The U.S. has enjoyed a good six year run in asset prices; simultaneously, the global economy has had anemic economic growth that has perpetually caused concern: this is not the time to increase risk. Some have likened the last several years to a Goldilocks economy, not too hot and not too cold; if so, it was a tepid economy fueled by the largesse of central banks buying assets in order to spur growth and inflation. Even though equity prices have mostly bounced back from their more than 10% correction and August/September frights, equity sentiment is noticeably lower than it was in July. The fear is that the Bears may have recently come home and found Goldilocks asleep.
The world economy seems on the brink of a new recession, led by a crash in oil and commodity prices that has caused,
- A massive decline in corporate capital expenditures,
- A downturn in developing country (i.e., emerging market (EM)) finances and stability, and
- Reinvigorated deflation fears.
Amid plunging capital and equity returns, financial leverage has skyrocketed in many EM countries and sectors. Admittedly, oil and commodity price declines seem like, and are, last year’s news; but it has taken a while for their effects to snake through corporate balance sheets and economies and for markets to relinquish hope of a quick price recovery. Nonetheless, near-term GDP growth is likely to be stable in Japan, resilient in the U.S. and Europe, and disappointing yet still positive in China; thus, the global economy probably will not go over the edge.
Most countries – particularly the developed economies – should continue to record mildly positive growth, however, we could have a financial hiccup along the way. Although global services are growing, manufacturing, which is more cyclical than other parts of the economy, is struggling. Large fiscal stimulus from either China or the U.S. could effectively reflate the global economy and earnings; equity prices would then resume their advance. But policy steps and fiscal outcomes in Washington and China are equally uncertain. Unless there is a strong rebound in economic growth, expect an upturn in corporate bond defaults in 2016, especially amongst high yield (below investment grade) companies.
The Central Committee of China’s Communist Party recently completed its fifth Plenum (annual strategy meeting). While the press is focused on China now allowing households to have two children rather than only one, more immediate positive economic effects may stem from China’s renewed focus on innovation, productivity, and price liberalization to stimulate growth as well as national social security and health insurance which will put money directly into the economy. More immediately, on this side of the Pacific Ocean – following the Fed’s decision not to change interest rates in September or October – is speculation around the Fed’s announcement on December 16. The Fed’s bias to raise rates remains in place; but soft economic data and a strong dollar may delay a move. Either way, when rate hikes start, they will probably be small, few, and far between.
Usually bear markets (widespread pessimism and downturns of 20% or more) occur when economies sink into recession, but market forces such as a liquidity squeeze, pricing air pocket, panicked spread widening, or idiosyncratic bad news may trigger the next one. If that occurs, new investment opportunities will present themselves; we call these fat pitches.
Michael Ashley Schulman, CFA
Hollencrest Capital Management