OREANDA-NEWS. April 12, 2016. This is the week when the stock market will be forced to confront its fears. After absorbing a first quarter decline of 11 percent, as investors wrestled with growth fears, aided and abetted by a collapse in oil, tighter U.S. monetary policy and downward earnings revisions, stocks valiantly fought their way back to even. Oil rallied on hopes for a supply response to the oversupplied market, the Federal Reserve backed-off its projected rate increase trajectory, even as the economy showed some resiliency and lower earnings were increasingly dismissed as old news that was already discounted. The week ahead will begin to reveal if the stocks have rallied in vain.

Earnings are front and center as reporting season gets underway. The big banks will be the initial focus and their results are not expected to be pretty. It was a moribund first quarter for investment banking and trading, prompting some of the banks to soften the blow by warning of this. It was also a quarter in which hopes for a steeper yield curve and rising net interest margin were once again dashed. And with deterioration in the credit outlook for the energy sector, the results for the banks are not expected to excite. The KBW bank index is down 15 percent year-to-date. Certainly an argument can be made that such a steep decline has left the group undervalued. But such a performance also reflects the reality of the difficult operating conditions in the first quarter.

Earnings Expected to be Down

Overall, earnings are expected to decline by 9 percent, according to Factset, once again led by energy. But if the energy sector is excluded, then the expected decline falls to 4 percent. Investors will also be counting on the usual pattern of actual results turning out to be better than estimates that have been lowered too much. If that pattern holds, then the quarterly decline may more closely approximate 6 percent. Either way, the quarter was not exactly a resounding success.  

What managements have to say about the months ahead will be carefully watched. It is easier to overlook the immediate past if the immediate future looks brighter. And earnings growth is expected to turn positive in the year’s second half. The full year forecast now estimates overall growth of 2 percent, as only energy, materials and telecom end the year in the red.

Will oil and Stocks Continue Their Decline?

It was no coincidence that stocks began to recover in February as oil began to firm. OPEC clearly miscalculated the resiliency of U.S. shale production, which has declined, but not enough (or fast enough) to prevent OPEC from feeling the pain of lower prices. In response it, along with Russia, is attempting to engineer a supply response of its own in the form of a production freeze, and the price of oil has climbed on hopes that a floor has been established. But a freeze is not a cut, and supply continues to exceed demand. The trend in both is moving in the right direction, but an imbalance remains. And Iran is going its own way, at least for now.

These major producers are scheduled to meet next Sunday in Doha to see if agreement on a freeze can be reached. The big question is how much of the recovery in oil since mid-February was attributable to expectations regarding the freeze, and how much of the coincident recovery in stocks was as well? If no agreement is forthcoming from Doha, does oil resume its decline? Do stocks? And even if there is agreement, just how effective will it be in stabilizing prices? OPEC members have a history of exceeding production quotas, and Saudi Arabia is tired of always being the swing producer. In any event, the market will remain oversupplied. And should prices rise, some U.S. shale producers stand ready to come right back into the market at \\$50 a barrel, others at \\$60.

The U.S. Economy Steams Ahead

The U.S. economy has shown some defiance recently in the face of sluggish growth elsewhere. Strong jobs growth and a bounce in manufacturing have reduced fear of a recession looming on the horizon. And the Fed’s dovish turn has alleviated pressure on the dollar. The advance estimate of first quarter GDP growth will not be released for a couple of weeks, but is widely expected to be in the vicinity of just 1.0-1.5 percent. This week we will get the latest projections regarding global growth from the International Monetary Fund (IMF) as its members gather in Washington for its spring meeting.

Managing Director Lagarde has recently warned that the recovery remains “too slow, too fragile and risks to its durability are increasing.” In January, the IMF revised lower its October forecast for 2016 global GDP to 3.4 percent from 3.6 percent. That updated forecast is expected to be lowered once again this week. The U.S. is a relative bright spot. But without some improvement elsewhere, even the U.S. economy will remain lackluster, and so will earnings.

So, the week ahead is full of developments that will test the resolve of equity markets and help to determine their near-term direction.

Important Disclosures:       
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