Global Markets: 2008 or 2011?

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1 February 12, 2016 Global Markets: 2008 or 2011? There s something wrong with the world today. I don t know what it is. Something s wrong with our eyes. We re seeing things in a different way. - From Livin on the Edge by Aerosmith Global markets have continued their difficult start to 2016, with the S&P 500 now down over 14% from the May 2015 peak as of the close on February 11. As we seem to be inching toward bear market territory, defined by a decline of 20% from peak values, it is worth re-examining our investment thesis. In past Market Updates, for example, our January 14 report Global Markets: Under Pressure, we touched on the proximate causes of the sharp 2016 stock declines thus far: global economic growth concerns in particular about China s growth, stock market, and currency; oil prices with West Texas Intermediate and Brent crude trading at more than decade lows; U.S. economy and the Federal Reserve (Fed) the odds of a U.S. recession and/or policy error; and geopolitical tensions rising tensions in various parts of the world. There isn t much to add to these discussions that hasn t been covered in our previous publications, so this update will concentrate on looking at some new information along with considering the current market condition looking through the lens of 2008 and Bear Market or Financial Crisis? Investors seem increasingly less concerned about the S&P 500 breaching the down 20% level, given that we are already much of the way there, than they are about whether this decline could devolve into another financial crisis with significantly worse consequences. Table 1 S&P 500 Bear Markets Looking at the recent history of bear markets, it is understandable that the fear of a larger decline would be fresh in investors minds since the last two bear markets went far beyond the garden variety (Table 1). In addition, the 2007 bear market Source: Strategas, PNC went down in the annals of history for the ferocity of decline both in terms of size and speed. Recent memory obscures the fact that the so-called typical bear market around a recession actually sees declines in the neighborhood of 20%. While a 20% decline is a painful occurrence, it is certainly in a different league from getting your investment cut in half or worse.

2 For our purposes, it is instructive to consider the circumstances surrounding 2008 and 2011 since similar circumstances might apply today. As shown in Table 1 (page 1), the S&P 500 in 2007 to early 2009, with the primary losses in 2008, saw declines of close to 60% thanks to an accompanying deep recession and global financial crisis. Also, 2011 is another key year to consider, though it does not show up on our bear market list or many others and tends to be forgotten by many observers. Using closing prices, the S&P 500 only reached a decline of a little over 19%. Since most use closing prices to calculate historic bear markets, the loss of almost 22% using intraday prices was lost to posterity. We think it certainly paid to ignore this significant scare at the time, since stock have gained about 60% since then. With the stage set, let us look at some aspects of the global economy and financial markets through those two lenses. U.S. Economy Softness in U.S. economic data is likely troubling markets, with U.S. GDP growth ending 2015 up only 0.7% in the fourth quarter and likely to be revised lower. The PNC Economics team expects 2016 growth to rebound to back to growth of 2% or more. Offsetting global macro factors such as the strong dollar and tepid global growth is the continued strength in domestic demand, aided by the consumer. We expect the strength in the U.S. employment picture combined with low gasoline and energy prices to continue benefiting U.S. consumers. Setting aside our forecasts, let us look at other evidence. Our studies have shown that PMI data are some of the best tools in now-casting economic conditions. Certainly, U.S. manufacturing PMI data have been on a weakening trend, but the most recent PMI data for January, at 48.2, seemed to indicate some stabilization. As seen in Chart 1, this level is still not consistent with a U.S. recession and is well above 2008 levels. While the Institute for Supply Management (ISM) Manufacturing PMI never broke below 50 in 2011, it was in a weakening trend and eventually reached a low of 48.8 in The ISM Non-Manufacturing PMI has held up better and remains above the 50 level. This series does not have as long of a track record, but again the levels are not consistent with recession. The current level of 53.5 is well above the 37.6 low in In addition, readings remain above the 2011 low of The current trend direction is troubling though, so we think it certainly should be watched closely. Chart 1 Institute for Supply Management Indexes Through January 2015 Chart 2 Jobless Claims, 4-Week Moving Average Through February 5, 2016 Source: ISM, Bloomberg L.P., PNC Source: Bloomberg L.P., PNC 2

