Part of our work at Equitas includes staying up to date on the latest research from top managers on Wall Street and across the nation. After the latest due diligence trip to New York City, only one short week passed before the second Presidential Debate dominated the entire news cycle. To my great disappointment, the candidates spent most of the time on personal issues, and relatively little on what we view to be the most important topic: the American Economy and Investment Outlook. While most of us cannot have any real effect on the political landscape, hopefully some of the research covered can help our clients and readers prepare for the upcoming investment landscape, regardless of the outcome of the election.
Our research process begins with two vital components: a projection of macro themes we expect to be realized in the next 1-3 years, and how we expect investors to react to these macro themes.
Our current Macro Themes for the near term include: the oil market continuing to stabilize, the US economy continuing to improve, and the rest of the world continuing to struggle.
Rough Seas Behind Us
The end of 2014 and most of 2015 delivered a few sharp blows to the US Economy. A global supply/demand disruption in energy and commodity prices shocked those sectors of the market (roughly 10% of the economy), and investors priced in a massive appreciation in the price of the dollar as our growing economy began signaling the end of Zero Interest Rate Policy from the Federal Reserve.
Although the supply of oil increased massively through 2015, rumors of OPEC production deals are beginning to surface. Additionally, global demand is finally showing signs of rising to meet current supply. Based on current consumption and production trends, we expect prices and economic activity to finally stabilize and show signs of tepid growth. Despite being rocked by the oil shock, and other shocks from abroad, US fundamentals from the labor market to corporate growth continue to show robust signs of life.
The side chart shows that the US dollar (DXY) moved from near 80 to near 98 as of mid-October. This represents a 22.5% increase in price for all US goods shipped abroad. As we have covered in previous KnowRisk letters, the companies in the S&P 500 earn roughly 45% of their revenues from abroad. This means that overseas revenues since 2014 have been much more expensive to generate. Absorbing two blows this large is no easy matter, yet the S&P 500 still managed to close 2015 with a modest gain of 1.40%. In 2016, the S&P 500 has thus far earned 7.84% with 3 months still left to go. The only lingering issues are several years of inflation growth below the 2% target, and the labor market only beginning to reach a level resembling full capacity.
Signs of Life Ahead
Despite the headwinds of oil and the dollar, US companies managed to maintain earnings and the S&P 500 index stayed slightly positive in 2015 for the year as a whole. As a counter-balance to the short term shocks, the US economy’s fundamental trends of rising wages and low debt remained robust. Median household incomes rose 5.2% to $56,516. Although wages are still lower than they were at the peak of the tech boom or pre-financial crisis, the growth is faster than it’s been since the 90’s. Broader economic fundamentals (from the unemployment rate to the number of people voluntarily quitting their jobs) are also signaling bullish times ahead.
While consumption is still near 70% of all GDP, it’s also important to remember that the resources that fuel that consumption are generated by private sector earnings. The chart of earnings projections below delivers good news in this regard. Absent any further negative shocks to the economy, earnings for 2017 are primed to rise for the first time in 2 years from ~120 to ~130. The bad news is that shocks are unpredictable, and have seemingly been more frequent.
Another positive sign for the economy regards our level of debt. Corporate balance sheets are cleaner than they have been in decades, and household debt to income has also returned to a manageable level. Lower, more manageable levels of debt mean that companies and households are less susceptible to temporary downturns in the underlying economy. The US is no longer so fully leveraged that a slight stumble could have disastrous results.
Given that growth has been slow, inflation has been low, and we are still dealing with a slightly depressed labor participation rate, we expect that Janet Yellen, Chair of the Federal Reserve System, will allow the economy to “run hot” for a while before raising rates in earnest. She will likely remain in the background until the election is over, but we might see a small rise before the end of the year if the economy posts larger than expected numbers. If earnings, wages, and the general economy continue to progress without interruption, we expect the environment to be appropriate for 2 small raises next year, with plenty of opportunities for re-evaluation. As the American Household/Consumer continues to experience wage growth, we expect lending and consumption to pick-up, feeding a potential “melt-up” situation over the medium term if rates are left unmanaged.
No picture would be complete without mentioning areas of concern. The timing and intensity with which the Fed acts could have a major impact on growth and recession risk. For example, if the Fed decides to raise rates too quickly, the economy might lose confidence and stumble in a Japan style prolonged recession. Alternatively, the economy might heat up too quickly, causing the Fed to raise rates too sharply in response, which could also rock the markets. Responding too early, or too late with too much vigor, could certainly cause a pullback and increased volatility. The possibility of another shock from abroad also looms large as foreign markets still struggle with negative interest rates. Additionally, we have to weigh the continued impact that the Volker Rule has delivered to markets. This rule has all but removed proprietary trading desks from large banks, along with their ability to act as a market maker. Many investors have decried this rule for removing liquidity and increasing volatility in the markets. We find it hard to disagree, but we have also noticed how this volatility increases the benefits of regular portfolio rebalancing. Absent any extraordinary event and regardless of election outcomes, we may see tailwinds arriving for the American economy.
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.
Disclosures and Disclaimers:
Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.
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Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.
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