Peter C Thoms, CFA
There is no use trying to sugarcoat it. Stock markets around the world took a beating in the third quarter. In fact, it was the worst quarter for stocks overall in four years, since the depth of the Euro crisis in 2011. The S&P 500 lost 6.9% in the quarter and the Dow Industrials lost 7.6%. On a year-to-date basis, the S&P 500 was down 6.7% by quarter-end and the Dow was down 8.6%. U.S. stocks are basically at their lowest levels in two years. European stocks have fared better so far this year, with the Stoxx Europe 600 Index still in the green for the year by 1.5%. Japans Nikkei is about flat year-to-date, and while Chinas Shanghai Composite lost 29% in the quarter, it is still only down 5.6% for the year. And all this happened while the U.S. economy continues to exhibit solid underlying fundamentals. Essentially, this was the stock market correction imported from China.
Despite the fact that bonds in general are already expensive by historical measures and that the Fed is on the verge of beginning a tightening cycle, high-grade U.S. bonds still managed to gain ground in the quarter as spooked equity investors scurried to the safer asset class. The 10-year Treasury yield fell to 2.04% from 2.33% at the start of the quarter, a meaningful drop in yield (and increase in price). High yield (junk) bonds suffered as the flight to quality pushed their yields up from 6.5% to 8.0% during the quarter.
U.S. stocks, after a strong start to October, are hovering about 7% below their all-time highs reached in May. At its recent low in August, the S&P 500 Index was down 12% from its May high. Declines of 10%, while unpleasant, are nothing extraordinary for stocks. In fact, there have been 33 10% (or more) declines since 1950. Recent years have been unusual for their lack of volatility, as it has been four years since the last 10% decline.
There were three main reasons for the markets poor showing in the quarter:
- Slowing growth, market volatility and currency depreciation in China
- A rout in the price of oil and other commodities
- Hand-wringing about the Feds decision not to hike rates in September
The world is trying to come to grips with the true pace of the slowdown in China and its economic implications. Authorities there have tried to tame market volatility with a variety of measures, but so far have been relatively unsuccessful; their failed efforts have sparked even more nervousness. Countries that ship a large percentage of their raw materials to China (such as Brazil and Australia) are certainly going to feel some pain as China slows and commodity prices decline. But here in the U.S., where we are mostly a consumer of goods manufactured in China, a lower Yuan means cheaper goods from China. It is also notable that China trade accounts for only about 7.5% of U.S. exports and about 1% of our gross domestic product (GDP). We buy a lot more from China than they buy from us.
Oil and other commodities tumbled during the quarter due to fears about the waning resource appetite in China and the glut of oil due to the continued strong pumping by both U.S. drillers and OPEC. Oil declined from $60 per barrel at the start of the quarter to $45 at the end. Crude oil production in the U.S., while still high by historical standards, appears to have peaked in April and has been declining since. Nevertheless, global oil supplies are expected to keep growing into 2016, potentially putting more pressure on prices.
Despite this quarters turmoil in the equity markets, the U.S. economy still appears to be relatively firm. In fact, if you were just monitoring U.S. economic data and had no way to check stocks prices, you would probably be of the mind that the U.S. has made solid economic progress in 2015. And you would be right. GDP growth in the second quarter was recently revised higher, to 3.7%. The employment picture in the U.S. continues to be solid. Job adds of 149,000 in September were a mild disappointment, however, but they were likely weak due to companies putting a brief freeze on hiring as they waited out the China-inspired market volatility. The unemployment rate was 5.1% in September versus 5.9% a year ago.
While much of the world struggles with growth challenges, the U.S. remains on relatively strong economic footing. Stocks continue to trade at slightly above-average valuations while bonds are fully priced. Earnings growth for the S&P 500 companies has been negative for the last two quarters, but it is mostly falling earnings in the energy and mining sectors that have driven the decline. The biggest driver of our economy, the U.S. consumer (who accounts for 70% of our GDP), continues to benefit from a stronger dollar (which lowers the cost of imported goods) and lower energy prices. There is not yet much evidence that consumers are recycling their savings back into the economy, however. Many are choosing to strengthen their own balance sheets by paying down debt.
Given that the global growth outlook remains challenged, it would not be surprising if some of that weakness were to bleed over into the U.S. economy in the coming months. Notwithstanding an uneven global economy, U.S. companies continue to be in very good financial shape.
Please do not hesitate to contact me if there is anything about the markets you would like to discuss.
Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619-435-1701 Fax: 619-435-1706