Momentum Fades, Risk Increases

After mounting an impressive turnaround rally which saw the S&P 500 rise 16.6% from its intraday low of 1810.10 on Feb. 11 to an intraday peak of 2111.05 on April 20, the stock market has recently given back some of its gains.  Momentum has also faded over the past six weeks. Since March 22, the S&P 500 has been flat.

If investors had been too pessimistic at the start of the year, they now seem to be less certain of the market’s future direction, given that valuations are higher now and the economic picture remains mixed.

A primary catalyst for the bounce back in stocks has been the sharp rebound in the price of oil. Oil rallied from a low of $26.05 on Feb. 11 to an intraday high of $46.73 on April 29, a gain of nearly 80%.

The higher price of oil has reduced fears about a wholesale collapse of the U.S. independent oil & gas industry. (Each week still brings new Ch.11 filings, but many oil & gas producers are hanging on, hoping that a sustained rise in the price of oil will be enough to keep them out of bankruptcy court.)  Thus, the rebound in oil also tempers concerns that reduced drilling activity and producer losses could drag down the broader economy and stock market.

Yet, there is downside risk in oil near-term. Since OPEC and Russia failed to reach an agreement to freeze production, the oil market remains fundamentally oversupplied. Trading in oil is likely to remain volatile for the balance of the year.

Another key factor in the stock market recovery has been the easing in the value of the U.S. dollar. The ICE spot U.S. dollar index declined steadily from early March to early May, falling 4.8% with the S&P up 0.6%. Over that period, the yen has jumped 13% to 107; while the Euro has risen 6.6% to $1.14.

A gradual decline in the dollar would help to rebalance global economic activity, boosting U.S. exports and increasing the value of overseas earnings for U.S. multinationals.  That rebalancing, however, would presume that economies outside the U.S. are on solid enough ground to withstand a modest decline in the competitiveness of their exports.

Many economists are scratching their heads over the yen rally because GDP growth in Japan continues to hover near zero and the country’s central bank seems intent on driving interest rates deeper into negative territory, if necessary.

The Eurozone, on the other hand, seems to be doing better, with first quarter GDP clocking in at a respectable 0.6% vs. 15Q4. Year-over-year GDP growth was 1.6%. The strong first quarter raises confidence that the tepid outlook for the Eurozone in 2016 will be achieved.

With the February-April rally, the stock market has stepped back from the abyss, but the global economy’s ability to achieve lift-off is still very much in question.  Meanwhile, the world’s central banks, the only authorities capable of addressing near-term economic weakness without political interference, are running out of capacity to respond to persistent weakness or perhaps a new set of problems.

The unprecedented monetary stimulus that central banks have provided is only justifiable as a temporary measure. In order to eliminate the distortions caused by these unconventional policies and preserve their capacity to respond to future crises, central banks must be able to withdraw this stimulus and reset their balance sheets when their economies return to normal.

After eight years of stimulus, however, many economies are still on life support. Most economists now believe that it will be years before financial conditions return to normal. Consequently, downside risks for investors will remain elevated and may very well increase over time.

Despite these concerns, there are some positive signs in the data that can provide support for investors who prefer to stay the course. For example, the improvement in GDP growth in the Eurozone and solid employment and personal income growth in the U.S. suggest that the recovery is continuing, albeit slowly. Low inflation worldwide provides the Fed and other central banks sufficient cover to maintain a gradual approach to normalizing interest rates.

The strong dollar helps support export growth outside the U.S., but at a cost to U.S. economic growth. It cannot be sustained indefinitely. Industrial production in the U.S. has registered year-over-year declines for seven consecutive months, due to the slowdowns in the oil patch and exports. 2016 first quarter real GDP growth was clocked at an annualized rate of only 0.5%, according to BEA’s first estimate. The Conference Board’s consumer confidence index has been flat this year, but the University of Michigan’s consumer sentiment index has declined moderately but steadily since peaking in early 2015. It is unlikely that job and income growth can be sustained, if industrial production and consumer confidence continue to slide.

Add to this growing geopolitical risks in hotspots like the Middle East, Afghanistan, Ukraine and even east Asia, Paris and Brussels, combined with the potential financial market fallout from the U.S. presidential election, and I believe that there is a strong case for adopting a more conservative risk posture.

May 10, 2016

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey  07036
(908) 448-2246

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