3 While being mindful that labor market measures are considered lagging indicators of economic growth, the four-week moving average of initial jobless claim remains extremely low and even below the best numbers we saw prior to the last recession (Chart 2, page 2). This series is also much improved from 2011, but it is notable that there was an increase in jobless claims about the time that the market sold off in Claims increased slightly starting in late 2015 and have just now moved down from the January mini-peak. Continued strength in the labor market is an important component supporting a higher likelihood of continued consumer spending. Leaving the best single predictors of U.S. recession for last, neither the 10- to 30-year spread nor the 2- to 10-year spread is indicating that a U.S. recession is imminent (Chart 3). The 2- to 10-year spread (when the yield on the 10-year Treasury is below the 2-year) has correctly predicted the last five recessions in advance and is the preferred indicator of multiple Fed banks. The 10- to 30-year spread (when the yield on the 30-year Treasury is below the 10-year) has correctly forecasted every recession since 1953 at least one year in advance. While the 2- to 10-year spread is below the levels reached in , perhaps indicating that we might be closer to a recession than in that period, the reading remains well above the signal point. There does also seem to be some fear of policy error Source: Bloomberg L.P., PNC in the markets that the Fed might tighten too quickly for the U.S. economy to withstand. The Fed s projections call for four rate hikes in 2016 while the financial markets are currently pricing in not even one. The PNC Economics team is forecasting two additional raises in 2016, at 25 basis points each. Debate over the Fed s expected path may continue to add some volatility in To be clear, this path will be dependent on the performance of the economy and inflation, so it is almost certain to change throughout the year. Fed Chair Janet Yellen in her testimony before Congress this week underlined that the Fed was monitoring financial conditions in the United States in determining the path and timing of future interest rate changes. Global Economy Chart 3 Yield Spreads Through February 11, 2016 Again our analysis will lean on PMI data since our research has found these data to be effective tools in now-casting both U.S. and international economic growth. So far, global PMI remains above the 50 level at 50.9, while the trend since the early 2014 peak is a concern worth monitoring (Chart 4, page 4). We think the good news when looking at the subcomponents of developed and emerging economies is that some of the most severe weakness has come from the emerging economies since 2015, with China s woes playing no small part in that. In any case, both the emerging and developed readings seem to have found at least some stabilization. Some of the most recent market worries have emanated from the European banking system, so the past PMI data can be instructive here as well (Chart 5, page 4). Eurozone data remain well above the 2008 levels. Perhaps the more interesting period, in our view, is the period when we saw significant stresses in the European banking system, some sovereign European yields, and GDP. The MSCI European Financials Index measuring the return on European financial companies fell almost 44% between May and November Spanish 10-year government bond yields rose from 4.9% in August 2011 to 6.8% in November

4 Chart 4 PMIs Through January 2016 Chart 5 Eurozone PMIs Through January 2016 Source: Markit, Bloomberg L.P., PNC Source: Markit, Bloomberg L.P., PNC Eurozone GDP growth quarter over quarter fell to 0% in second-quarter 2011 before turning negative in fourth-quarter 2011 and remaining negative through first-quarter Currently, Eurozone PMI remains above the 50 mark and GDP grew 0.3% in fourth-quarter Spanish 10-year government bond yields are below 1.8% currently. As evidence of the stress in European financials, the MSCI European Financials Index has lost more than 33% since its May 2015 peak and more than 22% of that in 2016 year to date. Low Oil: Friend or Foe? Markets were hopeful for oil price stabilization in 2016, and the even further decline in prices and the threat of more Iranian oil seem to be confirmation of oversupply for the near future. PNC economists point to the Chart 6 Oil Prices Through February 11, 2016 marked drop in U.S. energy exploration, with U.S. well rig counts dropping 65% in December 2015 versus the year prior, suggesting oil prices are likely to stabilize eventually in 2016 and Oil seems be one of the markets larger worries, with U.S. stocks trading almost in unison with oil on a dayto-day basis recently. Markets are interpreting the sharp decline in energy prices as too much of a good thing. While there is little doubt that lower energy prices are a net positive for the world s major economies, including the United States, Europe, Japan, and China, some negative impacts are certainly being felt in the shorter term. For example, U.S. high yield junk bonds have suffered given their sizable exposure to energy companies, and industrial production in the United States has been hurt by the Source: Bloomberg L.P., PNC decline in drilling activity. The offset is that as net consumers of energy, the benefits to consumers and non-energy-related corporations are strong. It is also worth noting that recessions have historically never started with low oil prices; rather high oil prices are to be feared as an indicator (Chart 6). 4

