Watching the Market-Moving Forces

To have a handle on the markets these days, watch the two big C’s: central banks and China. Since the financial crisis, these have been the main drivers of investment markets and economies. Everything else is secondary.

Most markets had a rocky start to 2016 because the Federal Reserve tightened monetary policy in December 2015 by raising interest rates a notch and signaling plans to raise rates steadily through 2016.

As you know, the Fed quickly had to backtrack. It scaled down its expected tightening for 2016 and announced it would pay more attention to global events when determining its actions. The Fed also substantially increased the monetary base, even before announcing its modified policies. Central banks in Japan and Europe at the same time announced major policy moves or promised to make some in the future. These changes quickly sparked rallies in markets, especially commodities and emerging markets.

Actions by central banks, even small ones, cause sudden, significant market moves. Central banks don’t even have to make policy moves. Statements of possible future moves can send investors buying and selling.

China also had the world on edge in 2015 and early 2016 as its stock markets collapsed and economic data weakened. Economic growth slowed as it became clear that the debt China built up after the financial crisis was unsustainable. Over the last few years, China’s been making significant policy changes to shift from an export-led economy to a more domestic-led one. China throttled back on some of the changes in early 2016 to prevent growth from collapsing.

I have written for some time that the major risk is the Fed might tighten too much, too fast. That’s still a big risk, but now I rank it second. The major concern globally is that China’s efforts at change could result in a steep, sudden devaluation of its currency, especially against the dollar. That would have widespread, negative repercussions.

After their violent fall and rise in the early months of the year, most markets are likely to settle into trading ranges unless there’s a major catalyst to move them in one direction. The central banks and China are the most likely catalysts, though there’s always the potential for other surprises.

The U.S. economy continues to plod along at a slow, steady growth rate. In 2016, we’ve seen downshifting in housing, household spending and some segments of the service economy. They’re still growing, but at a slower rate. Manufacturing, however, seems to be forming a bottom and may improve enough to offset some of the decline in other sectors.

Low wage growth and falling productivity, along with high debt levels, combine to keep a lid on growth. It wouldn’t take much to derail the economy, but there’s no sign of impending trouble. While the Fed might bump short-term interest rates a little, most market rates aren’t likely to rise soon.

U.S. stock indexes don’t seem to have much room to rise but could decline under the wrong course of events. Stock returns are determined by trends in three factors: earnings, valuations (such as the price-earnings ratio) and the risk premium.

Earnings growth hasn’t been strong for several quarters. Several trends in place are likely to reduce profit margins from their recent record levels. That won’t help earnings.

U.S. stocks aren’t cheap by any measure of valuation and are expensive by several measures. A major factor behind the increase of stock prices the last few years is a significant increase in valuation. It is hard to imagine investors being willing to pay higher valuations for stocks at this point.

The risk premium is a harder-to-measure concept. Generally, the future risk premium is high when stocks have been down for a while and low when stocks have been rising. At this point, the risk premium is low. Despite the limits to overall stock market gains, there are stocks with higher potential gains that good fund managers can identify.

Emerging market stocks and other assets, however, are looking more attractive. Their recent rise retraces only a fraction of the losses incurred since the 2011 peak. Many of the factors that led to their declines have halted or are reversing. Domestic and international monetary policies are expansionary. Commodity prices appear to have hit a bottom. China’s stabilizing. Foreign capital seems to have stopped fleeing the emerging economies and might be returning.

Emerging markets are subject to the same risks from China and central banks but they have much higher potential rewards than U.S. and European markets.

In most investments now, risks greatly outweigh potential rewards. This isn’t a time to bet on one investment or economic outcome. We want balance and diversification. Yet, we have identified several pockets of opportunity that have margins of safety. We see these in our portfolios.