Market Memo: Between a rock and a hard place

11-02-2016

As we approach the final leg of what has been a very difficult market environment in 2016, we find ourselves continuing to urge caution. Most of the near-term concerns that have worried us—the U.S. election, the Fed, the dollar, European politics, China, oil and 2017 earnings—remain concerns. Although markets are 4% off their all-time highs and near our 2,100 year-end target for the S&P 500, we see more downside than upside risk in the next few weeks. A lot of this concern is driven by what is currently happening at the polls, but we think the present market malaise is more deep-rooted than this. Let’s review the sources of our near-term caution:

  • Economic growth remains anemic Although last week’s headline GDP growth rate for the third quarter seemed better than expected, the word is out that it wasn’t. In fact, the positive surprise was largely driven by one-off factors including inventory accumulation ahead of the Christmas selling season and an unusually large shipment of soybeans to China. The underlying pace of U.S. growth remains barely above 2%, with little prospect of an acceleration any time soon.
  • Central banks are backing off their ‘lower forever’ promise Both the Bank of Japan and the European Central Bank have disappointed markets over the last few weeks with a reversal of their quantitative-easing programs, effectively shifting away from their negative interest-rate policies. The Fed meanwhile is signaling strongly that it would like to hike in December. With wage inflation on the rise at the same time, markets have shifted from a “lower forever” scenario on interest rates to a “bond bear-market” mentality. We think this view is overdone, as we see little sign that companies have sufficient pricing power to wage inflation on to consumers. Still, just the acknowledgement by central banks that they are reaching the end of their rope for cutting rates has been enough to shake up bond markets, with the 10-year Treasury now rising ever closer to 2%. This has hurt the hitherto market-leading dividend-paying stocks as their valuations decline when the discount rate rises.
  • The dollar is strengthening Although the dollar has recently taken a hit as the U.S. election has tightened, markets seem to be realizing that we’ve been in the midst of a stealth dollar rally since the spring of this year, with the greenback creeping up nearly 5% off early May levels after a major correction earlier this year. Dollar strength is a near-term negative given U.S. companies’ earnings exposure to foreign markets.
  • Oil prices seem capped at present levels The rally in oil prices off their February lows appears to have stalled in the $50 area. While we are comfortable that $50 is a “good enough” level for the U.S. economy (high enough to get our most efficient shale fields back on line, low enough to support consumers with lower energy prices), markets were hoping for more, particularly given oil’s importance to S&P earnings. Indeed, if the oil recovery stalls here, we estimate it alone will shave $2 off consensus S&P earnings for 2017.
  • Brexit fallout is still ahead of us Markets sense that vis-a-vis Brexit, we are more in the eye of the storm than in its hopefully calmer aftermath. Both sides of the English Channel seem stuck in a kind of dream state, hoping for the best but knowing in their heart of hearts that the U.K. and Europe are almost on an irreconcilable path to a “Hard Brexit,” and all the economic dislocation that would cause.
  • The U.S. election, as it is shaking out, seems to offer little upside As we approach Nov. 8, the election that we’ve always believed would be tight is shaping up to be just that—or maybe worse. In fact, for the markets near term, our base case now is that rather than lifting the policy uncertainty that has bedeviled us all year, the election could increase it. In fact, we could very well wake up on Wednesday morning very unsure about the policy implications ahead, even if we know the “winner” by then. Looking at the electoral map, for instance, it is no longer utterly unrealistic to envision a dead tie between Trump and Clinton, precariously throwing the election into Congress. Should Trump win (our best guess, by the way), supply-siders such as ourselves may have cause to celebrate the longer-term positive implications of corporate tax cuts and deregulation. But we suspect the market will fret over the near-term uncertainties surrounding Trump’s policy agenda. And even if Secretary of State Clinton prevails, she’ll assume the presidency under a cloud of suspicion, with at least one (maybe more) FBI investigation(s) on her trail and with a divided Congress at the other end of Pennsylvania Avenue. Hard to claim a mandate here, and future policy direction will be hard for the market to call.
  • China’s recovery remains uncertain Although China has proven resilient this year, slowing but not breaking, it has done so with a significant level of government fiscal support that probably isn’t sustainable. So the outlook ahead for China seems to come down to how its European, Japanese and U.S. export markets are doing, and in no case is a pickup in the cards. China may not blow up, but it is difficult for equity markets to count on it for re-acceleration.
  • 2017 earnings are still way too high. Bottom-up numbers for the S&P next year remain about $134, almost $20 above where we are likely to end 2016. Frankly, these numbers are simply not achievable, in our view, without some combination of a re-acceleration in global economic growth, oil prices and corporate profit margins. None of these seem likely, and our own forecast at Federated remains $125. Not bad, really. But below what is baked in at present price levels for stocks.

Add this all up, and we see stocks continuing to struggle through year-end. Stretched valuations and soft fundamentals seem to cap near-term upside, while the high potential for a political or central bank policy shift threatens more near-term downside. In this context, the coming presidential vote, which may leave us with either the policy uncertainty that would come with a Trump win or the governing uncertainty that would come with a Clinton win, may prove an appropriate metaphor for the market’s present dilemma. Said differently, for now at least, we find ourselves between a rock and a hard place….

Our recommendation is to remain cautious. We are maintaining our recommended 50% equity weighting for balanced-risk portfolios, just below the neutral point in our moderate growth stock-bond model. Within equities, we continue to favor defense over offense.