5 As we have noted previously, in many cases there are casualties related to low oil prices. This time it is not likely to be different, with companies and speculators leveraged to higher energy prices likely continuing to feel intense pain with restructurings and losses resulting from the impact. Financial Conditions Since the European banking system has seemingly come under pressure and the fear of contagion hangs in the air, we think it is worth taking a look at the capital levels of the U.S. banking system (Chart 7). The capital in the U.S. banking system has been significantly bolstered since the financial crisis and remains at similar levels seen in Financial conditions as measured by the cost of corporate borrowing over Treasury yields have certainly deteriorated since the beginning of 2015 with borrowing becoming more expensive (Chart 8). As noted previously, much of this increase in yield spreads is attributable to energy and commodity borrowers, which are probably under pressure given the current commodity price environment. Again, we think it is worth noting that the current spreads are nowhere near the financial crisis levels and have not even reached the 2011 timeframe readings. Chart 7 Tier 1 Risk-Based Capital Ratio As of September 30, 2015 Chart 8 Investment-Grade and High-Yield Spreads As of February 10, 2016 Source: Federal Deposit Insurance Corporation, PNC Source: Bloomberg L.P., PNC Conclusion S&P 500 declines, while uncomfortable and frightening given recent bear markets, have historically shown to be typical of long-term stock investing and its attractive long-term returns. The stock market has historically not proven a good predictor of economic growth. We reiterate our view that the U.S. economy continues to exhibit signs of growth, and we do not expect a U.S. recession in Investors should also find solace that the S&P 500 now has a dividend yield of over 2.4%, which is in excess of the 1.67% yield on 10-year U.S. Treasuries and near 0% on cash. We believe this differential raises the probabilities that stocks outperform bonds and cash over a longer period and argues that investors should continue to hold stock allocations consistent with their goals and risk tolerance rather than any knee-jerk reaction to sell amid the current challenges. 5

6 Chart 9 Bull-Bear Sentiment, Monthly Through January 2016 A possible catalyst for the market in the shorter term is that market sentiment has turned severely negative (Chart 9). While this might seem counterintuitive, high amounts of negative sentiment versus positive sentiment often are a prelude to a move higher in stocks. In fact, we observe similar bearish sentiment readings as occur today in the AAII poll prior to the bottom during the financial crisis and in the 2011 period. Even if this sentiment does not lead to a strong rebound, bear markets rarely begin with strong bearish sentiment; rather, the bullish sentiment usually rules when the bull market is close to death. Certainly our longer-term optimistic view is bolstered by our analysis which finds that the current situation has more in common with the 2011 period, which saw Source: American Association of Individual Investors, PNC a continuation of the bull market, than 2008, which devolved into the financial crisis. Since the decline in 2011 was marked by many of the same market conditions seen now, it is worth considering a less dire outcome than the seemingly endless stream of bad news is now providing. PNC will continue to monitor the situation closely, given that the odds of a poor economic outcome have risen more than we had expected to start the year. It is our view that stock market volatility will be elevated in the near term as the market continues to digest economic and financial market data. We acknowledge the difficulty for us or anyone to predict with any accuracy the short-term behavior of stocks, so we believe investors should continue to focus on their longterm goals, working with their PNC advisors to focus on an asset allocation that matches their risk and return objectives. We recommend systematic rebalancing to help manage risk and, for qualified investors, considering the possible addition of alternative investments in an asset allocation to help manage volatility. Please see our July 2015 Investment Outlook, A New Simple Rule for more on these topics. In addition, PNC recently added new smart beta strategies to our investment arsenal. Some of these strategies are designed to help reduce volatility and risk in portfolios which could be valuable in this environment. Please see our February 2016 Investment Outlook, New Investment Paths with Smart Beta and speak to your PNC advisor to discuss if these solutions might be appropriate for your situation. E. William Stone, CFA, CMT Chief Investment Strategist Marsella Martino Senior Investment Strategist Michael Zoller Investment Strategist 6

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