The Panics of 2016

The Panics of 2016
Monday, January 4, 2016
See the pdf and the collection of the individual charts linked below.(1) Hunches about 2016. (2) Looking backward and forward to more panic attacks. (3) Timely cut in outlook for earnings and S&P 500 early last year. (4) Hanging onto relatively upbeat earnings outlook. (5) De-energized earnings looking good. (6) Energy has lost a lot of weight. (7) Dollar headwind may be offset by commodity tailwinds for earnings of some companies. (8) Labor costs remain subdued. (9) Global oil demand growth picking up smartly, but demand/supply ratio still bearish for oil. (10) China’s M-PMI not so bad. (11) A few canaries gasping for air. (12) Round up the usual pessimists. (13) “In the Heart of the Sea” (+ +).

Strategy: Upbeat Outlook. I’m not sure what will happen in 2016, but I have a hunch. I do know what happened in 2015. My hunch is that it will be more of the same this year. I also know that since the start of the latest bull market in 2009, there have been numerous panic attacks followed by relief rallies to new cyclical highs and then to new record highs since March 28, 2013, as you can see in our S&P 500 and Panic Attacks. Odds are there will be several panic attacks this year, which we discuss below and which should also be followed by relief rallies propelling the stock market to more new highs. This assumes that earnings will be making new highs as well. Consider the following in this regard:

(1) Last year. Joe and I started last year by lowering our estimate for S&P 500 earnings to reflect the drop in oil prices and the strength of the dollar. As a result, we also lowered our S&P 500 target for last year to 2150 from 2300, which became our target for this year (Fig. 1). We came close to being right when the S&P 500 rose to a record 2130.82 on May 21 (Fig. 2). However, it closed down 0.7% for the year at 2043.94.

Is our 2300 target too optimistic for 2016? That would be a 12.5% gain for this year. Despite the recent renewed weakness in oil prices and strength in the dollar, we are sticking with $127.00 per share for 2016 and $136.00 for 2017, implying annual gains of 7.6% and 7.1% respectively. We’re also expecting that there is a bit more upside likely for the valuation multiple. Our estimate for last year’s S&P 500 earnings of $118.00 per share was apparently on the mark (Fig. 3). However, we still have to see how the current earnings season for Q4 will play out, with industry analysts currently forecasting a 3.9% y/y decline (Fig. 4). Odds are that the result will beat the current consensus estimate, as has been the case during each of the past 27 quarters. (See YRI Earnings Forecast.)

(2) Oil drag. The biggest drag on S&P 500 earnings last year was the plunge in earnings of the Energy sector. Excluding it, S&P 500 aggregate forward earnings was at a record high late last year (Fig. 5). With the price of a barrel of Brent now down nearly 70% since the summer of 2014 and matching the lows of 2008, there may not be much more downside. Even if there is, the sector now accounts for just 3.8% of S&P 500 aggregate forward earnings, down from 11.7% during the summer of 2014 (Fig. 6).

(3) Dollar headwind. Previously, we’ve noted that the plunge in oil prices has hit aggregate S&P 500 earnings more severely than has the soaring dollar. We’ll see if that changes during the Q4 earnings season. The JP Morgan trade-weighted dollar is up 20% since the summer of 2014. In theory, that should slash earnings by roughly 10% given that about half of S&P 500 revenues and earnings comes from abroad. On the other hand, industries and companies that aren’t directly or indirectly in the energy business are enjoying a big break on their energy costs. The weakness in other commodity prices is also a profits booster for commodity users.

(4) Labor costs. What about wages? There’s anecdotal evidence that they are rising at a faster pace. The new year starts with higher minimum wages in 14 states, with the average rising from $8.50 an hour to just over $9.00. On the other hand, there is also plenty of anecdotal evidence suggesting that companies are using technology where they can to lower labor costs.

More importantly, average hourly earnings for all workers rose just 2.3% y/y during November (Fig. 7). That included an odd jump of 3.1% y/y in the wages of workers in natural resources, which surely isn’t sustainable (Fig. 8). Wage inflation remains subdued across most industries: Transportation & Warehousing (0.6%), Education & Health Services (1.9), Wholesale Trade (2.2), Financial Activities (2.4), Leisure & Hospitality (2.6), Retail Trade (2.7), Professional & Business Services (2.9), Information (3.7), and Utilities (5.1). (See our Average Hourly Earnings.)

(5) Bottom line. The bottom line is that the bottom line should resume growing over the next two years following last year’s oil-related stall. This assumes that the global economy won’t stall this year and that US real GDP growth should grow at least as fast this year as last year. That would be 2.5% or better, in our estimation. So now let’s turn to an analysis of the global economic prospects.

