- 2016 is full of political risks due to the actions of the Federal Reserve and presidential elections in November.
- Certain areas of the economy are quite strong, while others are in a recession.
- How these issues resolve themselves will create tremendous volatility and opportunities for traders and investors.
2016 promises to be a fascinating year for the economy and the stock market. There are a number of reasons to be optimistic and pessimistic about both. The November elections could result in the status quo being extended or a huge shift in direction, creating uncertainty. For the first time in nearly a decade, the Federal Reserve is raising interest rates despite the lack of inflation even as many parts of the economy linked to global trade remain weak.
Yet, the consumer is strong with the labor and housing market showing steady growth with potent, demographic tailwinds. While the stock market is overvalued, economic trends remain inconsistent with a recession and most bear markets are sparked by recessions. Given these conflicting signals, 2016 looks to be another challenging and stimulating year for market participants.
This type of uncertainty eventually ends up creating fantastic opportunities for those that can remain engaged while carefully managing risk. This article will examine these issues in an effort to provide some guidance for the upcoming year in order to achieve this objective.
Higher Interest Rates
In a vacuum, higher interest rates lead to lower risk premiums and decreased economic activity. In reality, it is more complicated as interest rates tend to rise when the Federal Reserve determines the economy can handle it. In fact, interest rates typically increase for years before it begins to have a material, negative impact on the economy and stock market.
Usually, increasing economic activity leads to inflation which necessitates higher interest rates. This is not so during this recovery which has not seen a meaningful uptick in inflation despite being more than six years long. This is due to a variety of factors such as a weak recovery, excess capacity in labor and housing, deflation in commodities, consumer deleveraging, and a gridlocked federal government. It is important to note that intelligent people disagree about what extent each of these issues is responsible for the weak inflation.
Thus it is unusual in some ways that the Federal Reserve has decided to hike interest rates. It is not as unusual when considering that the Federal Reserve may be electing to act in order to preempt asset bubbles from forming that could lead to major distortions and damages to the broader economy and the Fed's institutional credibility when financial or economic conditions deteriorate.
For market participants, higher interest rates will lead to negative pressure for commodities, yield generating instruments and dividend paying stocks. It will be positive for brokerages, insurance stocks and regional banks. Brokerages and insurance stocks hold large amounts of cash in short-term securities so higher rates flow straight to the bottom line. Higher interest rates lead to wider spreads, making the business of taking deposits and lending money more profitable for banks. Banking stocks like Bank of America (NYSE:BAC), JP Morgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC) will be on investors radar's in a rate hike environment. LendingClub (NYSE:LC) could also be an attractive bet ahead of a continued rate hike.
One unique aspect of this recovery has been its resilience despite the weakness in the global economy and industrial economy. These areas have suffered from excess capacity that was built up over the past decade due to over optimistic assessments of growth in emerging markets and easy money. The sluggishness in these countries in concert with excess production has led to painful bear markets in industries like coal, steel, iron ore, aluminum, energy and precious metals.
It is also a testament to the US economy's dynamism that it has managed to maintain its growth trajectory despite a recession in many of these industries. While the S&P 500 is about 3% off from its all time highs and 33% above its 2007 high, the Dow Jones US Iron and Steel Index is down nearly 75% from its all time high in 2008. The weakness in the industrial economy is one of the major points in the bearish argument that the economy is rolling over into a recession.
Strength in Housing and Labor
Of course, bulls will counter that the industrial economy is no longer a meaningful bellwether for the broader economy. Instead, they will point to housing which continues to strengthen backed by a strong labor market and favorable demographic trends. New home construction has considerably lagged population growth since the bursting of the housing bubble, leading to upward pressure on home prices.
Rising home prices lead to greater consumer confidence and spending, creating a virtuous cycle for the economy. Additionally, it creates job opportunities for blue-collar workers who have been left out of the recovery. Due to the weakness in housing and labor markets that persisted till 2012, there remains further room for growth without concerns of the economy becoming overheated. At the nadir of the Great Recession, it would be difficult to fathom that less than a decade away, the US economy would be dealing with a potential shortage in housing and workers.
Two areas that will be of intense public focus and will certainly contribute to market volatility are the Federal Reserve and the November elections. The Fed's interest rate path and expectations of the interest rate path will have major impacts on risk premiums. Currently, the Federal Reserve has painstakingly signaled that further rate hikes will be gradual and data-dependent.
Similarly, the outcome of the November elections will be massive especially given its binary nature. On the presidential level, a Democratic victory will ensure more or less a continuation of the status quo. However, a Republican victory could lead to massive changes in foreign policy, tax rates, monetary policy, environmental regulations and healthcare especially since Republicans will most likely retain control over Congress.
Traders and investors need to be cognizant of these political risks in addition to the economic and market risks discussed above. Simply put, there is no playbook for 2016. Fortunes will be made and lost in the coming year.