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BMO Private Bank
MARCH 2016
Outlook for Financial Markets
“Wealth consists not in having great possessions, but in having few wants.”
Economy
The U.S. economy limped across the finish
line in 2015, rising at a tepid 0.7% annualized
growth rate for the fourth-quarter, according
to the Commerce Department. The slowing
trend has economists scratching their heads
because the economy was moving along at a
2% clip in the third quarter and at a 3.9% pace
in the quarter before that. The slowdown brings
the year-over-year growth rate to just 1.8%.
Notwithstanding a fourth quarter pullback,
consumer spending remains America’s primary
economic growth driver. A strong labor market,
low interest rates and cheap gasoline prices
have helped power the housing market and a
banner year in automobile sales. Automakers
sold over 17 million cars last year, their best
showing since 1999 when oil was $11 a barrel.
A lot has changed in the last generation. Even
though oil prices are more than twice as high
as they were at the turn of the century, wages
have risen and fuel efficiency has grown by
leaps and bounds. We calculated how many
miles a person can drive a car using the gas
money from one hour of work and it has
- Epictetus
rocketed up to 357 miles “per hour,” if you will.
Cars are so efficient and gasoline is so cheap that
it surpasses the previous peak of 341 miles reached
in 1999 (Exhibit #1). For all the talk of a woeful
economy, it’s heartening that personal consumption
rose 2.2% in the fourth quarter and 3.1% for the
year, the best annual growth rate since 2005.
Cheap oil prices and a strong dollar are a mixed
blessing. Business spending slipped 1.8% in the
fourth quarter as companies curtailed expansion
plans amid concerns that perhaps the oil price
is saying something ominous about the global
order. The energy and mining sectors were
particularly pummeled as outlays on mining
and oil wells plunged 35% for the year, the
sharpest pullback in 35 years, according to a Wall
Street Journal report. Exports of goods fell at
an annualized 5.4% rate in the fourth quarter.
Sharp declines in industrial production, corporate
profits and the stock market reflect a growing
concern that global economic weakness is spreading.
Industrial production has receded in 10 of the last 12
months and is situated about 2% below its 2014
peak. If analysts are correct, the fourth quarter will
Exhibit 1 » Average Hourly Wage (In Number of Vehicle Miles it Buys)
400
350
300
Gasoline Tolerable
250
200
150
100
Gasoline Painful
50
0
Highway/City (55%/45%)
Source: Bureau of Labor Statistics, EPA, BMO Private Bank Strategy.
Calculation Example: Jun. 2014 avg. wage = $20.54/hour, regular unleaded gasoline = $2.56,
average fuel economy = 30.3 mpg. Math = ($20.54/$2.56) x 30.3 = 246 miles of travel for one hour of labor.
Summary
Last year employers hired only
30,000 net new manufacturing
employees, down from 215,000 in
2014. The services sector has picked
up the slack, leading to the addition of
2.6 million jobs last year, certainly not a
recession signal.
It’s estimated that as many as
one-third of American oil and gas
producers could fall into bankruptcy over
the next 18 months.
The IPO market froze in January
as no deals came to market,
representing the first monthly
drought since September 2011.
Investors are simply not receptive to
new deals at the moment, reflecting a
widespread bearish view.
Parents hoping to raise welladjusted children strive to help their
kids stand on their own two feet.
Yet like an overly dependent child,
market participants continue to harbor a
belief that a central bank backstop will
pick them up and dust them off if they
get into trouble.
Fundamentally, small caps have
shown improvement relative to
large cap counterparts. Profits among
small cap companies are expected to
grow more than 11% over the next 12
months, while S&P analysts anticipate
earnings declines.
M A R C H 20 16
That’s because the decline has been dragged
down by a plunge in the energy industry. U.S.
factory output was little changed last year, while
oil and gas drilling is off by more than 60%.
Nevertheless, most recessions are preceded by a
decline in confidence and that is simply not the
backdrop in the current environment. Confidence
has steadily improved since hitting its recent low
in 2011, although 2015 gains were modest.
Job market performance has historically been
a reliable predictor of any trouble that may
be lurking on the horizon. According to
The Wall Street Journal, each recession over the
last 50 years was preceded by a 1% or more
decline in jobs, with no false signals. Last year
employers hired only 30,000 net new
manufacturing employees, down from 215,000 in
2014. The services sector has picked up the
slack, leading to the addition of 2.6 million jobs
last year, certainly not a recession signal.
