Federal Reserve

Will the Fed Confound Expectations?

Crystal balls have never worked when it comes to the stock market, and it’s looking like they’re about to flop on the future of interest rates as well.

In December, the Fed raised rates for the first time in nine years, the opening move in a long-awaited normalization cycle. The Fed statement that accompanied that hike was interpreted to mean that four more quarter-percent rate hikes were on the way in 2016, pushing the Fed Funds rate to 1.375% by the end of the year.

Now the consensus is shifting, as investors and Fed-watchers point to the wobbling stock market and certain weak economic indicators. Markets are acting as though the Fed’s next rate move isn’t going to happen in March as anticipated.

If you’re surprised, it’s likely because you trusted the Fed’s trajectory as interpreted by Wall Street and the financial media. The truth is that all the authoritative-sounding commentary about the Fed’s intentions is only an informed guess. That’s true even when the commentators are citing statements by the Fed itself.

The Fed is infamous for leaving plenty of wiggle room within its proclamations. The obfuscation may have reached its peak under Fed chair Alan Greenspan, whose “Greenspeak” was a marvel of dry, wordy ambiguity. But the careful statements from Janet Yellen’s Fed still leave the central bank plenty of latitude in its decision-making.

Fedspeak can serve a useful purpose in preventing over-reaction by the markets. But it’s also an implicit acknowledgement that it’s difficult for the Fed to know when and how to raise or lower rates.

Rate increases are based on interpreting an ocean of ever-shifting economic data from the economy, and once put into effect, they can impact the markets in unforeseen ways. One dynamic that is currently hampering the Fed’s efforts to create a rising-rate environment is the global flight to invest in the highest-quality currency, i.e. the U.S. dollar. The demand for greenbacks has created downward pressure on interest rates, working against the Fed’s goal.  

And as the phenomenon of Fedspeak suggests, the Fed also wants to avoid spooking the markets. It’s possible to see the Fed’s pronouncements as trial balloons, launched to gauge the reaction of investors. So far, the market reaction to the Fed’s latest remarks hasn’t been positive.

What’s ahead for this year? We would not be surprised to see two quarter-point rate increases rather than four. We’d be very surprised if there were no increases this year. Consider the larger picture, as the Fed does: Has anything changed in past several weeks that we didn’t already know about? Nope. China’s economy has been slowing for three years. Oil prices have been in decline for two and a half years. Employment is growing moderately, and inflation is stable and somewhat positive, which is exactly what the Fed wants.

Yes, markets are down. But we believe this is simply a healthy repricing of assets that had become too richly valued.

So what does this all mean for you as an investor? We don’t expect a barn-burning year in the market, nor a meaningfully negative one. We may see 3% to 6% returns, in line with a total rate increase of a quarter- or half-point, and muted but stable earnings for U.S. corporations.

With so many moving pieces in play in the market, we recommend sticking with quality blue-chip stocks. It’s important in this relatively late stage of the bull market to be a stock picker rather than a market buyer. Especially attractive are companies that are managing international exposure well and that are growing their sales. Sales growth can be a good signal even if earnings are weakened by the conversion of overseas revenues to the strong dollar. The strategy has worked nicely over the past 18 months, and we expect that to continue for the next 6 to 12 months.

 


*The foregoing content reflects the author's personal opinions which may not coincide with the opinions of the firm, and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss. Finally, please understand that–as with other social media–if you leave a comment, it will be made public.

Uncovering Investment Opportunities in 2016

An important factor in this mild slump has been the strong U.S. dollar. But as I’ll explain, understanding the strong dollar’s impact on the economy and on corporate earnings can help us uncover promising investments in 2016.

First, some background. After three decades of decline, the dollar has rocketed upward since mid-2014; it now sits at a 13-year high against a basket of foreign currencies. Reasons for this include the relatively robust U.S. economy and the official lift off of interest rates by the Federal Reserve on 12-16-15.

The strong dollar has hindered U.S. businesses that sell goods abroad: Revenues generated in foreign currencies effectively shrink when they are converted back into dollars. This dynamic can drive earnings down even when a company’s sales are growing.

Looking ahead to 2016, we don’t expect the dollar to continue its rapid appreciation. We do, however, expect it to remain strong going forward.  We also anticipate that price-to-earnings ratios will shrink a bit as interest rates cycle up. Oil, which has fallen sharply this year, will likely find a bottom, providing stability for consumers and businesses alike. And market volatility will continue as short-term investors jockey with each other.

Broadly speaking, we expect another year of muted returns, with U.S. equities rising by low - to mid single digits. How to uncover the most promising stocks against this subdued backdrop? One way is to identify companies whose strengths have been masked by the strong dollar.

For disciplined investors, these under-the-radar opportunities abound. Many large U.S. firms have actually experienced handsomely rising sales amid growing consumer demand globally. The market, with its focus on earnings, has overlooked this story, but we believe that’s a mistake.

Eventually, foreign currencies will head back toward equilibrium with the dollar. As they do, companies with strong sales will begin to grow revenues and earnings. Consider that in a more normal currency environment, U.S. companies would be thriving. By some estimates, the strong dollar has trimmed GDP growth by 1%. With more historically typical exchange rates, we’d be seeing GDP growth of 3% to 3.5%. That level of growth has historically sparked a virtuous cycle, helping corporate earnings grow, and then grow some more.

