3Q 2015 Market Commentary

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Market Commentary
By The Deighan Team

It has been a rough third quarter for the financial markets. The S&P 500 dropped more than 6%. The Stoxx Europe 600 dropped more than 8% and the Shanghai Composite lost nearly 30% of its value. As we move into the holiday season, it is hard to have a sense of Thanksgiving for these third quarter numbers. At first blush, these numbers seem frightening because we fear that they reflect a weak world economy. However, they are more indicative of economic transitions than of real economic weakness. China is transitioning from a manufacturing and export driven economy to a service based one, in much the same way the United States transitioned in the twentieth century. That has spooked investors who fear that Chinese growth will more resemble our own in the future than the blistering 10% annual growth of the past. The US is also in its own transition. The Federal Reserve has indicated it intends to raise rates this year from the near zero rate set in 2008. Fearful of that change, US investors have pulled back. European investors, still dovish after the uncertainties of the Greek debt crisis, also tightened their belts.

As we discussed in our Second Quarter Market Commentary, Chinese economic growth has been slowing. In the second quarter, Chinese GDP growth fell from 10% to 7%. The International Monetary Fund forecasted Chinese GDP growth to slow even further to 6.3% by 2016. Investors began to look behind the curtain. What they saw was an evolving economy. China had been propelled to economic prominence by cheap labor and manufacturing costs and a weak yuan making China an export powerhouse. However, the influx of capital this brought began to slowly grow the Chinese middle class and improve the standard of living and with that came increased labor costs. With a burgeoning middle class, China began to transition, like western countries have, from a manufacturing to a service based economy. Investors, fearful that flagging Chinese economic growth would substantially reduce their gains, began to sell.

On July 27, the Shanghai Composite Index (SHCOMP) fell 8.5%. Since June, the composite has fallen more than 27%. On August 11th, the Chinese government introduced a new currency trading system ceding some control back to the market in an effort to devalue the yuan and stabilize the market. However, this caused a steep drop in the value of the yuan as investors worried that the move was indicative of troubles to come. The US dollar appreciated by almost 3% against the yuan between August 11th and August 13th. Another sharp fall in the Shanghai composite followed on August 18th with the composite dropping some 6.2%. The SHCOMP ended the quarter down 28.63%. However, the SHCOMP does not necessarily reflect the overall health of the Chinese economy. Yearly GDP growth of 6%+ is still double what we have seen in the US in the past decade. Moreover, with more than a billion people, there is sure to be ample opportunity for business in China in the future.

Investors in the US, the world’s largest economy, had been hopeful that dropping oil prices, continued employment growth, corporate mergers and acquisitions, share buyback programs, and low interest rates would turn the tide of falling corporate revenues and marginal earnings growth. This hope kept the S&P 500 tracking upward, though this upward trend was driven by only a few companies. The severe downturn in China was enough to undermine these hopes and send US markets into a correction. Though US stocks began to rebound, uncertainty over the future of the federal funds rate hampered growth.

Fed officials in June estimated they would raise the short-term federal-funds rate from near zero to 1.625% by the end of 2016 and to 2.875% by the end of 2017. However, due in large part to the market turmoil overseas, the Federal Reserve declined to move interest rates in July. In August and September, the Fed again declined to raise rates, citing weak inflation and slowing jobs growth. Jobs growth in September was a paltry 142,000, down from 173,000 in August. The average for the year is 198,000 per month. Personal consumption expenditures increased only 0.4% in July and August. August marked the 40th consecutive month the measure has run below the Fed’s target. In an interview with CNBC, former Fed Chairman Ben Bernanke, who presided over the Fed during the great recession, said of the Fed’s reluctance to raise rates, “easy money is justified by the need to get inflation up to target…the goal post was 2 percent inflation. We’re not there yet.” Moreover, central banks in the Eurozone, Sweden, Israel, Canada, South Korea, Australia, Chile and elsewhere have all attempted rate increases since the financial crisis. All have had to retreat. That said, Janet Yellen, Federal Reserve Chair, and William Dudley, president of the Federal Reserve Bank of New York, have both indicated that the Federal Reserve is likely to raise short-term interest rates this year. They recognize the need to raise rates, not only to show investors that incremental increases will not sink the economy, but also to give the Fed some room to act should there be another recession.

Despite indications from the Fed that it intends to slowly back away from its accommodative economic policy, the European Central Bank (EBC) remains committed to its quantitative easing program introduced in the second half of 2014 whereby the bank began buying roughly €60 billion in government bonds per month. Though quantitative easing did weaken the Euro, pushing the euro-dollar exchange rate down to roughly 1.12 from a high of almost 1.40 in early 2014, European growth remains modest. The inflation rate for August was at 0.1%, GDP growth in the second quarter was at 1.5%, and the unemployment rate has remained at above 10% since 2008.

Unlike Europe, low interest rates and accommodative financial policies have seemed to exacerbate issues in emerging markets by encouraging firms to take on more debt, which they may not be able to afford. The International Monetary Fund (IMF) estimates the emerging market corporate debt-to-GDP ratio has grown 26% between 2004 and 2014. The IMF has warned that this combination of poor growth and increasing corporate debt has left emerging markets vulnerable. According to the Institute of International Finance, during the third quarter, investors pulled roughly $40 billion from emerging markets, almost evenly divided between equities and bonds. This $40 billion outflow marks the third quarter as the worst single quarter for emerging markets since the fourth quarter of 2008, which saw investors pull roughly $105 billion. Despite this, equities in emerging markets continue to be highly attractive on a relative value basis.

While all eyes are on worldwide equity markets, let’s not forget that bonds can be volatile too. We have written before about the bond fund miseries of the 1970’s to early 1980’s when interest rates on intermediate bonds shot up from normal ranges of 4-5% to abnormally high rates in the low double digits. In response to the high interest rates, most bond funds significantly dropped in value as bond prices have an inverse relationship with interest rates. No one wanted to liquidate bond fund positions at 65 cents on the dollar or worse. Even short-term funds were impacted, and one money market fund lacked the liquidity to make cash payouts for a short period of time. Eventually the bond markets righted themselves, as markets do, but it was a rough few years for the fixed income side of portfolios.

We think it is unlikely that we are poised to repeat that period of stagflation: unemployment is stable; inflation is low; the US economy is chugging along, and the Fed has committed to lead the march toward interest rate normalcy by increasing short-term rates slowly and deliberately. Nevertheless, old lessons die hard, as they should. As one client said recently, “I am not worrying about this because that is what I hired you to do.” We agree. We are “on deck,” and are carefully watching portfolios. However, you can help us to help you by keeping us apprised of your cash needs, especially anticipated large withdrawals. Please call or drop us an email if you expect significant cash needs. In the meantime, enjoy this beautiful Fall season.