While falling rates and oil prices in 2015 created a tailwind for the economy in 2016, rising rates and oil prices in 2016 will create a headwind for the economy in 2017. This will be unwelcome news to investors
Politics or Economics?
Coming off the 2016 presidential election in November, the US stock market rocketed higher. The steep rally was fueled in part by investors’ enthusiasm for the tax cuts and deregulation they expected from a Trump White House and a Republican Congress.
I say “in part” because the rally could also be seen as part of a more general rising trend among leading economic indicators, on which politics have little influence. Perhaps the most widely followed leading indicator is the Institute for Supply Management’s Manufacturing Survey (ISM). It’s a monthly survey of purchasing managers and their outlook on the economy. The ISM Survey notched its highest reading in over a decade in February, just as the stock market reached its high so far in 2017.
Given the ISM reading, we would’ve expected the market to rise even without the election. The stock market is itself a leading economic indicator and tends to move in tandem with the ISM Survey. As we’ve said many times, the market’s direction is driven by whether economic prospects are improving or deteriorating. And, at least through February, they were improving.
Falling interest rates and oil prices in 2015 benefited the US economy in 2016. Both trends stimulated the economy, albeit with a lag of several months. Falling interest rates lower the cost of borrowing while falling oil prices reduce the dollars consumers spend at the pump, freeing up more for discretionary spending.
But interest rates and oil prices bottomed in 2016 and proceeded to double off their lows. This raised, with a lag, both the cost of borrowing and the amount of dollars consumers had to spend at the pump—and didn’t have to spend elsewhere. And so, while falling rates and oil prices in 2015 created a tailwind for the economy in 2016, rising rates and oil prices in 2016 should create a headwind for the economy in 2017.
Indeed, we think we are at a peak in economic prospects for 2017. Timing such things is by its nature inexact. Different leading indicators operate with different lag-times, which are themselves historical averages. Our best analysis last year suggested this peak in economic prospects—and the stock market—could fall anywhere from last November to this March. We think we’re now at that peak and heading south.
In light of our outlook for a peak in both economic prospects and stock prices sometime between November and March, we moved portfolios into a defensive posture late last year, reducing equity exposure and shifting funds into bonds. This sort of tactical move is a kind of insurance, meant to provide protection against an expected future market decline. With the benefit of hindsight, we wish we had delayed the move as the markets continued to rise through February. But, like taking out insurance, tactical defensive moves are early by design.
We are maintaining our wary outlook for 2017 and, indeed, believe that outlook is finding confirmation in both the markets and the economy.
Reading the Tea Leaves
One such confirmation comes from the way stocks from different sectors of the economy are performing in 2017. Generally, when economic prospects are improving, stocks from more cyclical sectors of the economy do better than stocks from more stable sectors. Last year, for example, stocks in the highly cyclical energy sector were the market’s top performers while stocks from the very stable healthcare sector
came in dead last. This is what you’d expect in a climate of improving economic prospects.
So far this year, however, these roles have reversed, with healthcare stocks among the best performers and energy stocks the worst. This isn’t what you’d expect in an improving economic environment. Likewise, small-company stocks tend to outperform large-company stocks when the economy is improving. And so they did last year. This year, those roles have reversed, suggesting caution on the part of investors.
We could review several other binaries that have flip-flopped from last year to this year. They’re all sending the same message: Investors are wary and playing their hands defensively. This is Ms. Market sniffing out a deterioration in economic prospects ahead.
The economy itself is signaling that the current expansion is long in the tooth. Unit labor costs in the US have risen sharply, the result of an economy that added jobs steadily over the past eight years. Rising labor costs, in turn, are squeezing US corporate profit margins. And profit margins are the canary in the coal mine of the US economy.
When margins get squeezed, so do profits. And when profits get squeezed, corporations slow their hiring and their capital investment, effectively taking their foot off the economy’s accelerator, if not putting on the brakes. Whether gently or sharply, the economy slows. The slowdown eventually relieves the margin pressure caused by rising labor costs, allowing profits to climb again. What labor costs and profit margins are telling us is that we’re in the late innings of this expansion.
Kinds of Declines
As noted above, the economy can slow gently or sharply, that is, drop to a slower pace of expansion or go into actual recession. To be clear, we’re expecting a deceleration, not a recession. Accordingly, we expect a correction in stocks, not an outright bear market—that is, a decline of more than 10% but less than 20%. That’s the purely economic story.
Compounding the economic risk to the market, however, are the risks resulting from the global knock-on effects of a US slowdown. As the biggest import market in the world, when the US slows, every exporter in the world slows. As the rest of the world is already in fairly shaky condition, when global growth slows, the risk of a foreign financial crisis—we know not where—rises. While not our base case, it’s a risk we keep in mind.
Lastly, there’s the political risk posed by the Trump Administration and its seemingly extemporaneous approach to trade and foreign policy. While we hope cooler and more informed heads in the Administration will prevail, Trump’s anti-trade rhetoric and projection of military power on various fronts raise the prospect of a trade and/or actual war. While we don’t consider these the likely outcomes, we do factor them into our risk calculation as aggravating factors.
If either or both of these compounding factors came into play, the downside in the stock market could be greater than what you’d expect in response to a slowing of the economy alone.
A Little Market History
As we reminded readers last quarter, following Ronald Reagan’s election in November 1980, the stock market rocketed higher, driven by enthusiasms similar to those buoying the market recently. By September of 1981, however, stocks were down 20% from their peak just after the election. By August of 1982, the stock market was down 28%. Why? Because the economy sank into recession in July of 1981 and didn’t recover until November of 1982. Then, as we expect it will now, political enthusiasm proved no defense against waning economic prospects.
What We’re Doing
We’re maintaining the defensive posture we assumed late last year as our outlook for the economy and the market in 2017 hasn’t changed. At that time, we reduced equity exposure and raised fixed-income exposure in our portfolios, relative to each client’s parameters. Within equities, we reduced exposure to more cyclical sectors like industrials and materials while increasing exposure to more stable sectors like utilities and healthcare.
Farnum Brown, Chief Strategist
The opinions expressed herein are those of Arjuna Capital, LLC (“Arjuna Capital”) and are subject to change without notice. This material is not financial advice or an offer to sell any product. Arjuna Capital reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. Arjuna Capital is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Arjuna Capital including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.