April 2015 Recently the US stock market has been overlooking economic strength at home and worrying about weakness abroad. We think the global outlook improves in the back half of the year, easing investors’ concerns and returning their attention to the gathering strength in the US economy. HEADWINDS ONE ANSWER The stock market went nowhere in the first quarter of 2015 and this despite seeing a marked increase in volatility. For all its ups and downs, the S&P 500 returned only 0.95% for the quarter. While our stocks did better, it was nothing to write home about. A stronger US dollar devalues US companies’ foreign sales, which are transacted in the local currency and must be translated back into US dollars. If the US dollar rises relative to those local currencies, that translation produces lower revenues in US dollars. We noted in January that we were taking in sail—that is, reducing our portfolios’ equity exposure—for the first time in over two years. Throughout 2013 and 2014 we had clients’ overall equity exposure dialed up aggressively. As roughly a third of the S&P 500’s revenues come from abroad, the US stock market has a fair amount of exposure to these currency translation effects. In January, we dialed that back to a more neutral posture. As we noted then, we did so out of concern not for the US economy but for the risks posed to US stocks from abroad. DECOUPLINGS We noted in January that the US economy had largely decoupled from the global economy, gathering strength as much of the rest of the world faded. The US can go its own way largely because personal consumption accounts for 72% of the total. So if US consumers are healthy, as they increasingly are, so is the US economy. But another decoupling has taken place that gives us pause—that is, the decoupling of the US stock market from the US economy. During the first quarter the US stock market rose or fell largely in unison with the outlook for foreign economies. In light of this we have for over a year been shifting our equity exposure toward stocks in companies with fewer foreign revenues. But we don’t think this is the main reason the overall market has liked a weak dollar lately. Historically a strong US dollar has gone hand-in-hand with a strong US stock market because the positive effects of dollar strength tend to override the negative. We’ve discussed some of these positive effects in terms of the impact of lower oil prices on US consumer spending. A stronger dollar means cheaper imports, oil among them, and this means cheaper gas at the pump. This leaves consumers with more dollars to spend elsewhere, which leads to stronger economic growth. This is one reason the US stock market generally likes a strong dollar. FOREIGN CRISIS RISK This odd correlation was dramatized by the action of the US dollar: In the first quarter when the US dollar rose in value relative to foreign currencies, US stocks tended to flag. When the US dollar fell, US stocks rose. We think the strength in the US dollar has been driven more by weakness abroad than by strength at home. As we remarked last quarter, plunging oil and other commodity prices have slashed revenues to economies driven by these exports—Russia, Brazil, Canada, Australia, etc. This is unusual as a rising US dollar generally reflects a US economy that is strengthening relative to foreign economies. So why should US stocks like a weaker dollar? This sudden economic weakness sharply devalued their currencies relative to the US dollar. So, recent US dollar strength has been more a proxy for this commodity-induced Arjuna Capital | 353 West Main Street, Durham, NC 27701 | p: 919.794.4794 WW W .A R JU N A - C AP I T A L. C O M MARKET OUTLOOK April 2015 weakness abroad than for strength at home. But why should investors in US stocks care about weakness abroad if our economy has decoupled from global woes? The short answer is: While the US economy may decouple from foreign economies, the US stock market is vulnerable to crises in foreign financial markets. We saw this in 1995 with the Mexican peso crisis, in 1997 with the Asian currency crisis, and again in 1998 with the Russian debt default. None of these events derailed the US economy, but they did cause sharp, if temporary, pullbacks in the US stock market. This, we maintain, is what the US stock market is worried about. SWIMMING NAKED When you tally up the leading indicators for global growth you find that nearly half the world economy is set to slow. When the global economy slows, financial crises tend to happen. They do because growth masks weak points in the global economy, while slowdowns tend to expose them. It’s like the old saying: When the tide goes out, you see who’s swimming naked. (Until then, you don’t know who they are.) When that happens, we expect the market’s attention will quickly return to the growing economic strength at home. In this regard we’re particularly encouraged by improving European economies, particularly that of Germany. It’s too much to ask for US import demand to overcome weakness everywhere else in the world. But a stronger Europe will help mightily in the effort. Our best research suggests that the global outlook bottoms sometime in the second half of the year and turns up from there. That will be the inflection point where foreign crisis risk eases and US stocks realign with the outlook for the domestic economy. We could see a fairly sharp “relief rally” when this happens. We will also likely see a reversal in some of the leaders and laggards in the US stock market. CHANGING LEADERSHIP As global growth slowed companies in the more defensive, less cyclical sectors of the US economy naturally gained investors’ favor. Staples, healthcare and telecom shares have all bested the broad market year-to-date. When the global growth picture improves, these sectors’ defensive characteristics will prove less appealing. This is why the US stock market has liked a weaker US dollar of late: It indicates strength abroad rather than weakness at home. In 2013 and 2014, the market focused on the beneficial effects of falling oil prices on US consumption. Slowing global growth has also brought falling oil prices and with them weakness in energy shares, whose prices follow that of oil. When the global picture starts to improve, the energy sector could come back into favor as oil prices stabilize and begin to rise, albeit slowly and from very low levels. Since December, that focus has shifted abruptly to the destabilizing effects of plunging oil prices on foreign economies and the resulting higher risk of financial crisis. If a weaker dollar signals improvement abroad, it also signals reduced risk of foreign financial crisis. And that is what US stocks like about a weaker dollar. Also, as discussed above, when global growth turns up the US dollar should weaken relative to foreign currencies. When this happens, the currency translation effects that hurt firms with high foreign sales will start to help them. This should benefit large, multinational firms, many of which have lagged in recent months. WHAT WE’RE DOING This inflection point we foresee, however, could be months in the future. A lot can happen before we get there. Whether we have a financial crisis abroad, we obviously don’t know. But until the global outlook improves, the risks of such a crisis remain elevated. We took in sail in January because we believed the US stock market had begun overlooking strength at home and worrying about weakness abroad. We will maintain that neutral posture on stocks until we see signs of the global picture improving. Farnum Brown Chief Strategist Arjuna Capital | 353 West Main Street, Durham, NC 27701 | p: 919.794.4794 WW W .A R JU N A - C AP I T A L. C O M