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On Wednesday, the Federal Reserve (Fed) decided to maintain rates at their current level. More importantly, the Fed’s forward-looking expectations for rate increases (the dots) have gone from forecasting, just a couple of months ago, four rate increases in 2016, to yesterday’s forecast of just two rate increases. Interestingly enough, when the Fed raised rates in December, and targeted four increases for 2016, the futures market was predicting only a 50 bps rate rise this year, which is now what the Fed is targeting.

Currency markets quickly reacted, as the US dollar weakened, and other markets digested the news. Beyond the markets’ short term reaction, the slowdown in rate hikes raises concerns in the long term about how much dry powder the Fed and other central banks have at their disposal, given the state of the world economy. The truth is, economic growth has been slow since the massive injection of liquidity post the credit crisis, with annual GDP growth in America averaging around 2% since June of 2009. With so much liquidity injected into the system for so little an increase in economic output, the question becomes: What can central banks do if we enter another recession, considering rates are at record lows and trillions of dollars/euros/yen have already been printed?

Interestingly, Bank of America Merrill Lynch recently released a survey of fund managers in which 59% believe we are nearing the end of the game in terms of world economic growth. The signs are starting to emerge: a rapid decrease in commodity prices; concerns in the credit markets; and increased equity market volatility. Although asset prices quickly inflated after the credit crisis of 2008 due to a large injection of central bank liquidity, economic growth has not been as robust. This has exacerbated a number of social issues, ranging from increasing the wealth disparity (those with exposure to risky assets in 2009 have become much wealthier while those without continue to struggle) to reducing cash flow to older Americans who rely on “clipping coupons” to fund their retirement income needs. To paraphrase Winston Churchill, never has so much liquidity been used by so many central banks to benefit so few people. Economic growth has been slow, the wealth disparity has increased, and the reflation of asset prices has had the biggest benefit for those who already are wealthy.

In addition to these social ramifications, there is real concern over how much dry powder central banks have to fight the next recession. If we are nearing the end of economic growth, what options will they have to prop up the economy? This is a real concern, and is why some investment professionals have been lowering their long-term forecast of stock market growth. No matter how much liquidity you place in the system to re-inflate assets, stocks need economic growth for long-run appreciation. The question is: Will central banks have the tools to stimulate the economy if we slide into a recession? Many investors are concerned they will not, and that should concern us all.

(Source: MarketWatch)

The wealth of American households climbed to a new peak in the second quarter, bolstered by rising real-estate values that more than compensated for a flat stock market.

The net worth of U.S. households and nonprofit organizations—the value of homes, stocks, bonds and other assets minus all mortgages, debts and other liabilities—climbed by $695 billion to $85.7 trillion, according to a Federal Reserve report released Friday.

The report provides a snapshot of the robustness of American balance sheets before the turmoil that struck stock markets in August. Households lost close to $13 trillion in the recession, but a soaring stock market and resurgent home prices have boosted American wealth by $30 trillion over the past five years—gains fueled in part by a campaign of ultra-low interest rates and large-scale asset purchases by the Fed.

The difficult market environment in August reminded us about the three other Augusts – August 1997 (Asian crisis), August 1998 (Russian crisis) and August 2011 (European debt crisis). In each of those episodes, there were some type of global risk events, and as a result, US market suffered significantly.

In 1997, Asian financial crisis started in Thailand with the collapse of the Thai baht after the Thai government was forced to cut the Thai baht’s peg to US dollar after exhausting its foreign reserve. As the crisis spread to Indonesia, South Korea and Malaysia, most of Southeast Asia and Japan experienced declining currencies, stock markets crashes and a jump in private debt. The crisis raised the fears of global economic meltdown. As a result, the US equity market dropped by 5.6% in August. However, the US market recovered quickly with a 5.5% rally in September.

In 1998, the Asian financial crisis and the following reduced demand for crude oil and nonferrous metals, negatively impacted the Russian exports and foreign reserves. A series of political missteps and inability to implement a set of economic reforms severely erased investor confidence and led to capital flight. Without enough foreign reserve to support its currency, on 17 August 1998, the Russian government devalued the ruble and defaulted on domestic debt. The Russian default caused global liquidity dry up and credit spreads widen, which brought down the then-known hedge fund, Long Term Capital Management. US equity markets tumbled 14.4% in August, but again recovered nicely in September and October.

