Outlook for 2015
Our investment strategies benefit most when the Russell 2000 experiences a wide trading range over the course of several months. Our focus here is to assess the potential for an increased Russell 2000 trading range in 2015, rather than discussing conventional macroeconomic topics or their potential impact on equity valuations.
Factors we think could minimize the Russell’s trading range in 2015:
European quantitative easing: For several reasons, we think the European QE program is likely to have less positive impact on U.S. equities than the U.S. program had. However, by injecting large amounts of capital into global asset markets, we think it reduces the likelihood of a sharp selloff in U.S. equities in 2015.
U.S. interest rates: Maintaining the consumer inflation rate at 2% per year is half of the Federal Reserve’s dual mandate (the other half being the maintenance of maximum employment). Inflation has remained subdued globally, and the collapse in oil prices in the second half of 2014 has caused U.S. consumer inflation to stop rising and hold at a level below the FRB’s 2% target. This might cause the FRB to delay raising interest rates, and by removing a potential source of downward pressure on earnings multiples, this could also reduce the likelihood of a sharp selloff in U.S. equities
The decline in the “oil tax”: According to an analysis by UBS, each $10 decline in the price of oil contributes 0.1% to U.S. GDP. Oil’s $60 decline since June of 2014 implies a 0.6% contribution to GDP, which may not be sufficient to power strong growth by itself, but which can help counter other potential economic headwinds.
Factors we think could maximize the Russell’s trading range in 2015:
Stretched equity market valuations: Here we refer to an analysis by James Paulsen, chief investment strategist of the Wells Capital Management subsidiary of Wells Fargo.The S&P 500 currently trades at 18 times trailing 12 months earnings, which is in the 74th percentile of multiples in the post-WWII era.High but not outrageously high, historically speaking.However, the median price-to-earnings ratio and price-to-cash-flow ratios of all NYSE stocks are currently at record levels.The implication is that, on average, the broad U.S. equity market is more expensive now than it ever has been, leaving little margin for error should a hiccup occur in earnings growth.We also note Jeffrey Gundlach’s observation that since 1871, U.S. equities have never risen seven consecutive years.
Credit market stress: Below, we have updated a chart we included in last quarter’s note. In late 2012, high yield and government fixed income instrument valuations diverged, in anticipation of U.S. economic growth resulting from QE3. In 2013, the instruments moved in unison as interest rate expectations changed. Beginning June 2014, high yield has underperformed government debt, partly due to the end of QE, but also perhaps indicative of concerns about credit quality among corporate borrowers. This has been attributed mainly to highly leveraged “fracking” oil producers, who borrowed heavily from mid-western regional banks to expand production. As oil prices have fallen since mid-2014, these producers have struggled to remain solvent. While this is a typical credit cycle that could remain contained within the oil sector, it is possible that regional bank balance sheets will be sufficiently damaged to result in reduced credit availability in other industries.
China slowdown contagion: According to a recent Fortune Magazine analysis, real estate accounts for 25-30% of China GDP, when the entire construction value chain is considered (including upstream raw materials and downstream furnishings). More than 60 million vacant apartments currently sit unsold throughout China, and housing prices nationally declined 4.5% in 2014. Chinese construction has been the primary driver of global commodity markets in recent years, and the current slowdown has been coincident with the decline in many hard commodities. We believe this slowdown will continue, and will cause rising credit stress in those economies dominated by commodities production. Declining foreign trade can then spread this stress to developed markets.
In sum, in 2015 the global economy is already facing more stresses than it did in 2014. Although ongoing central bank activity has the potential to cushion the equity market swings that may result, we think we are unlikely to see another trend-free year for the Russell 2000.