It was hard to make money in 2015. In spite of a rally in the fourth quarter, most measures of global equity market performance ended the year in the red, and large capitalization stocks in the United States (as measured by the S&P 500) eked out a positive total return due only to dividend yields. Emerging markets continued to lag developed markets and have now posted a negative annualized return on a trailing-five-year basis. A strong dollar weighed on the returns of international equities, but currency movements alone can’t be blamed for poor performance outside the United States. For the past three and five years, larger capitalization stocks have outperformed smaller stocks, and domestic equities have outperformed international.
It’s not a victory lap we wish to take, but these returns are in keeping with our expectation throughout the year that the primary driver of domestic equity markets would be corporate earnings. Profit weakness translated directly into the returns shown in the nearby chart for 2015. We will learn more about the fourth quarter when those company reports begin to be released in mid-January, but profits for the first nine months of the year were down 10% year over year. Admittedly, much of that decline was attributable to woes in the energy sector, but even adjusting for this one part of the economy, corporate earnings likely rose at a modest single-digit pace for the 2015 calendar year.
Fixed income returns were constrained throughout the year as the market played the well-established guessing game of when and by how much the Federal Reserve would raise interest rates. Sectors with greater sensitivity to credit and duration (high-yield and inflation-indexed bonds, respectively) lost ground, while traditional investment grade fixed income posted modest positive returns. The Fed started down the long path of monetary normalization by raising the fed funds rate by 25 basis points at its December 16 meeting, with little impact so far on market rates.
As we turn the page both literally and figuratively to 2016, the landscape remains much the same as it was in 2015. The economy should continue to grow at a moderate pace, buoyed by healthy consumer spending, which in turn should allow the Federal Reserve to raise interest rates a few more times before year-end. It remains to be seen whether consumer spending will translate into a rebound in corporate earnings and if that will be enough to extend the bull market in equities for yet another year.
This is the time of year when Wall Street prognosticators polish their crystal balls and make predictions for the year to come, most of which turn out to be wrong – some egregiously so. Rather than join those well-populated ranks of pundits, we instead will simply acknowledge that the future is forever an unknowable place, while at the same time highlighting what we believe will be the more important dynamics to watch in 2016. And so, without further ado …
The 10 Numbers That Matter in 2016
10. Housing Prices. The primary store of wealth for the vast majority of U.S. households is the home in which they live. The housing market collapse precipitated the 2008 to 2009 financial crisis and economic recession, but home prices have rebounded to become a modest tailwind to wealth creation. Housing prices rose roughly 6% in 2015 (with data available through November), and we expect that modest rise to continue into 2016. Higher mortgage rates may constrain the housing recovery, but with the average 30-year fixed mortgage rate up only 3 basis points since the Federal Reserve raised interest rates in mid-December, perhaps mortgage rates won’t get in the way of a continued rebound in housing. As an important form of private wealth, the housing market is a key contributor to personal consumption, and therefore economic growth.
9. Unemployment. Just as housing drives personal wealth, so does the labor market drive personal income. The unemployment rate dropped to 5.0% in November 2015 – the lowest level since February 2008. That puts more money in the pockets of more people, while growing confidence in the labor market enhances the willingness of people to spend that money. Initial claims for unemployment are lower than they have been in over 40 years, and as of last October, there were close to 5.4 million job openings in the country. This backdrop argues that 2016 should mark another year of job gains in the economy, providing even further support for economic activity.
8. Wage Growth. Perhaps the biggest economic puzzle of the past few years is why this improvement in the labor force hasn’t been accompanied by more robust wage growth. Average hourly earnings grew at a measly rate of 2.3% in 2015, but that figure isn’t as dire when considered in the context of little to no inflation. Furthermore, as the unemployment rate drops, and as the average hourly workweek expands, at some point employers will feel the need to raise compensation in order to attract and retain employees. Record job openings, depicted nearby, also argue that wages will need to rise if those openings are to be filled. A modest acceleration in wage growth would bode well for spending and economic activity, whereas too much wage growth might put pressure on the Fed to accelerate interest rate increases lest inflation get out of control.
7. Consumer Confidence. Falling unemployment and rising housing prices put more money in people’s pockets, while also supporting confidence. The University of Michigan’s monthly survey of consumer sentiment about current conditions and future expectations shows a continued recovery to pre-crisis levels, albeit with some volatility from month to month. This is an important psychological support for spending, to accompany the real support from higher wealth and income levels. After all, if consumers save all their incremental income, or use it to pay down credit cards, the impact on the economy is nil. Rising confidence correlates to rising spending and better economic conditions.
