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Joe Mac’s Market Viewpoint: Déjà Vu All Over Again

Here we go again. The headlines are bleating that the global economy is tipping into recession. This time around, the concerns focus on the steep decline in crude oil and other commodity prices and the imbalances stemming from a global glut and faltering demand. MRP believes, however, that these sector-specific issues do NOT herald a global recession. But we do think stocks face other headwinds.

Consumers in the U.S. and in oil-importing nations have benefited dramatically from low oil prices at the pump. Thanks to a mild winter so far, U.S. middle class and lower income groups who are spending less on heating bills are getting an added boost to their discretionary budget. With more money to spend, retail sales are poised for a rebound, lifting first-quarter GDP above current expectations of 2.5%.

Meanwhile, housing remains a strong source of growth in the U.S. economy. Demand is robust, supply still lags, and low mortgage rates are helping to offset rising home prices as new buyers enter the market. After some slippage toward the end of last year, existing home sales and new home sales have recovered nicely. Homebuilder sentiment is at levels consistent with a doubling in the pace of single family housing starts. Household formations, stimulated by positive labor market conditions, have doubled from two years ago.

HOME SALES REBOUND …

Source: McAlinden Research Partners

The trends in home prices further solidify indications of an accelerating housing market: the Case-Shiller and FHFA Housing Price Indices are up 5.3% and 5.9%, respectively. Higher home prices will provide a nice wealth-effect boost for the home-owning middle class. At the same time, every uptick in home prices lifts more families out of the negative equity trap they’ve been mired in for years. Data from RealtyTrac confirms a continued downtrend in the share of mortgages that are under water to 11.5% – nearly half what it was in mid-2013.

… LEADING TO MORE CONSTRUCTION

Source: McAlinden Research Partners

Rising home prices and plunging energy costs leave the American consumer well-positioned to lead the global economy to stronger growth. And stronger consumer spending will also reinforce the position of the FOMC hawks to continue raising rates gradually, but more than the financial markets have priced in.

The U.S. dollar has had a four-year long bull run, but that could soon be coming to a swift end if inflation accelerates as we expect. Indeed, it is already surfacing in the important core services category, which is now nearly 3%. A bottoming and potential reversal of energy and goods prices could bring true inflation numbers sharply into focus and overall CPI to the Fed’s 2% inflation target faster than the  consensus expects. As the Fed raises rates, the inflation-adjusted rate will actually be falling to 0% or below. History points out that falling “real rates” are usually correlated with a falling dollar – making gold a particularly attractive investment opportunity. Other hard commodities should benefit as well.

CORE SERVICES INFLATION APPROACHES 3%

Source: McAlinden Research Partners

In the short term, I continue to be negative on the U.S. stock market. When MRP turned cautious on U.S. equities towards the end of 2014, I cited two major areas of concern: The disconnect between FOMC projections and the market, and the similarities between the current environment and the period leading to the 1987 crash: A doubling of share prices in a five year run, poor relative strength for small caps, the absence of a 10% correction for several years, and P/E ratios rising to well above historical averages. A 10% correction has now occurred in this cycle, but the other conditions continue to be present. While the negative market environment has not played out like 1987, – at least, not yet – I continue to be haunted by a sense of déjà vu: I do not believe this downturn is over.

The incessant selling in January brought the market into oversold territory, and it is due for some kind of bounce. Even so, the market must then still have to contend with the Fed’s interest rate tightening schedule looming on the horizon, inducing a further increase in volatility and pushing equities sideways, if not down to new lows. Indeed, it may well be that before this is over, the broader indices follow their small-cap and international brethren to new lows, possibly into bear market territory.

BROAD EQUITY INDICES: PERCENTAGE CORRECTION FROM 2015 HIGHS

Source: McAlinden Research Partners

Going forward, I would be particularly cautious of growth stocks, which can become richly priced in low-interest rate periods. In my August 2015 Viewpoint, I spoke about how the discount rate recalibration will be disproportionately harmful to growth stocks – pushing their prices down further than value stocks. Also, during Fed monetary tightening periods, like the one preceding the financial crisis, value stocks tends to outperform growth stocks. Value companies such as those in the Utility and Financial sectors look more attractive in a higher interest rate environment over growth companies in the Healthcare and Technology industries. Limiting exposure to speculative growth stocks and focusing on value would be a sound investment choice. I remain attracted to gold and gold miner shares in this environment.

Bottom line, I look for further volatility and possibly another major downleg for the popular indices. I believe economic growth will strengthen, total inflation will pick up, and the Fed will tighten on a path closer to the FOMC projections, but slower than inflation accelerates. Value should show improving relative strength, the dollar should weaken, commodities and commodity stocks should be big winners in 2016. Lastly, we are inching closer to adding energy as a new theme but still not there yet.