Investor Discussions - Q3|2015 Commentary
Wealth & Pension Services Group
Matt B. Bailey, CFA - Portfolio Manager
As the summer months came to a close, the global markets began to show cracks and volatility increased dramatically. Stocks corrected, bonds were weak, and commodity prices continued their previous path, lower. The S&P 500 dropped over 10% from its early summer peak, leaving it in the red on a year-to-date basis through Q3. The international markets weren’t any better and also sold off sharply. Overall, the global recovery appears to have taken a breather; however, most central banks remain committed to their easy money policies which may lead to future growth and higher asset prices.
As predicted, Q2 GDP was much improved over the first quarter’s reading and came in at an annualized real rate of 3.9%, as seen on Chart 1. Pent up demand linked to the harsh winter weather and port strikes was unleashed and drove domestic growth higher.
The labor market continues to improve (Chart 2) as the unemployment rate and underemployment rates now stand at 5.1% and 10.3%, respectively. It’s impressive just how far the economy has come since the 2009 when the unemployment rate stood above 10%. In addition to the unemployment figures, recent data releases linked to new home sales and consumer confidence have been strong and also suggest the economy is healthy.
Looking forward, the U.S. economic outlook remains positive, but has recently begun to show signs of growing tired. The strong U.S. dollar and low energy prices have produced headwinds for many U.S. corporations. These factors, coupled with weak international growth, led to the U.S. Federal Reserve’s (Fed) decision not to raise rates during their September meeting. This was concerning to many pundits who believed the Fed would raise rates this year due to strong domestic growth trends. In addition, many experts cited the Fed’s mention of weakness seen abroad as another concern (historically, the Fed hasn’t focused on the international economic landscape when making rate decisions). Even so, we remain optimistic and think the U.S. recovery will continue into the foreseeable future.
Outside the U.S., the economic picture remains mixed as many regions struggle with sluggish growth and deflationary pressures. Within Europe, growth slowed during the quarter due to fears over a weak Chinese economy. Yet, credit demand remains strong and is typically a good indicator of future growth. Also, the European Central Bank (ECB) continues to utilize their quantitative easing program and has recently said it will increase it if needed. Finally, the issues surrounding Greece seem to have abated for now. This should allow policy makers to focus on how to stimulate economic growth.
Japan continues to muddle along, but has recently experienced a slowdown in manufacturing and exports. Much of the weakness has been blamed on lack of Chinese demand and the recent strengthening of the yen. When a country’s currency strengthens, it effectively makes their goods more expensive and thus less attractive to foreign buyers. Even with all of the negative data, Japans remain in expansionary mode as of its latest manufacturing report.
As we’ve previously notated, the emerging markets and frontier markets continue to struggle. Weak foreign demand, persistently low commodity prices, and capital outflows have all played a part. In addition, the Fed’s recent comments related to slowing global growth have increased uncertainty over their outlook. Looking ahead, countries currently experiencing slow growth such as Brazil and China will likely remain weak.
During the third quarter, U.S. stocks experienced large bouts of volatility and corrected by over 10% for the first time since 2011. The S&P 500 index (large caps) and Russell 2000 index (small caps) finished the quarter down 6.44% and 11.92%, respectively.
Last quarter, we reported that company valuations had reached very high levels and that the markets appeared vulnerable to intermediate-term weakness. In addition, we noted that momentum had started to wane and that risk to the downside outweighed upside potential. These factors along with others were likely catalysts of the recent correction.
Looking ahead, valuations have returned to levels more conducive to positive future returns; however, the technical damage done to the long-term trend is concerning (see Chart 3). This suggests that negative investor sentiment will likely outweigh fundamentals in the near-term and volatility is likely to remain elevated. Nevertheless, our research continues to suggest that an inflection point is approaching (for more information on how we use technical data, please see: Investor Discussions - Technical Analysis. This has the potential to create a great buying opportunity as we approach the fourth quarter (seasonal analysis has shown that Q4 has historically been a favorable time to own stocks).
As shown on Chart 3, the international developed markets also struggled during the quarter. The MSCI EAFE index ended the quarter down 10.23%, as many of its underlying country indexes fell by nearly 20%. Within Europe, countries such as Germany, France, and Spain were hit the hardest. Outside Europe, the Asian-Pacific markets were not spared, as Japan and Australia experienced their own corrections. Although valuations within these markets appear relatively attractive compared to the U.S., many issues remain and their outlook is unclear. In the near term, they will likely trade in line with the U.S. markets as they attempt to find direction.
Emerging Market (EM) and Frontier Market (FM) equities, as represented by the MSCI EM index and MSCI FM Index, finished Q3 down 17.90% and 10.74%, respectively. EM continued its recent struggles and sold off violently during the quarter. Many investors liquidated their exposure due to fears of slowing Chinese growth and other lingering issues. On a positive note, the frontier markets have been performing relatively well due to the recent stabilization of oil prices. Many Middle Eastern and African nations fall within this market and are highly correlated to the price of oil. Looking ahead, many analysts have predicted that oil prices may move higher over the next 12-18 months and this should bode well for the frontier regions.
Bonds remained top of mind during the quarter, as everyone awaited the Fed’s rate decision. Although many experts expected a rate hike in September, the weakness seen in stocks led to safe-haven bond buying and pushed rates lower. The U.S. 10-year Treasury index (10-yr) finished the quarter down at 2.06%. Lower rates led to the Barclays US Aggregate Bond Index finishing Q3 up by 1.23%. Riskier bonds as represented by the Barclays Corporate High Yield Bond Index ended down 4.86%; however, the Barclays Global Aggregate ex-USD Bond Index finished up 0.64% due to U.S. dollar weakness.
The outlook for bonds is cloudy at best. Interest rates remain at historic lows and are expected to rise as the global economic recovery ensues. Nevertheless, many central banks continue to keep their short-term rates very low and many are buying bonds in the open market (the second action is known as quantitative easing). Either way, the upside for bonds appears limited and it’s our opinion that underweighting them relative to stocks may be a prudent decision.
The commodity market was battered during the quarter even as the U.S. dollar remained relatively flat. The Bloomberg Commodity Index finished down 14.47%, while the U.S. dollar index was up less than a percent. Much of the poor performance was attributed to lower oil and agriculture prices.
Commodities have struggled since mid-2014 (see chart 4) and continue to face significant headwinds including: the potential for further U.S. dollar strength, waning global demand, and oversupplied markets. With that being said, we think oil prices should start to stabilize in the coming quarters. Also, stock market uncertainty has historically led to higher gold prices. Gold is seen by many as a safe-haven currency and tends to do well during volatile periods.
As the end of 2015 quickly approaches, the global markets remain uneasy and volatility is high. Federal Reserve policy continues to garner everyone’s attention and will likely play a major role in the market’s direction over the next few months.
Overall, risk remains high but an inflection point may be nearing. Our long-term view of stocks continues to be positive but with an expectation that volatility is likely to persist. In addition, stocks remain relatively more attractive than bonds due to the increased likelihood of rates rising, and commodities remain in a bear market. Finally, although cash is not paying much, it should be viewed as an effective risk-management tool in today’s highly volatile market environment.
As always, please feel free to contact us with any questions you may have.
William Kring, CFP®, AIF®
Chief Investment Officer
Matt B. Bailey, CFA®, CMT®
Source: Bloomberg.com, Morningstar