Right now, companies with otherwise strong sales are being ignored by the market based on the dollar’s drag on their earnings. And that means they’re cheap. At Lighthouse Financial, we believe a portfolio of blue-chip companies with strong management, sales and fundamentals will do well for investors over a one- to three-year time horizon. The key: using a rigorous research process to identify them.

There are always good investment opportunities, even in the midst of market doldrums. Think of them as seeds under the snow. Stake them out, wait for the sun, and they may grow very nicely. Don’t hesitate to contact us if you’d like to learn more. 

For more information, please email us at invest@lighthouselink.com.

 


*The foregoing content reflects the author's personal opinions which may not coincide with the opinions of the firm, and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss. Finally, please understand that–as with other social media–if you leave a comment, it will be made public.

Sailing Through November

 

Volatility has been the watchword for global markets this year. That goes whether you’re talking about emerging market’s economies or currencies, China’s or America’s stock markets, or global commodities prices. This year Canada slipped into a shallow recession and Brazil’s recession deepened. China’s Shanghai Composite Index surged 60% before crashing over 40%. Copper and oil have fallen over 20%. And our own stock market just completed its deepest correction since 2011. The VIX Index, which measures investor fear, temporarily spiked to four-year highs. Yes, volatility, which was mysteriously absent through 2012, 2013 and most of 2014, is back.

By now, we all know the list of risks & issues that caused the correction. Various signs of financial instability in China made us wonder if perhaps the world’s second-largest economy might be slowing more rapidly than expected. Certainly the government’s pathetic response to stock market chaos spoke of desperation. And falling commodities prices hinted at widespread global economic weakness.

Since the US has been in relatively better shape, the dollar has appreciated strongly against many foreign currencies. At the same time, our Federal Reserve is poised with its finger on the button to begin raising interest rates. And this expectation compounded the currency move and added to financial fragility in emerging markets.

Finally, Saudi Arabia’s strategy to limit US shale oil production growth has largely succeeded. Simply put, Saudi is one of the lowest cost producers in the world, and took advantage of the fact that supply was rising much faster than demand. As a result, corporate profits within the US energy production sector are more than 50% lower than year-ago levels. Many oil rigs have been idled and jobs eliminated.

Through the summer, the world looked like a more dangerous place for investors. And then at the beginning of October, everything turned around. And here we are, having just enjoyed the best month for US stocks in four years. What gives?

First, while global economic growth is clearly tepid, we’ve had some recent announcements regarding further monetary easing from central banks in both China and Europe, which are supportive of asset prices. This pattern of economic weakness followed by monetary stimulus is by now very familiar, with a strong positive impact on stocks. In addition, our Federal Reserve continues to be patient, preferring a stronger growth environment before raising rates.

Second, China’s financial markets have stabilized. That’s admittedly a small step toward normalization, but it’s worth pointing out that we are no longer reading headlines suggesting a full-blown financial crisis in China. And by the way, haven’t we known for some time that the Chinese economy is in secular decline as it transitions from export-led growth to consumer spending-driven growth? So it looks as though traders overreacted to China’s stock market correction.

Third, oil and the dollar have also stabilized, and this is critical to our stock market recovery. West Texas crude oil bottomed near the end of August at about $38/barrel but since then has kept a tight trading range of $44-50/barrel. To the extent oil remains over $40/barrel, it will be constructive for equities. At the same time, we’ve seen the dollar back off from its highs. Our currency appreciated at a very strong pace (about 25%) against a basket of foreign currencies from mid-2014 through March, but here again, it has fallen back into a trading range ever since.

One reason oil and the dollar are critical is that they have negatively impacted US corporate earnings. Corporate earnings grew about 8-9% last year, but have cratered due to lower oil prices and a stronger dollar. So second quarter earnings growth for S&P 500 companies came in at -2%, and third quarter growth is expected to be about -5%. The big picture for earnings isn’t all that encouraging.

But remember, it’s not red across the board. While energy and basic materials sectors are expected to post third quarter earnings growth of -20% to -60%, other sectors like consumer discretion, healthcare, telecom and utilities are expected to report positive growth. And even though the tech sector doesn’t look wonderful as a whole, look at the stellar earnings announcements by Intel, Alphabet (Google), Amazon, Facebook and Microsoft.

And there are some very positive factors here at home that could sustain the stock market rally. Household debt is down, the savings rate is up, and if you exclude gasoline stations, retail sales were up 4.9% year-over-year in September. Lower oil (and therefore lower gasoline) prices will benefit consumer spending as we move into the holiday shopping season. Also, the housing market is zipping along with 8% y/y growth in existing home sales, and 4-6% growth in home prices. Finally, the labor market—despite energy sector layoffs—is rather strong. Initial filings for unemployment insurance are down to 15 year lows and the unemployment rate is down to 5.1%. Anecdotally, we’re seeing more headlines about wage increases (like Wal-Mart), and we’re hearing CEOs complain about the difficulty of finding qualified employees. In our view, there’s not much slack left in the labor market.

Therefore, our view continues to be one of cautious optimism for the US economy and stock market. The positives continue to outweigh the negatives. We expect US GDP growth to remain in the 2.5% range next year, and that oil and interest rates will remain low for an extended period. We also believe this slow but steady environment opens up more opportunity at home than abroad. Of course volatility will remain the side-kick of investors as a by-product of slower economic growth. And investment success will depend on staying the course in spite of short term market fluctuations.  


*The foregoing content reflects the author's personal opinions which may not coincide with the opinions of the firm, and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss. Finally, please understand that–as with other social media–if you leave a comment, it will be made public.