Third Quarter 2016 Outlook and Opinion July 5, 2016


S&P Global Ratings downgraded its forecast for U.S. growth this year, due to the Brexit vote and lower-than-expected first quarter growth. Chief Economist Beth Ann Bovino announced that she now expects U.S. real GDP to grow by 2.0% in 2016 (down from 2.3% in March) and 2.4% in 2017 (down from 2.5%). S&P now feels that the risk of recession over the next 12 months is now between 20% to 25%, up from 15% to 20% in March. S&P has revised its forecast downward many times for 2016 growth since last year, and yet, the stock market remains expensive due to Central Bank intervention. It should be noted that S&P’s outlook is still higher than the consensus view.

Brexit will certainly bring more volatility to the financial markets. It is difficult to conclude anything on the subject because until the U.K. invokes Article 50 of the Lisbon Treaty, the UK is still in the E.U. While it is likely at this point that the U.K. will leave, it is not impossible for it still to remain. Either way, uncertainty will weigh on global markets. This has been rallying the dollar against world currencies, which, if it continues, could provoke further devaluations and instability for the Chinese market, such as what we experienced in January of this year.

Back in the U.S., there is a decline in the growth of incomes in the U.S., and a 2% gain in incomes does not seem to be enough to take the economy higher. For the first half of the year, there was a one-third decline in the amount of announced stock buybacks by U.S. corporates. Recall that the largest buyer of stocks over the past year has been the listed companies themselves which have been purchasing their own shares. Nine out of ten sectors have recorded a decline in expected earnings growth since the beginning of the second quarter due to downward revisions to earnings estimates, led by the technology sector which had the sharpest downward revisions. This will imply five consecutive quarters of year-over-year declines in corporate earnings, the first time seen since the third quarter of 2008. The bright spot was manufacturing, which has been showing signs of expansion.

Both current and estimated P/E ratios for the stock market are higher than their 5 and 10 year averages, implying that the stock market is still expensive.

Global government debt now stands at $60 trillion, with corporate debt representing a similar size. Over $10 trillion of government debt has a negative yield, bringing the global average of ten year government bond yields to below 1%. The over-arching concern right now in the financial markets is that when either the global economy improves, or when inflation is triggered, interest rates will move higher and servicing this debt will become a serious headwind for growth at the sovereign, corporate, and personal level.

The upside in the stock market remains limited in a world facing too many risks. Janet Yellen of the Federal Reserve said in May that she “wouldn’t rule out” using negative interest rates in a “very adverse scenario”.

The current and potential emergency measures taken by the Fed, brought on by its extremely cautious stance, do not seem to square with a stock market still hovering near all-time highs. Government bonds are trading at all-time low yields, presaging a much softer economy, while the yield curve has been flattening, meaning that interest rates across different maturities of debt are becoming more similar. This implies slowing expectations of economic growth, and in my experience, the bond market is always smarter than the stock market.

For the first half of 2016, the S&P 500 was up 2.68%, the Dow was up 2.89%, and the Nasdaq was down 3.3%.

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