July 2016 | 3rd Quarter | Farnum Brown, Chief Strategist
SIGNAL AND NOISE
A casual consumer of mainstream media might think foreign crises drove the US stock market for the first half of 2016. As the year opened, plunging Chinese stocks sent tremors around the globe, pulling US stocks down by 11% in the first three weeks of the year. As the second quarter closed, Britain’s vote to secede from the European Union, a.k.a., “Brexit,” provoked a similar drama, with US stocks falling 5% in two days following the vote.
The same casual consumer might naturally think that given these rolling crises the stock market must be down from where it started the year. And yet the S&P 500 has returned 4% in the first six months of 2016. It’s nothing to pop the champagne over, but it’s a respectable return and entirely normal for half a year. How’d that happen?
While exogenous shocks like Brexit can have a powerful, temporary impact on the US stock market, what ultimately drives US stock prices is the outlook for the US economy. Is it improving or deteriorating? The answer to that question tells you the directional trend of US stock prices. So, while we heard a lot of noise about Chinese stocks and Brexit during the first half of the year, the signals from the US economy were telling a different story.
The stock market is a vast economic prediction wiki where millions of people around the globe bet trillions of dollars on various economic outcomes—whether on the level of US interest rates in five years or the profits to be reported by Google tomorrow. In this way, the financial markets express vast amounts of information every second of every trading day. They are a “hive mind,” to use current parlance, that expresses the “wisdom of crowds,” i.e., a degree of information generally superior to any single individual’s (occasional market madness notwithstanding).
This is why economists consider the US stock market a “leading indicator” of the US economy. A rising stock market is predicting a rising economy over the next six to twelve months and a falling stock market the opposite. Not that the market is always right. But it has a pretty good track record.
Another widely followed leading economic indicator is the ISM Index, a monthly survey of over 300 US manufacturing firms. The ISM gauges whether US manufacturing is gearing up or down. That information reflects a very well-informed group prediction of economic growth going forward.
For the first half of 2016 the ISM rose in five of the six months. The ISM and the US stock market were telling the same story, which didn’t have much to do with Chinese stocks or Brexit.
We take our cues from the leading indicators and expect the US economy to continue expanding through the rest of the year. That’s the prediction already baked into current US stock prices. Should that prediction prove wrong and the US falls into recession in the second half of the year, you can expect a violent correction in stock prices, reflecting a dramatically revised prediction. We think that’s extremely unlikely.
The question that intrigues us more is: What will the market be predicting as we move to the end of 2016? That is, what will stocks be predicting this year about the economy next year? The trick is to find something that predicts the stock market’s predictions—a leading indicator of the leading indicator.
Happily, we have such a thing. Indeed, we have two: global interest rates and inflation trends.
The direction of global interest rates tends to lead the US stock market by about 18 months. That is, if global rates were falling 18 months ago, all else being equal, we should expect US stocks to be going up. Why? Because falling global interest rates have their stimulative impact on the US economy with a lag of about 24 months. And the stock market sniffs out that impact with about a six month lead.
The direction of inflation, led by oil prices, similarly leads US stocks with about a six month lead. Meaning that if inflation (oil prices) were falling six months ago, all else equal, US stocks should be rising. Why? Because falling oil prices stimulate the US economy (via the consumer) with about a 12-month lag, which the stock market sniffs out six months in advance.
A standard caveat must be issued here, namely, that all else is never equal. The lag times aren’t precise and lesser cross-currents can complicate their impact. Nonetheless, these two trends of interest rates and inflation are the primary variables empirically shown to drive the business cycle. So what are they telling us?
Currently, the past path of global interest rates suggests that the direction of US stocks is up for the rest of the year and the US economy should continue expanding through the first half of 2017.
On the inflation front, the picture isn’t as sanguine. After falling for a year and a half, oil prices have risen over the past six months. That would typically be a bad omen for US stocks in the back half of this year.
As we said last quarter, eventually rising oil prices will become a negative for the US stock market and economy. But, oil prices fell so precipitously—on the order of 70%—from their 2014 high that they posed a dire threat to commodity-driven economies around the world—from Russia to Venezuela. This raised the risk of a global financial crisis, for which investors penalized stock prices throughout 2015. So, at this point, rising oil prices have reduced the risk of global financial crisis and thereby encouraged investors to revalue stocks upward.
We expect this unusual (but not unprecedented) condition of rising oil prices and rising stock prices to continue for a while yet, but at some point this happy couple will divorce. There’s no good way to predict at what level oil prices become too high. We just have to watch to see when higher oil prices turn from a help to a hindrance for stock prices.
A SILVER LINING
The yield on the 10-year US Treasury Note fell to 1.46% recently, an all-time low. It did so for two reasons. First, in the wake of the Brexit vote, global investors took flight into the safest credits in the world: US Treasury issues. Second, uncertainty over the future of the European Union and of the UK has lowered business confidence in that region, dimming economic prospects and driving down regional government bond yields.
When US bonds—the safest in the world—are paying significantly more interest than those of Germany or the UK or Japan, investors naturally prefer US credits. This keeps downward pressure on US interest rates and promotes a generally stimulative global interest rate environment. So, for the US economy there is a significant silver lining to Brexit (see above on the importance of global interest rates).
Our outlook for the US economy and stock market remain positive, with the same caveat as last quarter: oil prices will eventually prove too great a burden. Until they do, a supportive global interest rate environment, an improving US economy that boosts export activity around the globe, and falling risks of financial crisis should provide a tailwind to US stock prices.
That said, we can’t dismiss the political risk posed by Donald Trump. Nate Silver, perhaps the best political odds-maker around, puts Trump’s chances of winning at 38% with Hillary Clinton’s chances of winning at 62%. If Clinton wins, we would expect a relief rally in US stocks. Should Trump win, we would expect a significant sell-off in US and global stock markets. In terms of generating uncertainty, Trump’s election would make Brexit look like a garden party. But that remains a low-odds (not as low as we’d like) outcome.
With the above in mind, we’re maintaining a neutral weighting for stocks in client portfolios to reflect our positive intermediate-term outlook for the stock market and expectation of a Clinton win come November.
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