2015 was a roller coaster year for investors, with most markets and asset classes around the world ending the year in negative territory. The primary exception was U.S. growth stocks, where a handful of businesses, the so-called FANG companies (Facebook, Amazon, Netflix, and Google) accounted for 55% of the stock market’s meager return (the S&P 500 increased 1.2%, the Dow lost 2.2%). Partly because of this phenomenon, in the U.S. value stocks were down over 9% during the course of the year against their growth oriented brethren, while in Europe the gap was an unprecedented 13%.
For dollar-based investors, international equity returns were also uninspired, as the Morgan Stanley all country Index (MSCI ACWI) was down 4.3%, European stocks fell by 6%, and emerging markets declined by a whopping 17%. Japan was the one bright spot among major stock markets, increasing 7.8% in dollar terms. The strength of the dollar contributed substantially to some of these falls, as it gained an average of 12% against its main trading partners. As a result, dollar based investors lost money even while some non-U.S. markets were rising. Diversification across asset classes was also of limited usefulness, as commodities (down 25%, led by oil), MLPs (down 16%), and global bonds (down 3.2%) all fell. In the alternative space, hedge fund strategies slumped, with both long short and multi-strategy managers showing declines.
Looking forward, on the surface there seems little room for optimism, with markets having declined more precipitously year to date than they did last year. Here I would make several observations. First, as noted in our last market commentary, some of these falls make sense, as earnings growth, particularly in the U.S. industrial sector, has stalled, partly due to the impact of energy related problems. Secondly, in many sectors, market valuations were above long-term averages in terms of price to earnings and price to book ratios—particularly when one takes into account the slowing growth rate of the world economy.
Having said that, I think markets have vastly over reacted on two fronts: oil and China. To start with oil, while it is clear that the dramatic fall in energy prices has damaged the current profitability of energy related companies, these account for only a small portion of the U.S. economy, though a slightly larger part (7%) of the S&P. Furthermore, from here there would seem to be little further oil can fall, and it is worth keeping in mind that most of these declines in earnings will wash out of the system in the second half of 2016. More importantly, it is not at all obvious why global stock markets are treating falling oil prices as a negative.
Certainly in the U.S., where the consumer represents over two thirds of the economy, falling energy prices are putting more spendable cash in people’s pockets. Data suggests that, for the time being, the consumer is increasing his savings rate, as well as spending some of the windfall. In December, savings rates reached 5.5%, the most in three years. While that may eventually reverse itself, in the interim, it is no bad thing for the country to increase its saving rate, which has been low over the last few decades. Perhaps part of the explanation is the leads and lags involved. There is an immediate hit to the earnings of energy related business, and only later does consumer spending kick in.
A final note on oil. Though the price continues to bump along a rocky bottom, at the end of the day it is a cyclical commodity and the laws of supply and demand suggest that sometime in the next year supplies will start to diminish substantially. Although fracking has proved surprisingly resilient, and existing wells are producing for longer than anticipated, with prices at $25-$30 the number of new wells being drilled is starting to fall and oil companies are drastically cutting their capital budgets. Since the third quarter of 2014, the decline in rig count is now over 70%. Despite the increasing efficiency of extraction, over the course of the next several years this will inevitably curtail supply. Assuming we do not talk ourselves into a global recession, energy demand, which is projected to grow by 1.7 million barrels a day this year, will increase, causing prices to rally down the line. While I think it is premature to buy oil stocks at the moment, there will definitely be some opportunities in the coming months—especially in some of the midstream pipeline business, which have been unduly hammered.
As regards China, I again think that the impact of recent developments has been exaggerated. There seem to be two elements markets are primarily concerned about: the price of stocks and the impact of the economy on global trade. In terms of the former, it is important to keep in mind that the Chinese are newcomers to equity investments and tend to be very short term oriented. In addition, the Shanghai market is notoriously volatile, thinly traded and not very representative of the real economy, since 30% of its market cap consists of banks and 30% of state owned enterprises. It is an indicator of the nervousness that has gripped global markets that the day-to-day fluctuations of the Chinese market have had such a major impact on the rest of the world.
U.S. based investors in particular appear to have little to worry about. Less than 1% of U.S. GDP is related to China, and the level of imports are five times the level of exports, so concerns about potential currency devaluations are actually more of a positive than a negative for the U.S. economy. In contrast, in Germany 10% of the sales of companies listed on the DAX exchange are China related. According to Goldman Sachs, a 10% decline in import demand from China would cause only a .1% to .2% decline in developed country GDP growth rates.
While it is clear that the Chinese economy is slowing, this should be seen as a return to normalcy rather than a disaster, given the average growth rates, in the 10% range, we have seen over much of the past decade. It should also be kept in mind that China’s economy is over three times the size it was 10 years ago, so that while percentage growth rates are slower, the impact on the global economy is greater.
All of which is not to say that China does not have problems. The very rapid growth in credit across most sectors of the economy is a concern, as are capital outflows, though both are somewhat offset by the over $3 trillion of foreign reserves the government holds. Long term demographic trends as the population continues to age over the next several decades, the transition from an industrial export driven economy to a consumer oriented one, and increased competition from low cost manufacturers are all issues. But ultimately the most important problems China faces are political. Will the government be prepared to allow the economic reforms it needs to go forward if there is a short-term political cost in terms of its popularity and longevity? For the moment, we do not think there is cause for panic and mass liquidation of assets in an economy which is probably growing at between 6% a year and where retail sales are increasing at 10% a year.
