Global central banks have dominated investor attention, with diverging policies contributing to an increase in volatility. Meanwhile, earnings season has been mildly disappointing, while the US economy continues to shine relative to much of the rest of the world.
The Federal Reserve is not wavering from raising interest rates; but lower commodity prices and a continued strengthening of the US dollar could delay those plans, adding to investor uncertainty around monetary policy.
The European Central Bank (ECB) finally embarked on a quantitative easing (QE) program of its own, but we question the resultant Eurozone equity rally’s staying power. Meanwhile, the Greek political drama will likely drag on, but we place small odds on the country’s split from the Eurozone at this point. Global central bank policies are diverging. The Federal Reserve, although taking no action at its recent meeting, has a decidedly different tone than the others, all of whom are easing monetary policy—highlighted by a surprise interest rate cut from the Bank of Canada, and the announcement of QE by the ECB. It’s no wonder that there has been an increase in volatility in equities, a trend which we believe will continue in the near term.
Key questions are whether the actions by the ECB will boost economic growth in the Eurozone; might the US get dragged into Europe’s economic malaise; or will the divergences we’ve seen continue? We lean toward the latter. Eurozone prospects are discussed more in Jeffrey Kleintop’s article “Eurozone Economy: The ECB Can't Save It“, but from the US perspective it’s important to remember that only about 13% of its gross domestic product (GDP) is accounted for by exports, while only about 11% of that 13% is exported to the Eurozone according to Trading Economics. Given those relatively low percentages, the US economy may experience a bit of a drag from Eurozone weakness, but seems unlikely to be derailed in a substantive way. As a result of both relative economic strength and monetary policy, the US dollar has been on a tear over the past year, making foreign goods cheaper for US buyers—a deflationary impulse for the US economy. US dollar strength not a no-brainer? US dollar strength not a no-brainer?
Source: Factset Bloomberg , as of Jan 26 2015
However, when everyone lines up on one side of a trade, investors should approach that trade with caution—and that’s what we may be seeing with the strengthening dollar trade. While we remain dollar bulls longer term, there is the possibility of a countertrend move due to one-sided sentiment. Dollar strength has been blamed for some of the disappointments so far during earnings season. Fourth quarter 2014 reporting has been decidedly underwhelming with currency translation, regulatory costs, and the sharp fall in oil (and other commodities) all being blamed for soft results. Uncertainty seems to be rising in the corporate sector, much as it is with the investor segment, as executives try to discern the impact of these trends in the quarters ahead. We see the possibility for a decent sized correction in the US stock market for the first time in several years. We believe the secular bull market remains intact, but believe we are in a phase of heightened volatility not unlike the late-1990s. Valuation expansion has likely gone as far as possible in this environment, leaving earnings to do more of the heavy lifting. But with the aforementioned pressures on earnings, the market may have a tougher time generating the kind of gains investors have grown accustomed to. Along with the uncertainty regarding global growth and US Fed policy, the potential spark for a selloff could come from a crisis associated with the fall in the price of oil.
With oil down well over 50% in the past six months, there are likely to be short-term negative dislocations, even if the majority of US businesses and consumers are beneficiaries. Some dislocations are becoming evident, with capital spending plans being slashed and layoffs announced—both in the energy space as well as by companies that provide equipment and services to the oil industry. There also appears to be growing odds of defaults within the energy space of the high-yield market; and possible crises within countries most tied to oil. Remember, the plunge in oil prices in 1986 helped trigger the Savings and Loan crisis in Texas, while the dramatic drop from 1996-1998 was associated with both the Russian crisis and the Long-term Capital Management (LTCM) debacle. Lastly, we also want to note that there is the potential that the fall in oil is signaling something more serious in the global economy, with a nod toward the fact that many other growth-sensitive commodities have been sinking as well. Could commodities be signaling something more sinister? Could commodities be signaling something more sinister?
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