Global Economy: Weight of the Evidence. Will it be more of the same for the global economy in 2016? If so, that would be more secular stagnation, which would be more subpar growth. A case can be made that it might be more of less growth. There may be delayed depressing and deflationary consequences resulting from the plunge in commodity prices. There will certainly be more capital-spending cuts among energy and mining companies. There could be more bond defaults, which might tighten credit conditions not just for issuers of junk debt.

As Melissa and I review below, the consensus view about 2016 seems to be relatively pessimistic. We tend to be optimists. Nevertheless, we always strive to be realists by carefully examining the weight of the evidence. So let’s review the latest global data–the good, the bad, and the ugly:

(1) Lower oil prices a net positive. Debbie and I calculate that global oil revenues have plunged by $2.2 trillion from an annualized $3.8 trillion during June 2014 to $1.6 trillion during November of last year (Fig. 9). This series is highly correlated with the forward earnings of the S&P 500 Energy sector, which is down 68% from July 2014’s peak through mid-December 2015. Also suffering are oil exporters like Saudi Arabia, which recently announced a drastic cut in the government’s budget. (See our World Crude Oil Outlays & Revenues.)

On the other hand, the plunge in oil prices and in outlays on oil by consumers should be stimulative, more than offsetting the drag from cutbacks by energy companies and oil exporters. Sure enough, Oil Market Intelligence data show that world crude oil demand over the past 12 months through November rose 2.4% y/y, the fastest since July 2011 (Fig. 10). This suggests that, on balance, lower oil prices are boosting global economic growth.

Won’t this soon start boosting oil prices? Not if supply continues to outpace demand. Our oil demand/supply ratio indicator fell in November to the lowest since the end of 1998 (Fig. 11). So it remains bearish for oil.

That should be bullish for US consumer spending. It hasn’t been so far, as the $100 billion annualized windfall from lower gasoline prices has been mostly reflected in a comparable increase in personal saving since the summer of 2014. On the other hand, as Debbie reviews below, both the Consumer Sentiment Index and the Consumer Confidence Index edged higher in December. MasterCard Advisors reported that retail sales surged late in the holiday season.

(2) Eurozone lending better. While Europeans have lots of worries starting the new year, including terrorism and immigration challenges, monetary financial institution (MFI) loans to the private sector rose 2.1% y/y during November, the best pace since October 2011 (Fig. 12). Lending to households has led the way.

(3) China’s M-PMI not that bad. China’s official manufacturing PMI edged up to 49.7 during December (Fig. 13). It’s been just below 50.0 for the past five consecutive months. While this has been widely portrayed as a sign of weakening production, the output component of the M-PMI continues to well exceed 50.0, with a November reading of 52.2! In fact, this component hasn’t been below 50.0 since January 2009. The weakest component has been employment, which has been below 50.0 since June 2012, suggesting that automation is boosting productivity and reducing the demand for factory workers.

(4) Canaries gasping. The latest data on production in key export-led economies show either flat or declining trends over the past year through November: South Korea (-0.3%), Singapore (-5.8), and Taiwan (-6.2) (Fig. 14). Brazil’s output is in a free fall, with an 11.4% y/y plunge through October (Fig. 15).

In the US, West Coast ports container traffic is showing that over the past 12 months through November, outbound cargoes are down 10.2% y/y to the lowest since March 2010 (Fig. 16). This suggests that the strong dollar and slow global economic growth are weighing on US exports.

(5) Central banks barking, not biting. Of course, the big question is whether central banks will do more of the same in 2016. Will the Fed continue to raise interest rates, while the ECB and BOJ maintain their ultra-easy policies? It’s hard to imagine much more than another one-and-done scenario for the Fed given that the soaring dollar is already clearly depressing US exports.

2016: Not So Happy New Year? On balance, the popular financial press has chosen to spotlight lots of pessimistic predictions for the year ahead. No wonder the Bull/Bear Ratio compiled by Investors Intelligence ended up near 2015’s lows with a reading of 1.24 during the 12/22 week (Fig. 17). On the other hand, according to a 12/12 Barron’s survey, 10 of Wall Street’s top investment strategists are forecasting that the S&P 500 will rise to 2220 this year on average. Melissa and I have compiled links to a bunch of articles with a pessimistic outlook for 2016. There will likely be more panic attacks about these issues this year, as there have been since the start of the current bull market. Here is a brief overview of what the pessimists are worrying about:

(1) Global economic growth worsens. According to a 12/30 Reuters article, Christine Lagarde, head of the IMF, believes that “global economic growth will be disappointing next year and the outlook for the medium-term has also deteriorated.” Indeed, many forecasts for global growth don’t project anything much higher than 2.0%-3.0% for advanced economies and 3.0%-4.0% for emerging markets. (See, for example, the IMF’s October 2015 World Economic Outlook.) In a 12/19 Barron’sinterview, David Levy of the Levy Forecast went as far as to say that odds are the “slowly spreading global recession” will “engulf the entire planet” this year. In his grim forecast, it would be the first US recession caused by a downturn overseas.

