Quarterly Market Update
In this edition of BBVA Compass Market Outlook, Mses. Shackelford and Viguier-Galley examine the major financial and economic themes that are anticipated to drive global markets in 2015.
1. What is the outlook for the U.S. economy for the remainder of the year?
Economic cycles often become self- fulfilling prophecies and can play out over a period of several years. Fortunately, the U.S. economy is continuing on an upward trajectory, logging modest improvements with little risk of stalling, barring any sudden, greater than expected, moves by the Fed. The advance is driven primarily by satisfactory jobs growth. We also anticipate some bounce back from the winter weather and from housing where the recovery had lost steam on the heels of rising home prices and tighter inventory. While lower oil prices should positively impact consumer spending, lower prices have also severely dented capital investment levels in the petroleum industry, particularly in shale-oil production, which had previously helped to fuel the U.S. recovery.
The improved jobs market has failed to translate as of yet into broad wage increases which we would normally expect during a healthy cycle. And where there are small wage increases in certain areas, individuals are not spending the increase. As we have noted, while the rise in the personal savings rate is healthy from a structural point of view, the U.S. economy is driven 70% by consumer consumption, and even small changes have the potential for a larger impact.
Figure 1. The U.S. personal savings rate has increased since 2008.
2. In comparison, what is the outlook for Europe’s economy?
The Eurozone is in a different stage of the economic cycle than the U.S. as it has been plagued by double-digit unemployment, weak GDP growth, and a negative inflation rate. The economy appears to be on the mend, thanks to lower oil prices, a weakening euro, and the prospect of additional monetary stimulus. Crédit Agricole has revised the Eurozone growth forecast to 1.5% GDP for 2015 and 1.7% in 2016 on the strength of increased domestic demand, driven largely by the fall in oil prices. Because Europe must import the vast majority of the oil that the region consumes1, the drop in oil prices has wide-reaching impact. According to the European Commission, the preliminary measure of consumer confidence rose to minus-3.7 in March, its highest level since July 2007. The uptick is being credited to the boost to incomes from falling oil prices and to increased optimism for economic growth following the ECB’s asset-buying program which began in March.
3. Please explain the ECB’s new bond-buying program.
In an effort to stimulate the Eurozone’s sluggish economy, the ECB announced its intent to begin large-scale purchases of bonds using newly printed money in a QE program similar to what the U.S., Japan, and England have been executing for a number of years. The ECB committed to purchasing €60 billion (roughly $66 billion, depending on where the euro is) in public debt for 21 months until inflation is stabilized at a level close to 2%.2
Relative to the Fed, the ECB faces a number of challenges. The Fed bought bonds in a well-established market for Treasurys and mortgage-backed securities while the ECB has 19 governments and bond markets, ranging from Greece to Germany, from which to choose. The Fed’s bond-buying programs added $3.6 trillion dollars in assets to the Fed balance sheet, the ECB has committed to a closer to $1 trillion dollar purchase through September 2016. Perhaps the greatest difference lies in the fact that the Eurozone already has negative interest rates raising the question of the effectiveness of a program to further reduce rates.
Despite these challenges, the prospect of additional stimulus has certainly improved the global outlook for the Eurozone. In some respects, the ECB has been able to capitalize on what has been termed the Fed "put" (a financial strategy in which the buyer of the put acquires the right to sell an asset at a particular price to a counterparty if prices decline below a certain level). The Fed’s pattern of providing ample liquidity after the financial crisis of 2008 via QE programs led investors to anticipate that it would continue to do so, thereby helping to protect asset prices and encouraging investments into riskier asset classes. Similarly, the ECB is now in the position where it does not have to necessarily print money; ECB President Mario Draghi only has to talk about doing so. Indeed, the wide coverage of anticipated ECB moves, followed by the actual purchases, recently helped push the U.S. dollar/euro trade down from 120 to 105 in less than a month. Clearly currency translation is working in their favor as the weakening euro makes the Eurozone’s exporters and multinationals more competitive in global markets.