The promising news is that the decline in highly
paid oil and gas industry jobs affects just a small
percentage of the population. The industry
employed only 0.8% of the workforce at its peak
in the early 1980s; today it’s down to 1 out of
every 200 workers.
Bond Market
The world is increasingly connected. Investors
can sell a basket of Korean stocks and place that
money into Hong Kong stocks with a click of a
mouse, while Malaysians eat Ukrainian wheat
with nary a thought to its country of origin. This
escalation of global trade has linked what were
once relatively idiosyncratic business cycles
into one giant global economy. According to
the The Organization for Economic Cooperation
and Development (OECD), the volume of global
trade has tripled in two decades. That’s why
China’s recent economic hiccup is giving the
rest of the world heartache. Commodity prices
have cratered and plunging oil prices reflect
both new sources of supply and a questioning
of the resilience in demand. China’s oil
consumption is expected to grow by about
300,000 barrels per day this year, down from
500,000 last year. The trajectory of oil demand
growth over the next 15 years is anticipated
to be about half the rate of the last 15 years,
according to ESAI, an energy consulting firm.
The recent oil price plunge is sending
shockwaves through the industrial-heavy bond
market. Energy credit comprises roughly 15%
of the high-yield bond universe, although
conditions have tightened for virtually all
corporate high-yield bond sectors. Since last
May, high-yield bonds have fallen more than
Outlook for Financial Markets • March 2016
12%, roughly double the downdraft suffered by
large cap stocks. Provisions for non-performing
loans among the nation’s largest banks reflect
the stress. The five largest U.S. banks by assets
increased their loan loss reserves by $1.4 billion,
a 35% increase, in the December quarter.
Lenders that want companies to keep making
interest and principal payments will be inclined
to keep credit lines open and the wells pumping.
It’s estimated that as many as one-third of
American oil and gas producers could fall into
bankruptcy over the next 18 months. More than
30 companies, representing $13 billion of debt
obligations, have already filed. The current
downdraft is deeper than each of the five oil bear
markets since the 1970s (Exhibit #2). Much of
the accumulated debt was struck when oil prices
were substantially higher. Capital-intensive
North American energy companies have racked
up over $350 billion of debt collectively over
the last five years. Burdened with high fixed
payments and plunging revenue, borrowers
are losing nearly $2 billion per week at current
prices. While some of the largest players
have locked in hedges to protect their future
selling prices, many of their hedges expire later
this year. Perhaps a production agreement
between OPEC and non-OPEC producers could
eventually put a floor under the energy plunge.
Capital is flowing out of emerging markets and
we know from history that raindrops can lead
to floods. That’s what happened in 1997-1998
when massive capital outflows caused the Asian
financial crisis. Last year emerging markets
suffered net outflows of $732 billion, with China
accounting for most of the trend, according to
the Institute of International Finance. Emerging
market currencies fell nearly 18% against the
dollar last year, with the commodity-focused
Russian ruble, Mexican peso and Colombian
peso joining others in hitting record lows.
India, Venezuela and Egypt have instituted capital
controls. China and Saudi Arabia imposed
restrictions on bearish forward currency bets and
certain foreign investments. It was only a few
years ago when many of these same countries’
coffers were flooded, as billions poured into
commodity-producing markets. Some countries
put in place measures to control surging inflows,
fearing an inflation-induced bubble. Brazil, for
example, instituted a 2% tax on inflows in 2009.
Many of these policies have been met with
mixed success. Capital continues to flow out of
countries, including China and Venezuela, causing
domestic reserves to shrink. Investors are split
on whether or not emerging economies can
withstand the outflows. As a result, emerging
markets, both equity and fixed income, appear
relatively cheap.
Equity Markets
Corporate earnings growth is moving in the
wrong direction. With nearly half of S&P 500
companies reporting their quarterly results,
profits are off 2.6% compared with last year.
The downdraft marks the worst showing
since the first quarter of 2009 and the third
consecutive quarter of profit declines. Not
surprisingly, the 67% fall in energy earnings is
a heavy detractor. Others, such as the smiling
automakers, are on the other side of the gasoline
price, reporting a 28% year-over-year increase
in profits as consumers rekindle their love
affair with highly profitable trucks and SUVs.
