Market Data for year end 2015:
• S&P 500 Stock Index: 2044, down 0.7%
• Ten-year Treasury Note Yield: 2.27%, up 0.10%
• Gold: $1,060 per ounce, down 10.4%
• Oil: $37 per barrel, down 31.5%
The primary themes of financial markets in 2015 were the deceleration of the Chinese economy and the tightening of monetary policy by the US Federal Reserve. These two dynamics kept stocks under pressure, punished commodities, and pushed long-term bond yields in opposing directions, resulting in little change on the year.
The deceleration of the Chinese economy, with its focus on manufacturing and infrastructure investment, sent shock waves throughout the global economy leading to slower global economic growth. Emerging markets that relied upon exports of raw materials to China were particularly hard hit. In the face of US Federal reserve tightening, their currencies depreciated, thus reducing their ability to service debt denominated in US dollars. This added further strain to their economies.
The tightening of US monetary policy by the Federal Reserve was a focus of the market throughout 2015 culminating in the first increase in US overnight interest rates since June of 2006 on December 16th. Higher US interest rates threaten to slow the US economy by increasing the borrowing costs of consumers and businesses and increasing the value of the dollar, which reduces the competitiveness of US manufacturing and US corporate profits earned overseas. A strengthening US dollar also increases the pressure on commodities, which are primarily denominated in dollars.
The net effect on stocks by these dynamics was a steady pressure that left stocks little changed for the year. Beneath the surface, stocks exposed to the global economy, particularly those in the natural resource sector, declined in value, while those with a domestic focus and seen to be able to grow regardless of a slowing economy performed strongly. As mentioned above, commodities were ravaged due to weak global demand and chronic overcapacity across the spectrum. In the case of oil, the Saudi Arabians were determined to squeeze out foreign competitors, most notably the US shale drilling industry, by pumping oil at full blast in spite of significantly lower prices. Bond yields were torn between higher US overnight interest rates and a sluggish global economy, resulting in little change for the year.
Going forward, we believe the themes of a weakening China and tighter US monetary policy will continue to drive markets. It is difficult to discern the actual condition of the Chinese economy due to the unreliability of Chinese statistics. That having been said, the steady depreciation of the Chinese currency, the yuan, points to continued economic weakness. The Federal Reserve represents a danger in that their projection for the pace of higher overnight interest rates exceeds that of the market. The market is telling the Federal Reserve that economic growth and inflation are too weak to weather an aggressive increase in overnight interest rates. If this were to come to pass, the Fed would risk pushing the US economy into a recession, which would likely send stocks lower, perhaps significantly.
A “tail” risk for the market is a disruption to oil production in the Middle East due to geopolitical unrest. As of this writing, rioters in Iran sacked the Saudi Arabian embassy in Tehran reacting to the execution of a Shia dissident by the Saudis. (Iranians are Shia Muslims.) Saudi Arabia responded by cutting off diplomatic relations with Iran. Iran and Saudi Arabia find themselves in competition throughout the region, from Yemen to Syria. If war were to break out between the two countries, oil prices would likely skyrocket and the global economy pushed into recession. This would in all likelihood lead to a bear market in stocks and lower bond yields.
Our base case is that the Federal Reserve does not raise overnight interest rates quickly enough to push the US economy into recession. If this proves to be the case, we expect commodities and the economically sensitive stocks that were punished in 2015 to trade higher in price as the fear of aggressive monetary tightening is reduced. Conversely, those “growth” stocks which performed strongly in 2015 may find themselves coming under pressure given what have become near extreme valuations. We would also project that longer term US interest rates would trend modestly higher. For 2016, we expect to US stock market as measured by the S&P 500 stock index to trade in a range of 1850 to 2200. It ended 2015 at 2044.