CapSouth Investment Update
If you’ve paid much attention to the financial markets so far this year, you’re already aware that 2016 has gotten off to a rocky start. Coming on the heels of 2015, a year in which volatility rose and the markets were mostly lower, this has many investors somewhat concerned. I have listened to and read a lot of commentary over the last few weeks from investors and economists whom I respect and will pass along some of the more pertinent information and thoughts in this update. I’ll begin with a review of the returns of various markets, address some of the common concerns that I’m hearing, and finish with our view of some market fundamentals. This is a lot to cover in one update so it will be longer than normal, but hopefully it will be worth your extra time.
As of last Friday, Jan 22nd, the S&P 500 index was down about 10% from the high point it established last May, and near the low point it set in the August decline. Year to date through last Friday (or the January 2016 returns thus far) the declines have been 6.6% for the S&P 500, around 10% for small caps U.S. stocks, and 8-10% for various broad international markets. Bond markets, with the exception of high yield, have increased slightly in 2016. After a poor 3rd quarter 2015, stock markets broadly rebounded in the 4th quarter to the tune of 3-7% gains. The 4th quarter saw declines across the board for bonds; these ranged from slightly negative for higher quality U.S. bonds to a 2.5% decrease for high yield.
2015 was similar to 2014 in that stock diversification was not beneficial; large U.S. stocks squeezed out a small gain while small caps and international equities fell. Due to international lagging the U.S. for several years now, many investors seem ready to throw in the towel on foreign stocks. But we continue to believe that international diversification is prudent in the long term. Generally there are cycles in which the U.S. markets lead for a while and then foreign markets rotate to the lead. We’ve clearly been in one in which the U.S. has had the better returns. As with any type of investing though, it is extremely difficult to time the markets, and it is generally harmful to do so. Foreign stocks will rotate back into a leadership position at some point, and we want to have exposure to those markets when this happens. Long term, having exposure to both U.S. and foreign markets should result in similar returns but lower volatility than holding U.S. investments only.
One of the primary issues plaguing the returns we’ve received on international stocks the last few years is the strong U.S. dollar. On average if the dollar increases 10% against the broad foreign currency market, the foreign stock markets must go up around 10% just to keep our dollar based return even. Most broad international indices had positive 2015 returns on a local currency basis but were down when converted to dollars. Most “experts” believe the dollar is too high at this point. Once the dollar stops appreciating versus foreign currencies, this headwind or hindrance to returns is gone. If the dollar declines on average versus foreign currencies, we then have a tailwind which increases our U.S. based returns. It is generally during these periods of a stable or declining dollar that international investments have historically had periods in which they outperform U.S. investments. Of course other factors, such as economic growth and valuations, of which I won’t delve into in this update, affect international returns, but, outside of China, these are somewhat positive across much of the developed world. So, given this current environment, I believe international returns will begin to compare much more favorably to U.S. returns over the next few years.
Having just implied that the Chinese fundamentals may have some issues and due to news from China having negatively affected the global markets lately, I want to devote some space to this. There are a few fears or primary stories that have continued to worry investors over the last six months and that have had a large impact on the Chinese and international stock market returns the last few weeks. These include the
government continuing to devalue the Chinese currency, the slowing economy, and concern about a potential credit/financial bubble. To compound the problems, some of the Chinese government regulations have not helped their equity markets and have probably caused more damage than benefit. I think their government came to the same conclusion as several of these questionable regulations have been amended recently. The government also realizes they have some economic issues and is actively looking to stimulate and support the markets and economy. One of the most important things to remember in all of this is that their economy is still growing above 4% a year; the rate of growth has slowed but it’s still growing. And although some people think they will have a “hard landing”, most pundits out there think China is just moving into a period of slower economic growth and will handle this transition without major issues.
I think that digging further into the Chinese economy and government thinking is beyond the scope of this update, beyond my expertise level, and beyond the limits of what most of you care about, so I’ll move into how these issues affect the U.S. investor. Fortunately for us, our economic growth is fairly insulated from Chinese economic issues. We import many Chinese products, but they are a small export partner. This means U.S. companies aren’t generally relying on Chinese sales to drive revenue; some large U.S. companies have a retail presence in China, but these are the exceptions. Our banks generally have minimal direct exposure to Chinese financing. Barring major and mostly unpredicted issues, the stories coming from China will probably have little effect on the U.S. economy and our corporate earnings. These stories are likely to persist in 2016 though, and I would anticipate them continuing to cause some market volatility in the U.S. even if the effect on fundamentals is small.
The other major financial news lately has been the decline in oil prices. When China is not getting blamed for stock market declines and volatility, oil is. This is a weird correlation that makes no sense to me or to many of the people I’m listening to. If global demand for oil was poor and this was causing oil prices to fall, it would be a potential sign of worldwide economic issues and a cause for equity markets to drop. But demand is not the problem; demand for oil actually grew in 2015. The problem is supply...too much of it. Both the U.S. and OPEC (primarily Saudi Arabia) have increased production over the last few years, and Iran is about to begin supplying oil. To a large extent the oversupply and oil price declines are an intended consequence or strategy of the Saudi government; they are seeking to protect their share of the global oil market and drive higher cost producers out of the market. With oil trading around $30 a barrel, many countries and/or specific projects cannot profitably extract oil. We’re already seeing production and exploration slow down or completely stop in some areas. With prices so low, this will almost certainly continue so that supply and demand will balance out. When this will happen is educated guesswork but much of what I’ve read points to late 2016 or early 2017. At some point as this balance approaches, oil prices will almost certainly rise.