The January market swept in like an unwelcome
winter storm, and technology companies are
particularly exposed. Valuations have fallen
and business conditions have gotten more
challenging for these perennial Wall Street
darlings. Technology shares fell 4.7% in
January, wiping out their 2015 gain. Private
equity valuations have similarly slipped. For
Exhibit 2 » Crude Oil Bear Markets 1986 to Present
1990
1986 − 1990
0%
−
2004
-10%
-20%
-30%
Drawdown
represent the third consecutive decline in
corporate profits. Historically, manufacturing
tends to lead the business cycle, so the pullback
has economists worried. We believe that
production weakness may be sending a false
signal this time.
-40%
-50%
-60%
-70%
-80%
2008
−
Present
-90%
1
51
101
151
201
251
301
351
401
451
501
551
601
651
701
Number of Weeks
Source: Bloomberg; BMO Private Bank Strategy.
2
M A R C H 2016
years, advances in connectivity have been a
tailwind for tech. While public and private
technology firms have enjoyed varying
degrees of success, slowing global conditions
have impacted virtually the entire sector.
Liquidity, the money available to borrow, spend
and invest, started drying up in April and has
continued to tighten. While the giant companies
still have unfettered access to capital, many
of the smaller players are finding it difficult to
raise capital. The IPO market froze in January
as no deals came to market, representing the
first monthly drought since September 2011.
Investors are simply not receptive to new
deals at the moment, reflecting a widespread
bearish view. The relationship between
the number of individual investors that call
themselves “bullish” compared with those
who are “bearish” is in just the 15th percentile
of its historical range. That’s up from the first
percentile in the middle of January but is still
reflective of a high degree of skepticism.
Now that the markets no longer have the Federal
Reserve in their corner, investors are forced to
take their cues from more mundane metrics like
profits and global growth. The problem is that
neither profits nor revenues are terribly robust.
Thanks to a glut of supply and waning demand,
crude oil has become the de facto global growth
barometer, gyrating in sync with the equity
markets. The correlation between Brent crude
oil and the S&P 500 rose to its highest level in 26
years in January, briefly touching 0.97 on a -1 to
1 scale before tapering down in recent sessions.
China is the world’s second largest economy and
it accounts for 12% of energy demand. Even
sectors that typically benefit from cheap oil prices
are suffering, suggesting demand destruction is
exerting a greater influence on prices. Despite
the plunge in crude oil, the transportation sector,
an energy beneficiary, is off more than 10% this
year and more than 23% over the last 12 months.
Outlook
Parents hoping to raise well-adjusted children
strive to help their kids stand on their own two
feet. Yet like an overly dependent child, market
participants continue to harbor a belief that a
central bank backstop will pick them up and
dust them off if they get into trouble. Why not?
For years central banks did just that. The trend
started in 1987 when the Federal Reserve opened
the liquidity spigot and slashed interest rates
after the October crash took stocks down more
than 30%.
In 2009, when the market slid 18% in January and
February on top of a 37% plunge the previous
year, it was the Bernanke Fed that unveiled
quantitative easing, helping set the stage for a
multi-year rally. Now investors feel an everpresent need for comfort in the hands of the
world’s central banks. Despite the Fed’s move to
cut the apron strings last December, investors
still hang on their every word. Last January,
investors pouted when the most recently
3
Exhibit 3 » Russell 2000 Price-to-Sales Ratio
1,400
2.5
1,200
2.3
Russell 2000
1,000
2.1
800
1.9
600
1.7
400
200
1.5
Current Price-Sales Ratio: .98
Price-Sales Ratio
Relative to Median (1993 to Present): 1%
0
1.3
-200
1.1
-400
0.9
-600
0.7
-800
-1,000
1995
0.5
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Source: Bloomberg, BMO Private Bank Strategy
released Fed minutes didn’t reflect enough
concern surrounding recent market turbulence.
The Dow reversed course and ended the day
down more than 200 points. One week later,
investors pushed the Dow 400 points higher in
response to a move by the Bank of Japan to push
short-term rates into negative territory.
