Reframing the Picture

Economic data and securities prices always provide a picture of investor sentiment regarding the outlook for the economy and financial markets.  That picture is never static, of course, and it often is wrong.  It changes in response to new developments and data points.  Previous obsessions with key variables eventually fade away.  New ones take their place.  In just the past few weeks, that picture appears to be reframing once again.  Our job as analysts and investors is to determine whether and where we agree and to position our portfolios to reap the benefits (assuming that we are right).

In August, the stock market fell sharply as fears about China’s ability to engineer a soft landing for its economy and growing concerns about the negative impact of a strong dollar on the U.S. economy raised fears about the sustainability of the recovery.  A long awaited market correction began.  With each new data point, investors seemed to become increasingly bearish.  By the time that the market reached its low in late August, many participants were looking for the market to retest its October 2014 low.

But the market turned on a dime in September and, after a surprisingly quick retest of the late August low, recovered all of what it had lost.  In October, stocks posted their strongest monthly gains in four years, as fears about China subsided (for now) and confidence in a resurgent U.S. consumer returned.  A strong October employment report confirmed the renewed optimism.  Financial markets seemed to shrug off the prospect of a Fed rate hike.

Until last week, that is. In the week just ended, stocks were hit with a renewed bout of selling, the worst since late August.  Major averages declined about 4% on average.  Explanations were offered for the turnabout, including a weak fiscal third quarter financial report from Macy’s (which raised fears about the approaching holiday season),  another slide in the price of oil (due to an unexpected increase in U.S. inventories), second thoughts about the Fed’s rate hike and growing concerns about the outlook for global economic growth.

Of all of those, I believe that the last – the global economic recovery – is most worthy of investor attention.  In order to avoid a far more consequential relapse, the global economy recovery must proceed steadily and deliberately.  While the recoveries in the U.S. and the U.K. appear to be maturing, it is now time for the European Union and Japan to follow.  After that, it should be the emerging market economies.

The EU and Japanese economies were to benefit from a combination of central bank quantitative easing programs, low commodity prices (especially oil) and the decline in their currencies vis-à-vis the dollar (making their exports more competitive).  Unfortunately, however, the pace of improvements in both economies has been frustratingly slow.  The Japanese economy has been held back by the tight purse strings of Japanese consumers and slowing (infrastructure) in China, Japan’s largest export market.  The EU, likewise, has not realized as much demand as hoped from other emerging market economies, such as Russia, China and Brazil, for example, and the slow pace of recovery of its highly indebted members (mostly on the periphery).

Last week, for the second time in the past three months, the OECD lowered its outlook for global economic growth forecast for 2015 and 2016.  This time, it shaved its 2015 forecast by 1/10th of 1% to 2.9% and its 2016 forecast by 30 basis points to 3.3%.  It cited a slowdown in global trade and specifically, slower than expected import growth in emerging market economies, as a major contributing factor.

From my perspective, economic growth in the EU is key.  A strong recovery there would hasten the end of the ECB’s QE program and help raise both interest rates and the euro, giving the U.S. room to proceed on its path toward interest rate normalization.  A strong EU recovery would also boost consumer demand, which in turn would help lift commodity prices and many emerging market economies.

I have not yet given up hope on this global economic growth scenario.  Although this is very much a “thread-the-needle” scenario, it is not unrealistic given the scope of stimulative measures. Current economic growth projections for the EU are disappointing, but I think that there is a good chance that they will be ratcheted up over time, as long as the U.S. and emerging economies hold up.  This is the primary basis, I believe, for an optimistic view on the stock market’s upside potential.

Of course, there are downside risks and many market participants remain skeptical.  In the near-term, the market will have to get through last week’s selling and the terrorist attacks in Paris.  The changing picture of reduced economic forecasts suggests that stocks could once again become range bound for a time.  But unless and until events bring an end to the hope of a global economic recovery, I believe that the stock market is likely to return again and again to the upside potential of the optimistic global growth scenario.

November 15, 2015

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

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