4. What is the outlook for the U.S. dollar?
The U.S. dollar advanced almost 11% in 2014 and 6% for the quarter, according to the Bloomberg Dollar Spot Index which measures the greenback against a basket of 10 leading currencies. Consensus calls for the dollar to continue strengthening for a few more years. The U.S. is strengthening economically, and while we have assumed a tremendous amount of debt as the Fed orchestrated three cycles of QE, Europe and the rest of the world are also levering up substantially. Historically the greenback has been punished because we are a debtor nation. In fact, it has been devaluing since 1985 relative to the Swiss franc, for example. But now that the playing field is leveling and other regions of the world are catching up (except Asia ex-Japan for now), the focus has turned to economic growth. Additionally, the prospect of higher interest rates later this year makes the dollar more attractive. Nonetheless, the dollar’s trajectory is almost certain to be marked by shorter-term downward fluctuations within the longer-term upward trend simply because, although currencies move in long cycles, the path is seldom linear.
5. What is the outlook for the price of oil, and why?
Oil has tumbled for three quarters in a row, shedding around 45% of its value since June 25, 2014, and because the decline was so unexpected, there is a huge disparity among analysts in terms of their price forecasts. The difficulty lies in the fact that oil is priced not only on supply and demand fundamentals, but by a host of other factors, chief of which is geopolitical. Looking at simply the fundamentals, most analysts can agree on a 12-month target price of around $60 to $65 a barrel for West Texas Intermediate crude. Inventories remain high although shale-oil drilling is projected to slow, because global growth is sluggish and global markets are generally oversupplied. But in the face of geopolitical events such as the turmoil in Yemen, fundamentals become more complicated. Additionally, because oil is quoted in the U.S. dollar, the dollar’s recent strength impacts the price. In euro terms for example, the price of oil has "only" dropped 31%, from 72.42 euros to 49.85 on April 7, 2015.
6. Will the Fed raise interest rates before year end, and why or why not?
We anticipate that the Fed will raise rates towards the fall if jobs growth continues to be supportive. Whereby the ECB is primarily targeting inflation with its new QE program, the Fed has to tie its efforts to a healthy jobs market and to inflation. The Fed will likely want to implement the rate hike in advance of getting too near to yearend, or run the risk of investors starting to second guess Fed action. Having danced around the topic since QE 3 ended in October 2014, the Fed is likely ready to get the first hike over and done.
7. What is your outlook for stock markets, and is the era of double-digit stock market returns over for now?
In a reversal of the past few years, the U.S. economy may actually fare better than the stock market in 2015. We are still in an incredibly long bull market, but we anticipate it to taper off at some point. We could end up with more subdued returns characterized by heightened volatility and corrections as the year progresses.
Double-digit returns are probably over for this year, given the projections/direction of corporate profits. According to FactSet, analysts estimate S&P 500 companies will earn 3.3% less in the first quarter than a year earlier, down from the 5.8% growth analysts projected at the beginning of the year3. Because earnings are not keeping up with the higher valuations, multiples could contract, resulting in more modest returns.
The "lifts all boats" returns that are an inherent part of stimulus efforts have meant that, for the most part, stocks across the quality spectrum advanced during the bull market. A slowdown and increased volatility bring greater distinctions between low- and high- quality stocks, making stock selection and active management even more important.
We currently favor small- and mid-cap stocks because of the exposure their earnings have to the domestic economy. Larger multinationals are fighting the headwind of the stronger greenback on their earnings, while simultaneously needing to see more growth in Europe in order to be able to sell there and be competitive. The growth investment style should continue to outperform that of value because when growth is scarce, investors will pay more for consistent earners.
We like international stocks in general as a diversified portfolio can get lift from international even in the face of a strong dollar. We see slightly better potential returns if the European economy continues to improve versus that of the U.S., after considering the currency effect back into U.S. dollars.
1 As per Eurostat the EU-28 dependency on energy imports reached 53.4% by 2012. The highest energy dependency rate was recorded for crude oil (88.2%)
2 The Governing Council of the European Central Bank (ECB) today (January 22, 2015) announced an expanded asset purchase programme. Aimed at fulfilling the ECB’s price stability mandate, this programme will see the ECB add the purchase of sovereign bonds to its existing private sector asset purchase programmes in order to address the risks of a too prolonged period of low inflation. The programme will encompass the asset-backed securities purchase programme (ABSPP) and the covered bond purchase programme (CBPP3), which were both launched late last year.
3S&P 500 Earnings Chill Could Herald Profit Freeze, by Justin Lahart, WSJ, March 27, 2015.
BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.
This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).