The market needs to discard the central bank
security blanket. The problem is twofold. First,
the Fed has little ammunition left and it is
questionable that it could do much in another
severe panic. Short-term interest rates are so
close to zero and the Fed’s $4.5 trillion balance
sheet is so fat that additional quantitative easing
would be downright dangerous. Negative
interest rates could be the “nuclear option,”
and that initiative is already being followed
by a handful of nations. The problem is that it
sends physical cash into shoeboxes, potentially
undermining our fractional reserve banking
system.
The second problem is that many of the world’s
equity markets trade at a premium to their
underlying fundamentals. Mid-2014 was the
last time the S&P’s price relative to its revenues
was “normal” by the standards of the last two
decades. Between May 2014 and December
2015 the S&P 500 gained 10.5% - even though
revenues were flat. Now market participants are
accusing the Fed of a policy mistake, arguing that
there was no justification for raising rates given
quiescent growth and inflation. It should be
noted that the Fed’s rate regime was instituted
at the height of the financial crisis and had been
left in place for seven years - even though crisis
conditions eased. Keeping super-stimulation
in place has dangerously spurred risk taking in
everything from stocks to art. The Fed’s rate
hiking program is less about how high rates will
go than the speed with which the central bank
will stop being the market’s babysitter.
Relying on a paper tiger gives risk-takers
a false sense of security that could prove
costly when tangible metrics like earnings
and revenues start to matter again. Getting
the Fed out of the way may cause a little
more short-term pain, but the markets’
stability in the long run is more important.
Financial Market Strategy
Small cap stocks have gotten hammered over
the last few months. Since last June, the Russell
2000, a market index of small companies,
has plunged into bear market territory, falling
roughly 20% through January. While large cap
investors have needed Band-Aids, small cap
holders have required tourniquets. Interestingly
the bloodshed has pushed small cap stocks back
toward fair value. At their valuation peak, the
Russell 2000 traded at 1.3 times annual revenues
- even though the median price-to-sales ratio
of component stocks was under one. Now,
thanks to falling prices and rising revenues, the
index itself trades at its longer-term median,
suggesting a more compelling value argument
can be made (Exhibit #3). Fundamentally,
small caps have shown improvement relative
to large cap counterparts. Profits among small
cap companies are expected to grow more than
11% over the next 12 months, while S&P analysts
anticipate earnings declines.
Momentum is a metric that is holding us back,
as the directional trend for small cap stocks
remains negative. Markets rarely fall gently
toward fair value before rebounding. To the
contrary, investors tend to overdo it on the
upside and the downside, suggesting small
caps could get cheaper before they stage their
comeback. For that reason we’re waiting for
small cap momentum to improve. Bottom line:
we like cheap markets that are moving in the
right direction. For now, small caps may be
cheaper, but that doesn’t mean they’re downright
cheap – and anyone watching the market of late
knows that they certainly aren’t rising, not yet
at least.
Jack A. Ablin, CFA
Chief Investment Officer, BMO Private Bank
Outlook for Financial Markets • March 2016
Jack A. Ablin, CFA
Executive Vice President and Chief Investment Officer, BMO Private Bank
As Head of Macro Strategy, Jack chairs the Asset Allocation, Mutual Fund Re-Optimization and Harriscreen
Stock Selection Committees and is responsible for establishing investment policy and strategy within
BMO Private Bank throughout the U.S. He joined the organization in 2001 and has three decades of experience
in money management.
Jack earned a bachelor’s degree from Vassar College in New York, where he graduated with honors with an
A.B. in Mathematics and Computer Science. A member of the Beta Gamma Sigma International Honor Society,
Jack received an M.B.A. with honors and graduated cum laude from Boston University in Massachusetts.
He holds the Chartered Financial Analyst designation and is a member of the CFA Society of Chicago.
• Author of Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace, published in July 2009
by F.T. Press; Wall Street Journal’s best-seller list, 2009
• Frequent contributor to CNBC, Bloomberg, The Wall Street Journal and Barron’s
• Served as a Professor of Finance at Boston University, Graduate School of Management
• Spent five years as a Money and Markets correspondent for WTLV, the NBC affiliate in Jacksonville, Florida
• Named one of the Top 100 Wealth Advisors in North America by Citywealth magazine, in 2006, 2010 — 2015
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Written: February 8, 2016