A More Complex, But Still Favorable Investment Environment

The investment markets have become more complex as the start of Fed interest rate hikes approaches, as the dollar continues to rise, and as oil prices keep falling. While these uncertainties have increased stock market volatility, the outlook for stock prices remains favorable because the fundamentals supporting ongoing economic growth and rising corporate profits continue intact. We believe it is appropriate for the Fed to begin raising rates this summer, but we expect them to do so slowly and cautiously. We see more negatives than positives resulting from continued strength in the dollar, but we think investors’ confidence in ongoing dollar strength has become excessive. We also note that investors seem to be ignoring the negative impact of the dollar on corporate earnings where the underlying businesses are strong. With the euro having declined sharply and the European Central Bank easing, we think the German stock market offers profit potential. Oil prices remain weak, but the process to reduce the glut of oil has begun.

Over the past year, the investment environment has grown increasingly complex. While added complexity can create uncertainty and volatility in markets, the stock market still can perform well in such an environment if the underlying fundamentals remain favorable. We think this is the case.

The three complexities on which we will focus in this Outlook are the likelihood that the Fed will begin hiking its key fed funds rate by this summer, the strength in the dollar, and the weakness in oil prices. Since each of these can have both positive and negative implications for securities markets, their many potential permutations increase investor uncertainty. This has manifested itself through increased stock market volatility. The VIX Index, a widely-watched measure of stock market volatility that has averaged 14-15 in recent years, spiked above 20 only twice during the year between mid-2013 and mid-2014. But during the nine-months since then, as investors pondered the approaching Fed tightening, dropping oil prices, and the strengthening dollar, the VIX Index has spiked above 20 on five different occasions. Despite this increased market volatility, all of the major stock market averages have continued to advance since last summer, reflecting the improving economy and rising corporate earnings.

Investors are nervous as the start of Fed interest rate hikes nears. As the Fed has progressed from its anti-deflation Quantitative Easing (QE) program of buying $85 billion of bonds each month from September, 2012 through February, 2014; to its “tapering” program of gradually reducing those purchases by about $10 billion every one-to-two months from February, 2014 through last October; to preparing the markets for the beginning of rate hikes this summer, the markets consistently have worried that the Fed’s next step might end the economic recovery. We devoted last October’s Outlook Memorandum to a detailed discussion of why the Fed rate hikes that we thought likely to begin this summer would not keep our economy and corporate earnings from continuing to expand for another several years and the stock market from advancing well beyond this year. We did note, however, that the stock market historically has experienced increased volatility and a moderate price correction during the periods surrounding the beginnings of Fed rate hikes, and we said we expected something similar to occur again this year.

Our current thinking remains very similar to what we forecast in that October Outlook. The economy has recovered to a level relative to our estimate of its non-inflationary potential at which the Fed historically has initiated rate increases. But, while unemployment has declined sharply, the fact that an unusually high percentage of the “employed” are holding part-time jobs and private sector average hourly wages are up less than 2% over the past year suggest that there may be more slack in the economy than some of our traditional measures indicate. Similarly, the Core Consumer Price Index is up only 1.7% over the past year, below the Fed’s targeted level of 2%, so the Fed may delay its tightening by another month or two. Even if it chooses to act sooner, we are confident it will proceed slowly and cautiously. As we noted last fall, in normal economic cycles of the past, it has taken two-to-three years for the Fed to drain sufficient liquidity from the economy to cause a recession. We think they are likely to proceed even more slowly this time once they begin tightening. Thus, while we expect to experience increased market volatility this year associated with the change in Fed policy, the economy and the stock market will continue to advance into 2017, if not beyond.

The strong dollar is slowing US growth, hurting corporate earnings, and making stocks appear more expensive. The US dollar has been rising in value since last summer. From June 30 through March 31, the broad, trade-weighted dollar jumped by 13.9%, and it is up by 4% this year. These gains partly reflect the ongoing deflationary trends in Europe and Japan, and the QE programs the central banks in those regions are pursuing to lower their interest rates. With interest rates consequently higher in the US than in Europe and Japan, speculators are borrowing large sums at low interest rates in those regions, converting the funds into US dollars, and investing the money in higher yielding US instruments. Their selling of the local currencies and buying dollars pushes down the value of the former and raises the value of the dollar. Other factors contributing to the dollar strength include the faster US economic growth and, since the dollar tends to move inversely with the price of oil, the weakness in the price of oil since last summer.

