A Rough Start to 2016

(2016 Market Commentary)

The stock market has rung in the New Year with a thud instead of a bang. The S&P 500 Index of large U.S. companies is off almost 8% for the year and smaller companies are off almost 10%. Both benchmarks are down more than 10% from their most recent peaks, a “correction” in Wall Street lingo.

The primary drivers appear to be the falling price of oil and continuing questions about the stability of China’s economy, where economic growth appears to have slipped below official statistics and doubts linger about the sustainability of their economic expansion. Here in the U.S., the economy remains on solid footing (despite the impacts of oil on energy sector jobs and earnings), although a big part of today’s selloff was a surprising bout of underwhelming statistics on retail sales and industrial production. Housing activity remains strong, and employment remains solid in the services side of the economy, which makes up about 70% of U.S. economic activity.

In a nutshell, there isn’t one thing that you can point to as a cause of the market’s recent decline, which is one of the reasons it’s been so swift. None of the factors I’ve mentioned are new, but they are starting to come together in ways that have investors spooked. As bad as the headlines are, it’s important to note that nothing we’ve seen yet has suggested that the U.S. economy is shrinking (or China’s, for that matter). Growth does seem to have stalled, raising doubts about the future, and that’s a big part of what’s affecting investor psychology today.

$30 oil has created headwinds for the energy sector, and put a lid on employment gains as oil producers work to adjust to low oil prices, but home construction is steady and other sectors of the economy are still doing fine. Low gasoline prices haven’t provided as significant an economic boost as they have in the past, but they have allowed consumers to save more and shift some spending to other things. Add to that a strong dollar (which makes imports cheaper), and inflation is likely to remain a non-issue for some time to come.

One final point that isn’t widely appreciated is just how much the recent budget bill added to the economy. We’ve read estimates that increased spending (and increased deficits) should add about $80 billion to federal spending in 2016, or about 0.4% of Gross Domestic Product. After years of subtracting form economic growth, this will be a welcome change, especially with the Federal Reserve on a path to raise interest rates. The small increase in government spending will help to offset the Fed’s actions.

We can’t say for certain whether the recent selloff and weak data are harbingers of a new recession, but so far that doesn’t seem to be the case. We know that a recession will happen eventually, but it seems unlike to us that it will happen in the near-term. Interest rates are still very low (supporting consumer and federal borrowing) and the service side of the economy is still growing. So the economy, while a bit softer than we’d like to see, appears to be in OK shape.

That leaves our greater concern about stock prices. Corporate earnings have been setting records for several years now and must eventually come back down to earth, especially as the political dialogue has highlighted the lack of wage growth and concerns about income inequality. Wage pressures are building, which will put a dent in corporate profits. Also, as interest rates rise, the cost of corporate borrowing will increase, putting additional pressure on profit margins. Finally, a significant portion of corporate earnings comes from overseas, and a strong dollar will take a bite out of the revenues that companies earn from their foreign operations.

One final point. The headlines out of China have been impressive (and impressively bad). But we buy far more from China than we sell to them, so the fact that their stock market or economy is struggling has very little impact on the U.S. economy. At the end of the day, what happens in the Chinese stock market has very little impact on the U.S. market, besides creating anxiety and heightening a sense of uncertainty.

Stock prices have been on an upward trend for several years, and are frankly long overdue for a bit of a breather. We can’t say whether the current downdraft will stop at 10% again or deepen, but the underlying economy is still sound, and should support a return to normalcy in the stock markets in the coming weeks.

As always, we’re happy to answer any questions you might have about your investments, or the impact of recent volatility on your long-term plans.