On behalf of the Altium Investment Committee;
The third quarter of 2015 has come to an end but the same cannot be said for the topic of our last correspondence, stock market volatility. This time the end of the quarter coincides with the sad news of the passing of a great American hero, Lawrence Peter “Yogi” Berra. As our way of paying respects to Yogi’s memory, we’d like to quote him while introducing this quarter’s commentary. He was credited with saying “you can observe a lot by just watching” and you can also hear a lot by just listening. The past weeks have provided ample opportunities to do both watching of economic data and listening to people like Janet Yellen (Chair of the Federal Reserve Board) and President Xi Jinping of China.
The Fed’s decision to leave its benchmark interest rate unchanged (at essentially zero) has added to the list of uncertainties that are contributing to the stock market’s continuing volatility. The September jobs report and the downward revision of both the August and July numbers has likely pushed out an interest rate hike until Dec or early 2016. We heard Ms. Yellen say that the Fed “needed a little more time to assess the impact on the U.S. economy of developments in the international markets”. We assumed that she meant keeping an eye on the weakness in the Chinese and emerging market economies, the strength of U.S. dollar (vs. the major foreign currencies) and the yet to stabilize price of oil and other major commodities. She did give us a few more clues on September 24th , telling us that she didn’t think that the impact of international developments would be enough to prevent the Fed from raising the rate this year (which was enough to provide some temporary relief to the markets), but the ambiguity surrounding how global developments will impact Fed policy remains intact.
The lack of specific guidance on the international front is in sharp contrast to what the Fed has laid out on the domestic side, where it has provided numerical guidance for what it considers full employment and an appropriate inflation rate. The number of jobs created was still strong during the 3rd quarter despite the recent revisions, but the rate of wage growth (which the Fed would like to see at 3-4%) did not improve much since the Federal Reserve’s May meeting (wages grew at an annual rate of 2.4% in August up from 2.3% in May). The rate of inflation on an annual basis (as measured by the personal consumption expenditure (PCE) inflation rate), which the Fed wants to see at 2%, didn’t increase substantially and remains stubbornly below 1.7%.
In late August, the U.S. markets were negatively impacted by the following developments: a stock market crash in Shanghai; evidence of further weakness in the emerging market economies; a continued decline in commodity prices and the Fed’s acknowledgment that what’s happening outside the U.S. is indeed relevant to its decision-making. Prior to this sell off, the majority of market participants were betting on the Fed’s first rate increase in September. Why not? The U.S. economy had reached pretty firm ground, having convincingly shaken off its slow Q1 start and achieved a 3.7% rate of GDP growth in Q2 (this rebound was confirmed recently by the Government’s publication of a “final” estimate for Q2 GDP growth at 3.9%). The rate hike didn’t happen and the markets continue to wrestle with the outlook for Fed policy.
The U.S. stock market’s recent decline has caused a breach of its 4-year uptrend. However, as measured by the S&P 500 Index, the U.S. was the best performer amongst the world stock indices during Q3. Its valuation (as measured by the Shiller CAPE ratio) has come down from in excess of 27 times to a more modest 24 times, but remains high by historical standards. By contrast the emerging market stock markets, which our investment models do have moderate exposure to, performed poorly in Q3 and are at a very depressed historical valuation vs. the S&P 500 (see chart showing relative performance of Emerging Markets (EEM) vs. S&P500 (SPY).
Whether the decline we have experienced in the U.S. stock market is a normal (and overdue according to its history) correction in an on-going secular bull market or the beginning of a more serious bear market remains to be seen, but we think investors can take some comfort in the fact that the U.S. economy is not currently showing signs of entering a recession. Historically, the market has experienced a period of 2 to 6 months of heightened volatility before stabilizing, following a non-recessionary breach.
We often talk about the benefits of portfolio diversification in our quarterly commentaries and want to do so again this quarter given the outperformance of investment grade bonds during the period. This asset class did just what it was supposed to do during a period of stock market decline – it was up, while the stock market was down (see chart below which compares performance of the S&P500 (SPY), Long Treasury bonds (TLT), and Corporate bonds (LQD)). You won’t get rich investing in bonds, particularly in the current low interest environment, but their presence in a portfolio can certainly (and did during Q3) dampen down volatility.
While President Xi didn’t address it publically while he was here, the Shanghai stock market crash and increasing evidence of weakness in the Chinese economy gets a lot of the blame for the decline in U.S. stocks and the delay in Fed’s tightening cycle. But how surprised should we really be by these developments? The Shanghai market, fueled by retail buying on margin which was encouraged by a naïve government, had gone parabolic reaching a peak of 5200 in June, more than a double over 8 months. While this move could be categorized as “too far, too fast, the selloff (the index was down 22% during the 3rd quarter), should not have come as a complete surprise. Evidence of weakness in the Chinese economy had been mounting for 6 months to a year. We have known about the fundamental transition in China from a capital spending (largely on infrastructure) oriented, export-led industrial economy to a more domestic-oriented consumption-led economy as a natural consequence of China’s maturity for some time. This transition is largely driven by the force of inexorable and on-going demographics in China (the middle class in China is expected to grow to 350 million people by 2020 – the Chinese middle class may be larger than the total U.S. population in 5 years), which should not be derailed by a temporary setback in its fledgling stock market.
All eyes remain on the Fed, which is busy “observing a lot just by watching” the data in the U.S. and around the world. While we think the sweet spot for the Fed is to go ahead and initiate the tightening cycle in the near future, we cannot control how these developments will play out. We can however reiterate our investment thesis, which states that maintaining a balanced and diversified portfolio is the best way to manage risk in an uncertain world. We look forward to seeing you again soon and in the meantime, we’ll keep you posted on what we see going on in the markets around the world.
Gregory Slater, CFA, CAP®
Chief Investment Officer
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