While a strong dollar benefits our economy and markets by reducing the cost of imports, thereby trimming inflation, and by attracting investment capital to the US, it also has negative effects. For our export-oriented companies, the foreign currency price of their products to foreign buyers rises and makes it more difficult for them to compete against companies based in countries with weaker currencies. In addition, for US companies with operations in foreign countries, a strong US dollar means that their foreign earnings will be translated into fewer dollars than before and they then will report lower earnings due to the strong dollar. At the end of last July, analyst’s 2015 earnings estimates for the companies comprising the S&P 500 totaled $133.77. At the end of last month, the estimate was down to $120.87 due to the dollar’s negative impact on reported earnings as well as the impact of lower oil prices on energy company earnings. It is difficult to estimate precisely how much of this decline reflects the dollar, and how much oil, but estimates we have seen suggest that about $6 of the near-$13 decline has been due to the dollar. By reducing earnings, the strong dollar has raised the Price/Earnings ratio of the S&P 500 to 16.2 from 15.5, thereby making stocks appear more expensive and unsettling investors.

Another reason a strong dollar can make investors nervous is that it lowers US economic growth by slowing the foreign demand for US exports and making it more attractive for US purchasers to substitute imported goods for domestically produced items. In this way, it can be seen as analogous to Fed tightening. When the economy is strong, the Fed tries to slow aggregate demand by making credit more expensive and more difficult to obtain. A strong dollar has a similar effect on aggregate demand by operating through our trade balance. Thus, investors who fear that the Fed may be moving prematurely this summer in raising its fed funds rate see the strong dollar, especially if it rises further, as a second brake on our economy threatening the economic expansion.

There seems to be excessive confidence that the dollar will continue to rise. We recognize that the logic underlying an expectation of ongoing dollar strength is compelling. In fact, this logic has been so clearly apparent to investors recently that continued increases in the value of the dollar have come to be viewed as close to a sure bet. Those who follow our work are very aware of our preference for careful analysis and drawing logical conclusions. Experience has taught us, however, that when the logic of an investment is so clear and compelling that most investors understand it and have acted on it, the price of that investment generally quite fully reflects the forecast outcome. Accordingly, in those cases, it is better to invest with the minority view. We now feel that way about the dollar. It feels like there is too strong of a consensus that the dollar must continue to rise.

While we are reluctant to forecast a sharp reversal in the dollar’s trend over the months ahead, we think the dollar is likely to lose its upward momentum over the coming year. Since markets have a tendency to extrapolate current trends, this means that the dollar will come to be seen as less of a brake on our domestic economy and as less of a threat to corporate earnings. This generally will be a positive development for the stock market. One negative aspect of this, however, will be that any reduced drag on our economy from the dollar is likely to be seen as freeing the Fed to be more aggressive in raising interest rates. But, even then, we expect the Fed to proceed with caution.

Investors seem to be looking through the dollar’s effect on reported earnings. One other reason we are reluctant to become less positive on the stock market outlook due to the dollar is that we recently have observed the market looking through, or disregarding, the negative effects of the strong dollar on company earnings. For example, in recent weeks companies with farreaching international operations such as Nike, Oracle, and Accenture have reported quarterly results. In each case, the strong dollar trimmed a significant 4-7% from their revenues, orders, and earnings. Because each company reported healthy trends in their businesses before the negative currency effects, however, the stock market disregarded the negative currency effect and theshares rose sharply on the day of the earnings announcement. This suggests to us that the market is viewing the currency impacts as transitory and is valuing stocks more on the basis of their underlying business prospects.

