Investing Outlook: Tepid 2016?

For investors, 2015 was a disappointing year, with nearly all major asset classes registering declines for the year.  It was a year in which—whether you are talking about asset classes or individual securities—red arrows greatly outnumbered green arrows.

Here are the 2015 standings for indexes tracking several of the major asset classes:

Markets are off to a rocky start in 2016. In fact, the weather in global markets has been similar to the El Niño-driven weather in San Diego so far in 2016—raining cats and dogs.  Like the U.S. market volatility in August and September of 2015, however, the tough going in our markets so far this year has its origins mostly in China. The Chinese stock market fell 10% in the first week of 2016.  On Thursday the Chinese halted stock trading after only 30 minutes, with the index already having plunged 7%. While the Chinese authorities are clearly trying to calm investors, they may be producing the opposite effect. Markets work just fine as a mechanism for the price discovery of assets—but they have to be open to do so.  Now the Chinese have decided to do away with their market “circuit breakers” and let stocks find their proper prices. Whether or not this will calm Chinese investors is anyone’s guess.

Global investors are trying to get a grasp on the true pace and trajectory of the economic slowdown in China. While the first week of trading in China is a discouraging sign, the U.S. economy (but not its stock market) is actually pretty insulated from China. Trade with China accounts for about 7.5% of our total foreign trade and only about 1% of our gross domestic product (GDP).  China does a lot of work for us—mostly building and assembling things—but we do not sell much to China. And even if the Chinese market takes a dive, factory operations there being conducted on behalf of U.S. companies will likely be unaffected. All in all, problems in China and other emerging markets should encourage global investors to seek the relative safety of the U.S. currency and financial markets.

On top of the renewed worries about China, two other events this past week have contributed to the downbeat sentiment. First, North Korea claims to have conducted a successful test of a hydrogen bomb. U.S. officials dispute this claim, but this declaration alone was certainly enough to dent investor sentiment. Second, Saudi Arabia executed a Saudi Shiite cleric, Nimr al-Nimr, who was critical of the Saudi royal family. This sparked a furor in Shiite Iran, where protestors ransacked the Saudi missions. The Saudis then cut diplomatic ties, sending Iranian diplomats home. While the Sunni-Shiite rivalry has gone on for centuries, these events merely increase the fragility in a region already aflame with conflict.

U.S. stocks, as measured by the S&P 500 Index, now sit about 9.8% below the all-time highs reached in May of 2015.  While enduring the recent slide in prices is of course unpleasant for investors, declines of 10% are nothing out of the ordinary for stocks. There have been 33 (now almost 34) 10%+ declines from the highs since 1950. Each and every one has proven to be a good time to buy stocks. The market has often proceeded to go lower that down 10%, but in the longer term has come back to vindicate those with the courage to buy into weakness.

In the first trading week of the new year, U.S. stocks lost 6%. While most of the punishment in our markets seems to have been meted out over China, investors here in the U.S. are facing a dearth of encouraging news. The Fed has begun to raise rates, the Christmas season was underwhelming for retailers, oil remains mired in the $30s, and the year just passed will probably end up with corporate profits flat to slightly down (due wholly to losses in the energy sector). Meanwhile, while stocks are cheap relative to bonds, they are not cheap on an absolute basis. The S&P 500 currently trades at about 16 times expected earnings for 2016, on the high side of its historical valuation range. Investors are seemingly willing to pay up a bit for stocks given that bonds, with their paltry yields, are so expensive. Nevertheless, high valuations do make stocks more susceptible to negative headlines.

The U.S. economy is poised to deliver continued but modest growth in 2016. One indicator that investors see both inflation and growth constrained in the coming years is the rate on the 10-year Treasury. Despite the Fed’s 25 basis point rate hike on December 16th, 10-year Treasury note yields have actually gone down since then. They were at 2.30% on the day of the hike, but closed the first week of 2016 at 2.11%. This is a pretty dramatic drop for long yields as short yields have been pushed higher.

The slump in energy prices and other commodities, while very good for the consumers of these items, does have a negative knock-on effect in markets. First, corporate profits of the commodity companies themselves are lower, but all the companies that provide services to those companies are also having to contend with customers who are frantically trying to cut their own costs. With China continuing to slow and global oil supplies poised to keep growing in 2016, it does not appear that the commodities downturn has yet hit bottom.

Despite the volatility in our equity markets, the U.S. economy still appears to be on a relatively solid (albeit unspectacular) growth trajectory of about 2% or better. Employers added a robust 292,000 jobs in December, keeping our unemployment rate at a healthy 5%. U.S. consumers, the engine of 70% of our economy, have a number of tailwinds at their backs going into 2016. Interest rates remain low, energy prices are far lower than a year ago and the strong dollar is reducing the cost of imported goods. All in all, the U.S. is an island of peace, stability and relative prosperity in an increasingly tumultuous world.

Photo: Imaginechina/Corbis