Turning to the U.S., I think the picture is less rosy but certainly not dire. Most of the primary economic indicators look reasonably robust; unemployment, retail sales, real estate, etc. However, as noted above, even with recent falls, only certain parts of the stock market look attractively priced. More concerning is that the U.S. is now in the second half of the economic cycle, and options for policy makers, especially the FED, are becoming scarcer.
The strength of the dollar, up 26% against its major trading partners over the last two years, is another limiting factor, with 35% to 40% of the earnings of the S&P coming from overseas. Though it is noteworthy that the dollar has actually lost some ground in the recent market turmoil.
On the positive side, it is worth noting that the limits placed on the U.S. budget by sequestration are diminishing and that, after many years of decline public sector spending is projected to grow by about 2.5% over the next year. Overall, the consumer appears to be in good shape, with household net wealth currently at 630% of income, slightly below the record reached in 2007. In addition, debt service burdens are falling and are close to an all time low.
Nonetheless, continued dramatic falls in equity markets could certainly sap animal spirits on both the consumer and the corporate side. The conventional wisdom is that the so-called wealth effect dictates that for every 10% decline in the S&P there will be a .4% decline in consumption. Fortunately, most Americans have far more tied up in housing than stocks, and real estate markets remain strong in most parts of the country. According to The Economist, only 14% of household wealth is invested in the stock market and 45% of Americans do not own any shares. Of course, it should be noted that these lower income families have less spending power.
In our view, the political uncertainty caused by the U.S. electorate’s apparent preference for inexperienced outliers as the next president is also worrying markets. Though stocks generally tend to be range bound in the lead up to presidential elections (and to do well in the new leader’s first year), they hate uncertainty, and the fact that a number of the potential winners have relatively extreme economic views has compounded the problem. In short, our outlook for the U.S. market is for limited growth this year, though we expect to see a recovery from the recent sell off.
Of the other major economies, Japan looks the most promising, with the Abe government seeking to introduce reforms that could potentially impact both the markets and the economy. Pressure for corporate restructuring and reducing cross holdings by the banks is already being felt in board rooms which have long been somnambulant, and may eventually cause the gap in return on equity between Japan and the rest of the world to narrow. Meanwhile, the Japanese market, which has been very weak this year, is looking cheap, with low valuations compared to both the rest of the world and historic averages.
Emerging markets, which have beaten up for years, are looking more attractive, with the exception of countries that are dependent on commodity exports. Despite the fact that foreign currency reserves are generally high, currencies in the emerging markets as a whole have plunged a dramatic 40% since 2011, improving export competitiveness and creating some relative bargains for investors. Approximate valuations in terms of price to earnings ratios in the U.S. are currently 16, 14 in Europe, and 12 in Japan. For comparative purposes, in Korea PE ratios are 9, while in China and in Turkey they are 8 and in Russia they are 5. The same relationships roughly apply to price to book ratios in these countries, yet the growth prospects for the emerging markets are generally much higher than those of the developed countries. Overall, emerging markets are trading at a 35% discount to the developed countries –the cheapest they have been since 2005.
All of which is not to say that there are not concerning issues in emerging markets. Political uncertainty, declining investor interest resulting in substantial disinvestment from foreign investors, and deteriorating trade balances all need to be taken into account, but there can be little doubt that after five years of falls, numerous opportunities are starting to present themselves to the discerning investor.
Europe also continues to look reasonably attractive, with the strength of the dollar providing openings, particularly for export-oriented companies. As noted above, stocks are relatively cheap and also have a higher dividend structure than the U.S. For instance, current dividends in the U.K. are 4.5%; in the U.S. they are 2.4%. In fact almost 2/3 of European companies offer higher dividends than the pay out from corporate bonds; in the U.S. the ratio is considerably smaller. Similarly, average price to book ratios in the U.S. are 2.5, but are only 1.6 in Europe. Europe is also behind the U.S. in the economic cycle, with the European Central Bank publically committed to more monetary stimulus and low interest rates while the FED is starting to move in the other direction.
On the fixed income side, investment quality bonds, which have been the best performing asset class in the U.S. over the last 20 years, were relatively strong performers in 2015, though high yield and non dollar fixed income securities did considerably less well. Looking ahead, with interest rates at historically low levels, it is hard to see much value in bonds, other than as a defensive measure. High yield securities have fallen precipitously in the recent panic, are now fully pricing in a recession, and are at historically high spreads compared to government debt. Much of this is, of course, the result of justifiable concerns about default issues in the energy sector. However, for the selective investor, there are doubtless interesting opportunities to make money in high yield debt.
In this chaotic environment, alternatives offer some attractive possibilities. While many of the traditional uncorrelated investments like commodities and real estate have failed to add value in the past year, over time we still believe they have an important role to play as diversifiers. In addition, despite their recent mediocre performance, we continue to look for affordable hedge funds, which can add value on a risk-adjusted basis. Given relatively low expectations for bond and equity markets in 2016, we anticipate increasing our allocations to low risk, market neutral strategies in the future.
I hope this review may have addressed some of the concerns and qualms many investors understandably have at the moment. At a time like this, I think it is important to have a stable, disciplined process and not allow oneself to be buffeted by the day-to-day vicissitudes of the market. Inevitably, the type of turmoil we are witnessing creates dislocations, and therefore, opportunities for the long-term investor. Our process seeks to add value by combining a disciplined, strategic framework with a nimble, tactical approach to market conditions. While there may be occasional periods during which we fail to achieve these goals, over time we believe our record speaks for itself.