6. Manufacturing Confidence. In stark contrast to improving conditions in the consumer area, manufacturing sentiment, as captured by the Institute for Supply Management’s Purchasing Managers’ Index, is at recessionary levels. We discussed this divergence in our November 2015 commentary titled “A Tale of Two Economies,” and the dichotomy has only widened since then. The obvious culprits are falling energy prices and the subsequent impact on providers to the energy industry, coupled with the drag that the strong dollar imposes on export markets. Add weaker international demand into the mix, and it creates a perfect storm of misery for the manufacturing sector that we expect to wane in 2016 as energy and currency trends of 2015 aren’t repeated. Although there is no evidence yet that manufacturing weakness is dragging down the broader economy, the situation warrants attention as the new year unfolds.
5. Energy Prices. The price of oil fell from a peak of $107 in July 2014 to a low of $34.73 per barrel of WTI crude oil in late December 2015 and is lingering in the mid-$30s in the first week of the year. This is what happens when reduced demand (as global economic growth slows) meets rising supply (as shale oil production in the U.S. expands). OPEC’s decision to maintain output indicates that prices will likely remain lower for longer, and activity in the sector reflects that growing realization. Press coverage overwhelmingly depicts this as an economic negative, but lower prices are economically beneficial to consumers of energy, whether corporate or individual. Retail gasoline prices are down 27% since summer 2015, providing an extra boost to personal incomes and a potential boost to economic activity and corporate profits as well.
4. Core Inflation. Inflation is the economic equivalent of the boogeyman in this environment – widely feared, but never there when we look under the bed. Controlling inflation is, as well, half of the mandate of the Federal Reserve (the labor market being the other half), which prefers to rely on a core measure of inflation that excludes the more volatile elements of food and energy. At 2%, core inflation has just recently risen to the Fed’s stated comfort level, and inflation trends in 2016 will influence or even dictate the pace at which the Fed raises interest rates. At this point in the employment cycle, inflation and job growth are closely linked: as unemployment drops and labor markets tighten, upward wage pressure should follow (see point 8 listed earlier). Although this hasn’t happened yet, it is probably the single dynamic driving Fed policy in 2016.
3. Fed Funds Rate. So what will the Fed do? After hiking the fed funds rate last month for the first time in 75 meetings, the Fed has committed that future moves will be “data dependent,” without precisely outlining the set of data on which it intends to depend. Certainly the job market and inflation are high on its list of factors to monitor, but this Fed has demonstrated a willingness to include market conditions, international economic developments and investor sentiment in its deliberations as well. As 2016 is a general election year, politics will also play a role, albeit slight, in those deliberations. The futures market currently implies that the Fed will raise rates two to three more times this year, bringing the fed funds rate to between 0.75% and 1.00% by the end of 2016. That would still be an environment of very low interest rates, but it remains to be seen what impact that would have on consumer costs or the ability of investors to earn a reasonable rate of return from more traditional fixed income investments. We do not expect Fed policy to be a source of market uncertainty in 2016, unless developments in the labor market or inflation disrupt the Fed’s plans to raise rates at a gradual pace.
2. Equity Market Valuations. The S&P 500 bottomed at 676.53 on March 9, 2009, and, although the recovery from that nadir appeared to stall in 2015, the gain of nearly 200% over the past seven years is impressive. Rising valuations, measured most readily by the price-to-earnings (P/E) multiple, have supported that rally. Yet at 19.0x trailing operating earnings, current valuations are close to one standard deviation higher than the post-World War II average of 15.4x. These are not the bubble valuations of the late 1990s, during which the P/E multiple of the S&P 500 approached 30x, but rising valuations are not likely to provide the same support in 2016 as they have over the past few years.
1. Corporate Earnings. Valuations are important, but the ultimate fuel that fires the engine of equity markets is corporate earnings. Weak earnings growth in 2015 held back the market, which, as noted earlier, was largely a function of contraction in the energy sector. And yet as the economic cycle ages, it becomes increasingly harder for companies in all sectors to cut costs and boost margins, and in an environment of anemic economic growth and low inflation, it is furthermore difficult to increase unit sales or pricing. Wall Street disagrees with our characterization of the earnings picture. An aggregation of consensus bottom-up expectations for the earnings of the companies in the S&P 500 indicates expected earnings growth for the market of 18% for 2016. This strikes us as a clear triumph of optimism over realism, and we would be happy for the market to generate earnings growth in the low to mid-single digits in this seventh year of the economic cycle.
The economy is on solid footing, although we expect growth to remain subdued in 2016. The silver lining in this otherwise dark cloud of subpar economic growth is that what the economy lacks in vitality, it makes up for in durability. We simply don’t see the economic excesses that normally arise by this stage of the cycle and anticipate another year of activity like we had in 2015. That should allow the Fed to raise rates at a measured pace, which will at some point allow us to re-establish more traditional fixed income positions – such as municipal bonds – in client portfolios. We are more concerned about the equity market and the ability of corporate earnings to support market gains, but this observation underscores the importance of active management. Although the market may wrestle with full valuations and weak profit growth, individual companies offer more compelling investment options, and our managers will spend their year in pursuit of those opportunities.
We wish you and yours all the best for a prosperous and healthy 2016.
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