With recession fears now nowhere to be found, the market averages have raced their way back to a positive return for the year, a much-welcomed development considering where they were on Feb. 11. The bears have retired to their caves, and the negativism in the media has all but disappeared.
The rising price of oil
It is counterintuitive to look at the rising price of oil as a positive for the economy. But in this case, it is. Rising prices have reduced Wall Street’s worry that the banking system was about to have another financial crisis due to lending to the oil patch and related sectors. While this was always an imagined concern, never based on the reality of bank capital and loans to those sectors, markets sometimes become irrational, and this caused the sharp sell-off in the banking sector (much of which has been retraced). Generally speaking, the banking sector is key, as markets view the sector as an indicator of the health of the overall economy.
The China issue
The issues with China include its total debt (government and corporate) and its overcapacity in the basic heavy industries. The good news is that in its newest five-year plan, China says it will address its debt issues and basic industry overcapacity. In addition, at the G-20 in February, Beijing officials indicated that they would not devalue their yuan. And, since then, it has strengthen slightly against the dollar.
Yet despite Beijing’s assurances to the contrary, China’s debt bubble and currency devaluation issues remain a constraining market concern. Beijing is now encouraging Chinese companies to swap their debt for equity. We’ll see if this works. If it doesn’t and their debt bubble bursts, they will be forced to devalue, likely taking much of Asia with them, and likely causing a recession in that part of the world. This worry is Wall Street’s major concern, and it will take time to resolve. For now, markets have given Beijing the benefit of the doubt.
The labor markets
The 242,000 jobs created in February, along with upward revisions to January and December, indicate that businesses continue to hire, and that hiring remains robust. The leading indicator, new claims for unemployment insurance, has been telling us this for the past year. Except for some points in 2015, you have to go all the way back to 1973 to find a lower four-week moving average for this series (the week of March 12). In fact, the labor markets have been strong enough to encourage previously discouraged workers to re-enter, and the labor force participation rate has now risen for four straight months, now standing at 62.9 percent of the population (up from a low of 62.4 percent).
Monetary policy efficacy
The European Central Bank, as expected, increased its quantitative easing at its March meeting and further pushed its benchmark deposit rate into negative territory. Then, the Federal Open Market Committee (FOMC), the rate-setting arm of the Fed, passed on raising rates at their March meeting. Markets reacted positively to each of these events. New Fed projections reveal that the FOMC sees two rate increases in 2016. Yet, ominously, it sees continued slow GDP growth (2.2 percent in 2016 and 2.1 percent in 2017). Wall Street fears that rising rates later in the year, in the face of worldwide economic sluggishness, could turn a tenuous growth path in the U.S. into another recession. However, those rate hikes are at least three months out; that’s “long term” for the equity markets.
Then there is the issue of the effectiveness of monetary policies among the world’s major central banks. Having already loaded up their balance sheets with debt, the next step for policy in a slow-growth world appears to be negative interest rates. Most economists are skeptical as to the efficacy of such a policy. Nevertheless, both the European Central Bank and Bank of Japan are currently experimenting with the concept.
The value of the dollar and other worries
The good news is that the dollar has stopped strengthening, and that means that manufacturing exports and multinational earnings will benefit. On the other hand, the dollar has weakened dramatically against the Japanese yen, making Japanese goods more expensive for foreigners to purchase. That is a problem for Japan, whose economy is in recession again, so they are in desperate need of rising exports. The ongoing worry is that another round of currency wars could result.
Other longer-term issues include the European refugees and Great Britain’s threatened exit from the European Union, but since these are not imminent issues, Wall Street is ignoring them for now. I suspect that they will come back to bite sometime down the road.
Conclusion
On balance, the immediate positives outweigh the longer-term negatives. For the immediate future, earnings look to be the most important factor for market pricing.