continue to limit upward price pressure on oil - barring external shocks and Middle East regional conflict.
As Tidegate Capital stated throughout 2015, and we still believe today, the Fed doesn’t need to raise rates. Instead, they feel an obligation to. In December, Janet Yellen and company raised the Fed Funds rate for the first time in 10 years; she doesn’t want to be fashionably late to the inflation party, though, in our eyes, the party hasn't started yet, and there is still plenty of time to prepare. Indeed, many of the economic releases that are published have questionable data backing them: clearly unemployment is higher than reported due to discouraged workers who have given up looking for jobs, bringing the true unemployment number closer to 10%. Global bonds are in an even worse predicament than their U.S. Government and Corporate counterparts: in many regions, yields are below zero and any move higher in rates in those countries will translate into significant negative returns for those holdings. One unintended consequence of sub-zero interest rates is occurring in Japan where the treasury is being forced to print more currency as bills go out of circulation due to "hoarding under the mattress”.
Housing has many positives going for it as we begin the second quarter of 2016, and at this point in the recovery, mortgage rates would have to move materially higher to stem demand if it wasn't for one major limiting factor: it is still extremely difficult to get a loan due to the increased credit requirements since 2008. Many of the current purchases are being driven by higher than historical cash purchases, which from a long-term investor perspective reduces risk in the housing sector.
There remains a headline concern, however, which was recently discussed in Washington, and that is if banks and government agencies decide to begin lending to high-risk borrowers again. It is almost as if they forgot about the last crisis, and a return to such practices would seriously weaken the strong underpinnings of the housing market in the long term. We remain optimistic that rational thought will prevail and the housing sector will reflect normalized appreciation as we move ahead.