All the economic jargon and reasoning aside, the lower oil prices are, for the most part, a great thing for the U.S. Sure this is temporarily hurting our energy sector, but energy as a percent of our total economy is somewhat small. And the U.S. energy producers will most likely be a winner long term of this “shakeout” as their production costs are lower than that of much of the world (the Middle Eastern countries are about the only ones who can produce oil at a lower cost). While our energy sector is being hampered by oil prices, the rest of us are enjoying a tremendous benefit. I’m a big fan of the $1.61 gas price at my normal station
as I’m sure you are too! The low gas prices mean that the typical U.S. consumer has extra money to spend or to invest, and this impact to our economy is generally believed to be much greater than the temporary profitability declines of the energy sector.
Now let’s move into a brief evaluation of the U.S. economy as there is some concern among investors that it is not as strong as perceived and that recession is a possibility. I’d be naive to say there is no way we’ll have a recession soon as none of us can predict the future, but, leading up to previous recessions, there has generally been at least one of the following contributory factors in place: financial crisis, excessive inventory build-up, a market bubble (such as technology in the late 1990s or housing in 2007 & 2008) or a rapid interest rate tightening cycle. I don’t hear any banking experts prognosticating that our banking sector is in or near crises; in fact, most of them believe it is in much better shape now than it has been for a while. Inventories, while bouncing around some over 2015, have generally increased and are at higher levels than normal. However, there are some financially sound theories as to why this is the case. The primary one is that companies are building inventory while it is cheap. Low oil costs and a strong dollar have created an environment in which companies’ input costs are generally quite low so that building inventory of anything that doesn’t have a shelf life or become quickly outdated makes strong economic sense. As to a market or sector bubble, there does not appear to be any strong evidence pointing to the existence of such. Finally, interest rates will most likely continue to rise as the Federal Reserve raises rates, but no one, even the Fed members themselves, expects a rapid rate tightening. Market expectations are for two more small hikes this year; such a gradual increase is not expected to have much of an effect on the economy. Historically, Fed rate hikes from interest rate levels as low as we currently enjoy have been a positive for both the economy and the equity markets. So, in summary, none of these common recessionary factors appear to be much of a concern at the present time.
All this being said, the argument could still be made that the economic growth is likely to slow down. Our economy, as measured by GDP, is primarily driven by three factors: consumer spending, government spending and housing. Consumer spending is by far the most important factor as it has accounted for nearly 70% of the GDP composition over the last several years. Wage growth, employment growth and low oil prices all are benefitting consumer spending so that it is expected to continue to grow at 2-3% in the near term. Government spending is expected to increase this year as some of the sequester cuts expire. Home prices have been rising over the last few years on average across the country. Unless these things begin to turn around, our economy should at least continue the slower level of economic growth (around 2%) that we have experienced the last several years.
Moving on to the U.S. equity markets, it’s my view in evaluating the market and economic fundamentals that they do not appear to support a strong stock market decline. This being said, I do expect volatility to remain higher in 2016 than it has been the last few years, and almost any analyst out there would agree. As I’ve stated previously though, volatility is a normal part of investing, and it often has little to do with market and economic fundamentals. To determine how attractive the stock market is, I believe there are several factors that must be evaluated. These include: corporate earnings growth, economic growth, valuations, and the interest rate environment. For the most part, these are all positive. U.S. corporate earnings, outside the energy sector, have continued to rise in aggregate over the last year. Just prior to this we discussed the
economy and our expectation of continued growth near term. Stock market valuations are in line, to slightly below, longer term averages. Interest rates are still extremely low. All of this is supportive to the U.S. stock markets. Unless there are some changes to these fundamental factors, I view the recent declines in the stock market as mostly noise driven and would view further declines as an opportunity to increase risk, or increase equity exposure.
To this point I’ve only briefly mentioned bonds in the 2nd paragraph. The expectations of a rate hike in 4th quarter, which did occur, was a drag on bond returns. As the market is expecting a couple more hikes in 2016 and as rising rates are an anchor on high quality bond returns, I do not believe these bonds will have much return in 2016, and the returns could possibly be slightly negative. Lower quality (or junk) bond returns will probably depend more on stock market related variables such as earnings and economic growth in the long term, but, as equity returns are, these returns are heavily news and sentiment driven in the short term. Returns in this area have therefore been negative the last two quarters, but the positive side of this is that their valuations are much more favorable now than in mid-2015. I’m not ready to say this is a great time to increase exposure to high yield bonds yet, but I believe the opportunity for better returns is definitely increasing. Overall though, the bond markets are probably not going to provide us with much in the way of return in the next couple years. The primary benefit of them in the short term is to reduce volatility when mixed with equities, and we hope that our bond exposure in aggregate will at least provide a return that matches inflation.
So as I wrap this up and with everything above in mind, I want to repeat something I’ve stated several times in the past. No matter how accurate or mistaken I am in anything discussed thus far, short term market movements remain unpredictable and volatile as to the range of returns. If your time frame is below five years, it is probably best to have low or limited exposure to the stock markets. However, if your time horizon is 5-10 years or more, I strongly believe equities are actually the safest place to be in that they offer the greatest potential for returns in excess of inflation over longer time periods, and historically 5 and 10 year average returns on a diversified equity portfolio have almost always been positive. If you’d like some data supporting the claim that stocks are actually the safest investment once your time frame increases to 5-10 years or more, I’d be glad to email the info; hopefully I’ll have more space in a future commentary to further expound upon this.
As always I hope this has been insightful and beneficial to you...and I hope that, due to its length, you are still awake. If you have any questions regarding our thoughts or what I’ve discussed in this update, please feel free to contact me!
Marshall Bolden, CFA
Vice President, Chief Investment Officer