The market has not become too complacent and continues to register the many potential risks on the horizon. The upcoming UK referendum on remaining in the European Union, slowing Chinese growth, volatile commodity prices, and the potential for interest rate hikes in the United States all could cause risk assets to sell off in upcoming months. However, with the benefit of hindsight, investors are acknowledging that the discounts they demanded in order to own many assets earlier in 2016 were unjustified by economic conditions or company fundamentals, and that they perhaps overestimated the risk of various negative events.
Economic releases year-to-date have defied the extreme pessimism that prevailed in February (and for that matter in third quarter 2015). US GDP growth was weak during the first quarter but is on track to rebound to 2.5% in the second quarter based on the Federal Reserve Bank of Atlanta’s GDPNow model, a typical bounce-back for this seasonal data series. Notwithstanding May’s weak US nonfarm payroll figure, most labor statistics (ADP’s 173k jobs in May, wage growth, the 4.7% unemployment rate, etc.) look encouraging. Similarly, economic releases in Japan and the Eurozone have largely surprised to the upside (helped by low expectations), with extensive monetary easing efforts bearing some fruit and fiscal stimulus looking more likely. Deflation does remain a threat in these regions, and long-term growth prospects face headwinds like demographics. But, the situation looks better in the United States, where various Federal Reserve Board governors spent much of May cautioning markets they were underestimating the odds of further rate hikes.
Earnings growth globally was weak in first quarter, with US earnings down around 8% year-over-year and Japanese earnings down a whopping 20%. Consensus expectations for full-year 2016 growth also continue to be marked down across regions; European earnings may be flat in 2016, and S&P 500 companies may only see 1% growth. Stretched valuations for US equities left them vulnerable, especially in light of margins being pressured by rising wages. Still, the roughly 10% drop in US equities at their February lows from December levels looks more like a reaction to macro-driven fears than fundamentals, as does the roughly 11% year-to-date decline in more reasonably valued Japanese stocks, which may grow earnings around 16% during the current fiscal year. Even in the overvalued US market there is some upside potential if surging crude oil and the sell-off in the US dollar remove two of the main headwinds to index earnings.
In a similar vein, the decline in emerging markets assets last year, which accelerated into first quarter, looks unjustified in light of subsequent events. When some of the doomsday scenarios failed to materialize, these asset classes were poised to snap back. Chinese economic growth is slowing, though first quarter’s 6.7% rate would be the envy of most nations. Excess capacity in many industries is causing deflation, and credit continues to flow to unprofitable firms. But, China has significant resources to deal with these problems and was never likely to lose control of its currency. The yuan has depreciated and provided a relief valve, and foreign exchange reserves seem to have stabilized. Government and household borrowing is very limited, and it is the very fact that banks are flush with deposits and thus not reliant on wholesale funding that makes a Chinese banking crisis unlikely.
That said, we don’t want to sound overly sanguine about prospects for returns. High valuations for US stocks are a headwind, and the rebound in US high-yield bonds, which pushed yields to 7.4%, offers little cushion for further credit deterioration from here or low recovery rates. Similarly, next week’s referendum on the United Kingdom remaining in the European Union is a hard-to-quantify but significant tail risk, especially if a positive outcome encourages other Eurozone members to pursue similar referendums. European stocks, while fairly valued, could certainly take another leg lower. Finally, while negative interest rates have lowered borrowing costs, they have created significant problems for savers, and the market has probably been justified in rerating the valuations of many banks lower in recent months.
Summing it up, markets have not swung from excess pessimism to unjustified euphoria. US equities are now in the black for 2016, but many peers, including Europe and Japan, remain in the red. Valuations for many asset classes reflect lingering concerns and offer a cushion should earnings or macro fundamentals deteriorate further. Any number of obstacles could trip up risk assets later in 2016, including politics, commodity prices, and (dare we say) rate hikes. However, as is often the case, what may hurt one asset (e.g., higher borrowing costs hurting leveraged companies) may prove a windfall for another (banks would likely receive a boost from higher net interest margins).
Wade O’Brien is a Managing Director on Cambridge Associates’ Global Investment Research team.