In 2011, the European debt crisis intensified after it started in the wake of the Great Recession around late 2009. In August, the government bond yields in Italy and Spain breached 6% level as the European leaders struggled to reach an agreement to expand the bailout fund. The US equity market dropped by 12.4% during the months of August and September. However, once again, it recovered in October, gaining 10.9%.
This year, the stock market rout started in China when the Chinese government unexpectedly devalued its currency, which triggered concerns over global economic slowdown. The US equity market declined by 6.1%.

The equity market drops in the first three crises all recovered nicely and quickly. Will this time be the same? We believe it is quite likely though we still recommend caution.

1. There is no crisis this time so far. The Chinese economy will definitely or has already slowed down from double digit to 7% or lower. But everyone tends to agree that it will grow at a reasonable pace. The Chinese stock market rout started after a dramatic run-up and a bubble-level valuation. The sell-off, though painful, was a necessary correction. As a word of caution, the bad news from China may not be over, we may  see more market volatility going forward.
2. The US equity valuation is not cheap, but not at an extreme (see table above). During the crises in 1997 and 1998, the equities are much more expensive.
3. The US monetary policy is ultra-loose. Even if the Fed may raise interest rates this year, the monetary policy is still very accommodative. The interest rates in 1997 and 1998 were much higher.
4. The US economy is solid. In Q2, the US economy grew at 3.7% annual pace. ISM Manufacturing Index is still in expansion territory and unemployment rate is close to 5%. The slowdown in China will have limited impact on the US growth as the exports to China only account for 1% of the GDP in the US. However, the slowdown in China will have significant impacts on the US companies that are doing businesses there.

(Source: Julex Capital)

An Upbeat Start to Earnings Season

In the first quarter of 2015 reported earnings per share (EPS) were $21.51 for the S&P 500 Index, representing a decline of 14.23% from the prior year. The Materials and the Industrials sectors were the worst performers, with year-over-year EPS declining over 40%. Although Utilities and Financials were bright spots, gaining 40% and 20% year over year, respectively, many corporations provided overall lower guidance, and Wall Street analysts lowered second quarter earnings expectations.  Thomson Reuters’ data forecasted a 5.9% gain in earnings for Q2 in January for the S&P 500 Index, and by June these estimates were revised to a loss of 1.5%.

Corporate earnings releases kicked off unofficially on July 8th, when Alcoa (ticker: AA) reported solid second quarter profits. Through the market close on Tuesday, July 21st, 102 companies (roughly 20%) in the S&P 500 Index have reported earnings. Seventy percent beat earnings expectations, and 55% exceeded revenue forecasts. On the heels of a report that existing home sales were strong in June, reaching highs not seen since February 2007, it is no surprise that housing companies posted positive earnings. Specifically, Lennar Corp (ticker: LEN) reported $0.79 per diluted share, versus last year’s $0.61 per diluted share. Corporations that did not perform as well typically had revenue exposure overseas, and were hurt by a strong dollar, which reduces income derived outside of the US. Although the Technology sector posted year-over-year gains last quarter of 8.90%, tech companies surprised the market this week with lackluster earnings, with names like Qualcomm Corp (ticker: QCOM), Apple (ticker: AAPL), SanDisk Corp (ticker: SNDK), IBM and Microsoft (ticker: MSFT) missing expectations in one way or another. For example, Qualcomm reported a 47% decline in quarterly profits; Apple’s iPhone sales were lower than anticipated; SanDisk reported a drop in both revenue and profit; IBM’s operating EPS fell 13%; Microsoft earnings and revenue beat expectations, but had a loss for the quarter when previously disclosed restructuring charges were included.

Despite the soft spot in the Technology sector, the overall earnings season has started out well. In fact, we’re seen growth across Basic Materials, Consumer Goods, and Financials, with names like Bank of America (ticker: BAC) and Citigroup (ticker: C) beating expectations. Additionally, Walgreens Boots Alliance (ticker: WBA), Monsanto Co (ticker: MON), Constellation Brands (ticker: STZ), Darden Restaurants (ticker: DRI), and UnitedHealth Group (ticker: UNH) all posted EPS growth of 57%, 48%, 30%, 26%, and 15%, respectively. Should earnings continue to beat expectations, the US Equity market may extend its gains and even tolerate a future rate hike by the Fed.