Thurs, JAN 28th, 2016
“The key to making a good forecast is not in limiting yourself to quantitative information.” – Nate Silver
A couple of things to understand with our forecast:
1) We are not rigid thinkers. As incoming data arrives, our outlook is subject to change – either at the margin or entirely.
2) This exercise is best used as a guidepost, a framework, for how we are currently looking at markets and opportunities. It is not to be taken as an exact science, nor is it wise to marry yourself to these concepts or figures.
3) Hopefully, when reading this section what you’ll take away is a sense of the lens through which we are presently viewing the world and how this informs our approach toward portfolio management in 2016.
With that said, let’s get to some forecasting!
The fourth quarter is in the books. The U.S. economy grew at about the contemporary trend of the last decade or so for the whole of 2015: A trajectory of approximately +2.25% GDP growth has been quite consistent throughout much of this economic expansion. And this pace – while certainly less robust than in past recoveries – has been enough to add jobs (nearly +14M from the recession nadir), trigger investment, and improve general levels of confidence and household spending. The result has been solid economic progress, including surging corporate profitability and consequently a strong stock market. Meanwhile, the Federal Reserve has remained tremendously accommodative to both the real economy and the financial markets, and inflation has been at most lukewarm. Over the medium-term we expect more of the same from the U.S. economy as we see little out there that is likely to alter the present flight path.
How can we remain cautiously optimistic in light of current volatility, worries over China and potentially slower global growth? First, while numerical information is important and is something we monitor constantly, it doesn’t always reveal the entire story. For example, as we write this letter oil prices are -70% off their highs some 18 months ago and a menu of other commodities have been thumped as well. The prevailing view among forecasters has been wrong most of the way down. Now, these same seers are telling us that low commodity prices spell trouble for the global economy. They make a case for this by looking at subjective hard figures (i.e., price in this case): Lower prices must mean weak demand, right? And if true, such weak demand can’t be good. We see it differently by looking past the commodity price decline to shape our views.
Demand for commodities hasn’t changed much over the past couple of years. Folks are still driving, consuming, engaging in commerce. Businesses remain productive and the number of “widgets” produced is increasing. Labor markets and income – the lifeblood of demand – are salutary. All told we simply do not see a backdrop that fits the aggregate demand erosion thesis. Rather what makes more sense is that recent challenges in commodities markets are primarily a function of supply, not demand. Simply put, production growth of oil, gas, copper, zinc, wheat (etc.) over the years has outrun demand growth. Indeed, on a global basis companies made capital investments and contract commitments to mine, drill, and grow commodities for a world where China was going to grow at double-digit rates forever. This assessment was neither prudent nor probable. Add to this backdrop gains in technology, like fracking for oil & gas, and growth on the supply-side has been colossal.
Seven years into this global economic recovery the imbalance of supply and demand in commodities markets was bound to catch up to price. This is what has happened. And we don’t view this is a harbinger of impending doom. Instead we see this as a period of adjustment to match a world where growth isn’t +5 to +6% per year, but perhaps more like +3%. This is neither sudden nor disastrous. It’s a natural process in which the American economy and American business can succeed. We recognize that this narrative is counter to what we see in a financial media that wants to draw attention to every tick. We see an environment where the U.S. economy is still expanding and most companies are still profitable. With that said, the “easy” gains have likely been made for the foreseeable future, equity correlations are lower, and investment selection is therefore increasingly important.
A quick note on the Fed: Our House call all year was for a +0.25% December rate hike to commence the normalization of monetary policy and on December 16th Yellen & Co. finally raised the Federal Funds rate. We think that the Yellen Fed will be slow, steady, and pragmatic in normalizing rates. This “lower for longer” narrative should be supportive to both the U.S. economy and the stock market. This slow tempo is even more likely now given recent volatility and growing anxiety.
On net, we contend that the underlying fundamentals for equities – the “four pillars” as we’ve outlined in the past – are unbroken and we remain cautiously positive.
Jason L. Ware, MBA / Chief Investment Officer
Albion Financial Group