Just two months ago, investors across the globe were spooked by multiple threats. As a result, stocks dropped sharply and signs of a new bear market were visible. But markets recovered and the broader US market, measured by the S&P500 index, is again close to all-time highs. Are happy days here again and can stocks continue to rally?
Recovery in oil prices brings relief
A major concern has been the sharp decline in commodity prices. However, after briefly hitting a low of below $30, prices recovered strongly. Not only oil, but all commodities rallied, putting the CRB Commodity index more than 15% higher since the lows of mid-February. However, that’s only a modest 2% higher YTD. Moreover, compared to a year ago, it’s still 18% lower and 70% lower than 2014 levels. That indicates that although prices recovered, the environment remains completely different from a few years ago. There’s still stress on a number of companies and default rates may stay elevated if prices do not recover significantly. In addition, the picture for most commodity exporting countries remains bleak. Russia, Brazil and Saudi-Arabia’s budgets need much higher oil prices. While conditions improved compared to earlier this year, it’s far too soon to become upbeat. We may have seen the bottom in commodity prices, demand should improve to offset current high production levels.
China is holding the keys to higher demand in oil, and this brings us to another major theme driving the markets. Recent macro figures eased concerns investors had over China. Early this year, prospects to a slowdown of less than 6.5% GDP growth led to beliefs that Chinese policymakers should devaluate the Chinese currency, Yuan, further. This could lead to more capital outflows, creating a downward spiral. However, targeted policy measures by the Chinese government stabilized the economy. The Asian giant even saw a pickup in growth and GDP grew with 6.7% YoY during the first quarter. Also some underlying aspects, such as cement sales and credit growth point to a less harsh landing than expected. As a result, analysts upped their forecasts to 7.0% GDP growth this year. A new devaluation such as in August last year is unlikely and in fact currency reserves have increased lately, easing pressure on the Yuan.
Will the Fed hike?
The sharp devaluation of the Yuan last year forced the US Federal Reserve to postpone its first interest rate hike to December last year. Nonetheless, Fed-members indicated that 2016 could see four additional increases. However, during the turmoil of January and early February, this scenario already became less likely. Inflation remains modest and economic indicators remain soft. This led Fed-chair Janet Yellen to turn more dovish recently. For this year, only 2 rate increases are indicated, the first potentially in June. However, the market only expects one additional step this year. The next FOMC decision is scheduled for April 27 and the market will be looking for clues if a June hike is ‘live’.
Market strong, but not supported by results
The strong stock markets and a weaker US Dollar could absorb the next rate hike well. But the bullishness of investors is not supported by company earnings. It is true that a somewhat weaker USD helps profitability for US corporates. In fact, 40% of profits for S&P companies are derived from abroad. That’s a strong reminder that investors should take a global view. But a weaker USD only modestly helps. For Q1-2016, S&P 500 companies are expected to show a decline in earnings per share of 8%. Sales are expected to come in 1% lower. To be fair, the decline is caused by Energy and Financials. Excluding both sectors, EPS is expected to stay neutral and sales may even rise by 2%.
But a word of caution: the so-called FANG stocks (Facebook, Amazon, Netflix and Google/Alphabet Inc.) distort the picture. Excluding these four tickers (FB, AMZN, NFLX, GOOG),
EPS may decline with 8% and sales with 1%. The tech sector is expected to show weak results with 4% lower EPS and stable revenues. However, we already witnessed misses by giants Microsoft (MSFT) and Alphabet Inc. (GOOG). Since the strong performance of the NASDAQ Composite was largely driven by the FANG-group, investors should remain cautious.
Another reason not to become overly bullish is the slowdown in buybacks. In the recent few years, buybacks were an important contributor to EPS growth (less outstanding shares means higher earnings per share). For 2016, buybacks are expected to be slightly lower or flat at best. On the other end, investors could see an improvement in dividend income. Analysts by Deutsche Bank expect that dividend growth will outpace EPS growth by 3%. And in a world were income is very important, that’s an important factor to consider. Especially when yields on bonds remain low and holding cash is even punished.
New themes that drive the market?
In a nutshell, the major market themes that drove markets recently cause less concern than a few months ago, or even provide a bit room for optimism if the positive developments of the recent weeks stick. But obviously the world is more complex and new themes loom at the horizon. For instance, the effects of a potential Brexit and the US Presidential Elections later this year shouldn’t be ignored. On the other side, additional measures by Central Banks, such as the recent expansion of the ECB’s QE-program that now includes corporate bonds, could offer support. However, we shouldn’t forget that valuations are at elevated levels. So that the US market will reach new all-time highs soon, isn’t a guarantee…