The markets have been nothing short of a roller coaster ride recently. In fact, the stock market levels were the same for January 2014 and January 2016. So, we haven’t seen much headway in growth.
As we all know, the markets move in spurts and the prevailing winds can change quickly. The market has been moving sidelong for almost two years, however, a sideways corrective phase is certainly preferable to a bear market. This type of corrective phase allows market multiples to come down and it also allows investors an opportunity to digest earnings.
There are several conflicting items we see in the economy, which are causing the market uncertainty.
Thanks to a markedly weaker gain in consumption than expected, it now appears that first-quarter GDP growth was no more than 1% annualized. This number follows a disappointing growth of 1.4% in the final quarter of last year.
Despite the weakness in GDP growth, employment growth remains strong. Furthermore, after weakening in the second half of last year, both the manufacturing and services activity surveys have improved significantly in the past couple of months.
The slowdown in consumption growth to about 1.5% in the first quarter is mainly due to the decrease in motor vehicle sales from a record high last year. Real consumption was initially estimated to have increased by a very strong 0.5% m/m in January.
In reality, this market and this economy make investors feel neutralized. There’s not a lot of good or bad. We are simply in an uninspiring economy that is grinding sideways. With that being said, we are not necessarily concerned. We would certainly prefer a sideways market over a bear market. Further, we firmly believe that we can use this volatility to our favor, and eventually this market will “right itself” to the upside.
The markets have been nothing short of unpredictable thus far in 2016, which repeats what we experienced in 2015. While we believe 2016 will continue to be an up-and-down year, we do not currently believe we are heading into a bear market. The economy continues to create jobs and things appear to be smoothing out in China and Europe.
That being said, there are several negative trends we see today which warrant our attention. These trends, if sustained, will affect growth as we move forward.
Profit margins in the US appear to have peaked and are on the decline – The 11.5% decline in corporate profits last year, which included a 7.8% decline in the fourth quarter alone, doesn’t necessarily mean that negative growth is imminent. Admittedly, profits usually begin to decline in the latter stages of the economic cycle, but that alone does not cause a recession. Instead, it is the corresponding increase in labor costs and price inflation that trigger a recession, because the Fed usually responds by hiking interest rates aggressively.
Falling profits is far from a perfect predictor of a sustained economic downturn. Profits fell in the mid-1980s without a resulting economic downturn and in other cycles the decline began several years before that recessionary cycle began. Furthermore, we are not even certain that profits have peaked in this economic cycle. It is the Fed, not falling profits, that kills economic expansions and in this case it hasn’t even begun to sharpen the axe.
Inflation, particularly in wages – Despite lower gasoline prices weighing on headline CPI inflation, the much bigger story is the surge in core inflation to a four-year high of 2.3% in February, which illustrates that the Fed cannot stay on the sidelines for much longer.
Altogether, the three-month annualized rate for core CPI inflation is now at 3.0%, which is the highest level since August 2011. While any chance of a Fed rate hike in the short-term has all but evaporated, the data just released supports our view that a faster-than-anticipated rise in core inflation will force the Fed to raise interest rates more rapidly than markets expect.
Moving forward, we anticipate that we will continue to tweak our investment portfolios as we see opportunity arise and trends emerge. Currently, we are focused on quality and have actually moved up the risk scale a bit to make our holdings a bit less aggressive. We believe we will continue to experience significant volatility and, as such, want to remain somewhat more conservative.