ECB monetary easing makes European stocks more interesting. We earlier mentioned that one of the factors underlying the strong dollar is that the European Central Bank (ECB) has begun its own Quantitative Easing program of bond buying to help the Euro-zone escape the deflationary forces weighing on it. We think this makes it likely that the European economies will begin toperform better this year, and over the next several years. Just as our own Fed’s QE program created a very favorable environment for stock investors over recent years, we think European stock markets will perform well during the next few years as the ECB pursues its QE policy. Consequently, in accounts where it is appropriate, we have invested some money in a German stock market fund. We chose Germany because it is Europe’s strongest economy, thus less risky than the others, and one that is export-oriented and thus likely to benefit meaningfully from the recent decline in the euro. Since gains we earn in the German stock market might be diluted if the euro were to continue to decline versus the dollar, this investment will perform better if the dollar stabilizes or weakens over the coming year. As discussed above, we judge this currency risk to be manageable.

The glut of oil continues to roil markets. The third complicating market factor is the price of oil. We detailed our thinking on this subject in our January Outlook, and the process we described that should reduce the current glut has begun to unfold even as the price of oil has, on balance, declined further since the start of this year. The US price of oil began the year at $53.27 per barrel, dropped to $44.45 in January, rallied on increased Middle East tensions to $53.53 in February, and ended March at $48.38, down 9.2% for the quarter. The world continues to produce more than one million barrels of oil each day in excess of current needs. This primarily reflects faster than expected growth in US shale oil production. OPEC and Saudi Arabia have refused to act in their traditional role as swing producers, keeping the price up by reducing their own production to maintain balance between supply and demand. Whether their motive for enduring such large reductions in their own oil revenues is to reduce higher-cost US shale oil development or to increase the economic pressure on Iran, whose nuclear intentions and growing political power in the Middle East threaten Saudi regional dominance, is unclear. Certainly, Saudi Arabia’s leading a coalition of Sunni states in bombing attacks on the Iran-backed Shiite Houthi rebels in Yemen is a sign of the latter.

The more than 50% drop in oil prices from those of a year ago has both positive and negative effects on the world economy. If consumers and business spend less for gasoline, fuel oil, and their other energy needs, they have more money to spend on other consumption, or for investment. This will tend to raise worldwide economic growth, and the demand for oil, over time. During the first quarter, we did not see such a bounce in US consumer spending, but this might have been due to other factors such as the harsh winter weather in half the country and labor problems at west coast ports. On the negative side, oil and gas drilling has been accounting for about 10% of total US investment spending. With oil prices down, funds for drilling have contracted sharply. The resulting 30-40% cutbacks in drilling pose an immediate drag on US investment spending, employment, and economic growth.

Despite the drags, most economists consider lower oil prices to be a net benefit to the worldwide economy. In fact, during the past quarter OPEC has slightly increased its forecast of 2015 worldwide economic growth and oil demand. They and other experts continue to forecast that oil demand will rise by a bit more than one million barrels per day this year. This increase will go a long way toward bringing supply and demand back into balance.

If OPEC’s objective was to slow US shale oil development, they are achieving that goal. As shown below, the number of drilling rigs operating in the US (blue line) has dropped in half since last fall, down to about 800 from 1,600 previously. All oil wells have a natural production decline curve, and shale wells decline more rapidly than others. It took about a year after US shale drilling began to rise sharply in 2011 for US oil production (orange line) to turn upward. Similarly, we expect to see a meaningful slowdown in US production growth by this fall. Thus, the natural production declines in wells around the world and rising demand seem likely to bring supply and demand back toward balance later this year.

2015.04.01 Graph1

Oil and gas companies and energy service providers are seeing their revenues and earnings sharply cut by the depressed oil price. Analysts estimate that these earnings reductions account for roughly $7 of the total $13 decline since last fall in the consensus forecast of S&P 500 2015 earnings. But, as oil supply and demand move toward balance this year, we expect investors to value oil company stocks on a less depressed oil price and more normalized earnings just as they seem to be normalizing the earnings impact of the strong dollar.

In conclusion, the market environment has become more complex and, thus, more volatile. But, as long as underlying conditions remain favorable for economic and corporate earnings growth, and valuations are reasonable, we expect stock market trends to continue to be positive.