Update Winter 2016

Slip Slidin Away

Key Points
The sharp market sell-off so far in 2016 has triggered fears of a
pending U.S.
recession, but such concerns are overwrought.
Fundamental conditions remain relatively solid outside of
slowing Chinese
growth and the collapse in oil prices.
It will likely take some time, but investor sentiment should
recover over the
coming months.
Happy New Year!? The markets are off to a rip-roaring start this year -in the wrong direction. Few investors were sorry to see 2015 go, with
its stomach-churning moves ultimately ending up with major indices
experiencing losses for the first time in 7 years, but the start to 2016
has been decidedly worse. Marked by multiple triple-digit down days
on the Dow during the first several weeks of trading , the apparent
catalysts for the sellinggeopolitical and Chinese growth fears
havent greatly altered the overall picture to any great degree. Mixed
economic data, a renewed collapse in oil prices, financial turmoil in
China and worries over credit conditions and corporate earnings
prompted fears that the U.S. economy may be heading for recession.
This has put additional downward pressure on equity markets and
other risk assets.
Top Themes as a New Year Begins
1. The odds of a recession are lower than what equity markets
are forecasting. Following what proved to be a mediocre period for
equities last year, the drastic decline has some believing the U.S. is on
the cusp of a recession. It looks as if stocks are pricing in a 50% chance
of a recession; when looking at underlying trends in the economy, the
odds may actually be closer to 25%, in line with the typical recession
risk usually witnessed during any period in an economic cycle.
2. Corporate earnings remain under pressure. Fourth quarter
results are expected to show a 6% decline, which would result in profits
contracting for three consecutive quarters for the first time since 2009.
Analysts are also forecasting a modest decline for the first quarter.
3. Falling oil prices should help the U.S. economy but could
cause some short-term pain. Lower energy costs are long-term
positives for consumers and businesses and should be a positive for

trade. In the near-term, however, the sharp collapse is causing credit

issues, hurting earnings and sparking deflationary fears.
Fundamentals Are Stronger than What Markets Reflect
The sharp market downturn appears to have turned what has long
been concern over weak economic growth into more dire forecasts of
an end to the bull market and the onset of a recession. Investor
sentiment has imploded in the face of worries over the fragility of the
economy, a slowdown in U.S. and Chinese manufacturing, confusing
signals from Chinese policymakers and another collapse in oil prices.
Importantly, however, the negative turn in sentiment is not due to a
significant fundamental shift in economic data or a policy mistake.
Most fundamental conditions remain steady. The U.S. economy is
growing slowly and wages are accelerating while broader inflation
remains contained and an average of 200,000 new jobs are being
created on a monthly basis. Federal Reserve policy is still easy and the
European Central Bank, Bank of Japan and Peoples Bank of China are
all in easing cycles. Outside of the equity downturn, other financial
assets are not showing severe dislocations. Non-energy fixed income
credit sectors are relatively stable, and government bond yields have
not dropped by as much as would be expected if the economy were
severely worsening. The main fundamental changes are the economic
downturn in China, the drop in the value of the yuan and the
corresponding free fall in oil. Falling oil prices by themselves, however,
do not indicate an imminent recession. Rather, they reflect excessive
supplies of oil around the world. Nor is China headed for a hard
landing. Growth there is slowing but remains positive.
The challenge for investors in this environment is to decide whether to
turn defensive on a short-term basis to guard against further
downturns, or remain patient on the expectations that panic conditions
will ease once investors realize a recession is not in the cards. The
latter strategy appears to be more prudent. In many ways, the current
scenario is similar to the market turmoil in 2010 through 2012 when
periodic crises resulted in a series of sharp sell-offs and subsequent
rallies in risk assets.
So what will it take for markets to break out of the current downdraft?
For one, firmer economic data from China and evidence that
policymakers can manage the countrys financial conditions will be
helpful. Additionally, signs that both U.S. and Chinese manufacturing
levels are recovering will help stabilize the markets. Finally, stabilizing
oil prices would go a long way toward improving investor sentiment
and settling market volatility.
It will no doubt take some time for improvements to occur, but
economic fundamentals are more solid than equity prices reflect. As
such, investors should stay with a moderately pro-growth investment
stance and equities may present favorable long term opportunities at
current price levels.

Amin Khakiani
January 21, 2016