Collapsing crude oil prices have severely shaken investor confidence in the global macroeconomic outlook. But there's more to recent risk-asset market weakness than solely $27 per barrel of crude oil. Anticipated calendar-year 2016 S&P 500 earnings per share have now declined to $122.80 as of Jan. 26 from a much more optimistic $129.30 at the end of third-quarter 2015, representing a 5.0% decline in expected profits in just more than three months.
Furthermore, the forward 12-month price-earnings (P/E) ratio on the S&P 500 has fallen to 15.1x as of Jan. 20 from 16.4x at the end of the third quarter. This dramatic reassessment of prospective corporate earnings and market valuation partially reflects growing investor awareness in late 2015 and into early 2016 that U.S. economic fundamentals may not have been as strong as previously perceived before the Fed began policy normalization at year-end.
There is also growing concern that flat global industrial activity may foreshadow a more worrisome downturn in consumption or possibly even a recession. We have been closely monitoring decelerating industrial activity in the U.S., represented by the near monthly sequential decline in the industrial production index since it peaked at 107.9 in December 2014 (106.0 as of December 2015). Not coincidentally, the industrial downturn followed the interim peak in crude oil at $107 recorded at mid-year 2014.
Although the markets research team at S&P Capital IQ retains our somewhat injured optimism concerning the 2016 outlook for stocks, the global equity market meltdown is clearly sending signals that cannot be ignored. The way we see it, global equities are either close to completing the valuation correction that in hindsight actually commenced in the first quarter of 2015 when the S&P 500 stalled at the 2,130 level at an elevated 18x forward P/E market valuation, or the U.S.--and possibly the global economy--may be heading toward a deflationary recession.
The interplay between average readings of the industrial Purchasing Managers' Index (PMI) and the service sector PMI for the U.S., Europe, and China on a combined basis help address these momentous financial market questions. The average reading of the manufacturing PMI has slipped slightly to 50.4 at year-end from 50.7 in September 2015 when forward earnings expectations for globally focused S&P 500 corporations started to slide.
However, the average services PMI reading for these countries has been stable and much stronger at 54.6-55.4 in the final quarter of 2015, which suggests an overall healthy macroeconomic backdrop for the U.S., Europe, and China. Over the course of 2016, the fate of global risk assets will depend greatly on the more likely outcome between two opposing scenarios. Is depressed global industrial activity signaling a coordinated downturn for major geographic economic regions? Or will continued healthy global consumption soon put an end to the longstanding decline in industrial activity that is contributing to relentless downward pressure on demand for, and the pricing of, raw materials including crude oil?
Perhaps most important to the 2016 market outlook, observe how the average readings of the services PMI have improved to a 54- 56 range since April 2014 from the prior 52-54 that existed between 2012 and 2013. In the current low energy price, post-U.S. quantitative easing economic environment, how the balance of this sub-par but elongated recovery cycle is perceived by investors will depend greatly on the prevailing future range for the aggregated services PMI indicator (54.6 last as of Dec. 2015).