As we enter the final two months of 2015, we note four major themes unfolding within today's market. In addition to reviewing each of these themes below, we also will review near term portfolio adjustments that may occur (or have already occurred) within the portfolios because of these themes. Major year-end themes that should continue to impact the markets into early 2016 include:
- Trends in Economic Growth and Corporate Earnings
- Trends within Emerging Markets and Commodities
- Potential Credit Market Concerns as a Result of Lower Energy Prices
- Understanding the Federal Reserve's Impact on Money Flow Dynamics
First, domestic and foreign economic growth projections continue to soften. In the U.S., we expect GDP to slow considerably from 3.2% in Q2-2015 to a range of 0.9 - 1.7% in Q3-2015. From a global viewpoint, the Eurozone and Japan are expected to grow at 1.5%. In addition, China's GDP estimates continue to soften and most market participants expect China's "official" GDP figures to decrease to approximately 6%.
If we combine slow growth expectations with today's corporate earnings, we see that the market continues to trade above 18x earnings. In 2014, corporate earnings averaged approximately $113-$118. Today, we estimate that 2015 corporate earnings are going to be in the range of approximately $109-112. Below is an illustration of historical and estimated quarterly earnings.
As you know, we over-weighted equities for most of the business led recovery from 2009-2014. However, with slower economic growth as well as slower earnings growth (where corporate profits may have already peaked), expect us to place the portfolios back to an equity underweight in the near future.
In regards to our second theme within emerging markets and commodities, we note that global fixed investment has experienced three very strong cyclical periods since 1970 (chart below). The latest global fixed investment boom was led by China's demand for commodities from 2002-2009.
However, since 2010, China's economy has continued to gradually slow even after an aggressive easing campaign on the part of the Chinese central bank. In fact, it appears that the Chinese central bank has only succeeded in slowing the rate of contraction. This gradual contraction can be seen in the "official" economic statistics such as the Manufacturing PMI illustrated below. This gradual contraction indicates that China's demand for resources will likely continue to soften in the near future.
As such, expect us to exit our emerging market equity allocation in the near future. While we have strongly underweighted emerging market equities within our portfolios over the past few years, we simply believe this asset class will continue to remain under pressure in the near future. In addition, currency pressures within emerging markets will only increase as the Federal Reserve raises interest rates.
In regards to credit market concerns, we are starting to see small signs of credit market weakness as a result of extremely low energy prices. According to the Bank of International Settlements, oil and gas companies increased their debt via the bond market at an annual rate of 15% per year from 2006 ($445 billion) to 2014 ($1.4 trillion). Most of the debt financing from these energy companies occurred within high yield bonds.
JP Morgan now estimates that overall high yield default rates are approximately 2.2%. However, these default rates should rise in 2015 and beyond if energy prices remain around $50 per barrel. Given the likelihood that oil prices will remain under pressure, we recently cut our high yield bond exposure by approximately 50% within our portfolios. Looking forward, if oil prices remain under pressure, expect us to continue to reduce our high yield bond exposures.
Lastly, we must recognize that the Federal Reserve is strongly influencing money flows between asset classes. This is occurring as market participants anticipate and attempt to predict "When will the Fed raise interest rates?" When the Fed does raise interest rates, the U.S. dollar will continue to strengthen.
A strong U.S. dollar is bad for emerging markets for two reasons: capital flows and U.S. denominated debt. Emerging market economies are generally heavily reliant on capital inflows to finance fiscal or current account deficits. If the U.S. raises interest rates, capital flows should flow to the U.S. which would choke off emerging market economies. Secondly, emerging market economies have borrowed large sums in U.S. denominated debt. Consequently, if emerging market economies experience a currency devaluation due to capital flows and higher U.S. rates, servicing that debt becomes inherently more onerous.
Rest assured that as we move to the end of 2015 and look ahead to 2016, we will keep you updated as always.
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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.