Capital Markets Outlook | Q1 2016

The wall of worry grows higher

Putnam Investments


As 2016 begins, investors in global markets are betraying trepidation. It’s often said that markets climb a wall of worry, and today that wall is high, with a number of inscriptions. The first might be the inability of the U.S. economy to reach escape velocity from what some commentators have dubbed secular stagnation. Others worry about the narrow leadership of the equity market.

Outside the United States, the set of issues that the world has been dealing with to varying degrees over most of the past several years remains almost unchanged. They include geopolitical tensions: Japan and China digging in their heels over disputed areas of the East China Sea; European nations wrangling over how to handle the increasingly worrisome Syrian refugee crisis; and the deepening rift between Saudi Arabia and Iran as they continue to fight proxy wars in Yemen and Syria.

And amid all of these issues, the Fed has now initiated what many describe as an ill-timed tightening cycle.

While all of the worries on this proverbial wall merit attention from investors, Putnam’s global macro research is focused on one particularly pressing concern in early 2016: the inextricable link — and negative feedback loop — between commodity prices and credit markets. But first, it’s important to consider more positive indicators.

Fortunately, there are, in fact, many pockets of optimism to offset the dour tone. One of the most noteworthy trends we see in our analysis of the economy is the resilience of the services sector, not just in the United States, but around the world. It is, of course, widely known that the U.S. economy is driven primarily by services. However, a fact much less appreciated by investors is that services constitute a substantial and expanding share of economies that investors still view as primarily industrial — including China.

The development of a service-oriented economy is a seminal transition, and so we need to remain aware of the potential shortcomings of traditional indicators for monitoring it. Many of our high frequency data items were originally created to monitor post-WWII economic health. There is a risk, then, that myopic focus on these data points loses sight of broad trends in an economy that is no longer driven primarily by things like factory output. This notion is evident even at the micro level in something as simple as how we shop. Amazon.com, for example, has had higher total sales over the past four quarters than Macy’s, Sears, Kohls, Nordstrom, and J.C. Penney combined! This prompts the questions: What makes a bricks-and-mortar retailer, and what makes a tech company? This illustrative example is at the nexus of the linkages between the old and new economies.

The consumer provides reason for confidence

Much of this dichotomy between the industrial and service sectors can be attributed to the robust financial situation of U.S. households. Just as consumer balance sheets were strained from 2007 to 2011 due to the declining value of homes (U.S. households’ single largest asset), so too have they been bolstered over the past 3-4 years by home values rising a cumulative 30% from the cycle low in early 2012.

Combined with lower nominal interest rates, the ability of U.S. consumers to service their debt is quite strong. Federal Reserve’s measure of new personal bankruptcy filings provides evidence: It has declined steadily since mid-2010. The strength of the labor market has also contributed to a healthy household balance sheet. According to the Bureau of Labor Statistics, the ratio of the number job openings relative to the number of people in the labor force is now at its highest since the peak of the last cycle in 2007. Indeed, there is ample evidence to suggest that the U.S. labor market is substantially tight.

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