(2) Europe disintegrates. Europe is obviously a big mess, and it could get messier. The ugliest items on the 2016 worry list for the region include a “Brexit,” more terrorist attacks, and an out-of-control refugee situation. Bloomberg’s late December “A Pessimist’s Guide to the World in 2016” included the prospect of the UK leaving the European Union. That would cause global banks, hedge funds, and manufacturers to move operations elsewhere as they seek to stay within the free-trade bloc. Making matters worse, the Paris terrorist attacks have increased the risk of disruptive political and policy shifts, Rebecca Patterson of Bessemer Trust recently told Bloomberg. Politics aside, more terrorist threats could further jeopardize consumer spending, inbound tourism, and cross-border trade. It doesn’t help Europe also to have a massive influx of refugees, Harvard Professor Niall Ferguson said in a 12/26 Barron’s interview. He sees more downside than upside for the European economies from the tidal wave of immigrants.

(3) Chinese growth slows more than expected. Perhaps one of the biggest 2016 wildcards is how China’s growth will fare as it pivots from a manufacturing- to service-based economy. The pessimists’ view is that China’s growth will fall below the government’s target and that the spillover to other regions could get nasty. David Levy toldBarron’s in his interview cited above that “the more bullish consensus view underestimates the linkages” between the US and EMs including China, which may have “a very tough time” as it “tries to refocus its economy.” Niall Ferguson said in his Barron’s interview that “a policy error in China” could cause “huge instability,” having an effect on all other emerging markets. This week’s Barron’s features an article by Jonathan Laing titled, “The Trouble With China.”

(4) Commodity bust triggers credit crisis. A 12/28 Reuters article titled “Wall Street in 2016: What could possibly go wrong?” observed, “U.S. crude is now about $37 a barrel, down more than 65 percent since June 2014. Should the prices of oil and other commodities fail to firm, the risk is of spreading deflation, as declining earnings in those sectors spread to financial firms, suppliers and more,” thoughts attributed to John Manley, chief equity strategist at Wells Fargo Funds Management. If oil prices continue to fall into a bottomless pit, oil-exporting nations could implode economically and politically, unleashing all sorts of problems for the global economy.

(5) Fed’s rate hikes unsettle. Following last year’s 12/16 one-and-done rate hike, Fed Chair Janet Yellen stressed that additional monetary tightening would be gradual this year. Two days later, FRB-Richmond Fed President Jeffrey Lacker said that four hikes in 2016 would be gradual, in his mind. A few days before, the 12/12 Barron’sreported that David Kostin, Goldman Sachs’ chief US equity strategist, believes “the market’s P/E multiple will contract as others come around to [the four rate hike] view.” Future rate hikes were also on Reuters’ 12/28 list of potential problems in 2016. It noted one of the obvious resulting negative impacts: “As rates rise, stocks could become less attractive compared with other asset classes like bonds.”

(6) Soaring dollar clobbers US exports and S&P 500 profits. Also on Reuters’ worry list is that the dollar continues to soar as the Fed hikes interest rates, diverging from the easy monetary policy path taken by other major central banks. “[The dollar could] shave 3 to 4 cents from first-quarter earnings of U.S. companies with foreign exposure,” noted a currency expert in the Reuters article. Not only that, but “profit gains haven’t looked so punk since the bad old days of 2009” observed the author of the 12/12 Barron’s article cited above.

(7) Geopolitical instability proliferates. In his 12/26 Barron’s interview, historian Niall Ferguson accentuated the geopolitical negatives: “I expect next year to be more violent than 2015. Many investors don’t realize that since the outbreak of the Arab Spring in 2011, fatalities due to armed conflicts are up by about a factor of four; terrorism is up by a factor of six.” A few specific concerns on the pessimists’ lists include: the US ceding regional power to China or Russia, the Islamic state attacking Middle East oil production, and Russian or Iranian hackers launching cyber-attacks on the US financial sector. They undoubtedly will add instability in Saudi Arabia following this weekend’s mounting tensions with Iran after the Saudis executed a popular Shiite cleric.

Movie. “In the Heart of the Sea” (+ +) (link) is a whale of a tale directed and produced by Ron Howard. According to the movie, which is based on a 2000 non-fiction book of the same name, the sinking of the American whaling ship Essex in 1820 inspired Herman Melville to write his novel Moby Dick. Early industrial societies used whale oil widely in oil lamps and to make soap and margarine. It’s easy to sympathize with a whale intent on killing those who are killing his mates for their blubber. Fortunately, the killing stopped with the commercial development of substitutes such as kerosene and vegetable oils.