The third quarter of 2015 was the worst quarter for equity asset classes since 2011, as expectations of deflation and a global slowdown possibly turning into a recession increased. The third quarter was strong for bonds around the world as interest rates declined.
For the broad market indices at the end of the third quarter of 2015, REITs performed much better than other equity classes, which is expected as real estate companies use a great amount of debt and variable borrowing costs decline when rates decline and returns increase. Stocks in the U.S. declined substantially, but were better than international developed stocks, which were down more than 10%. Emerging market stocks suffered the most as commodities declined and local currencies weakened against the U.S. dollar. Emerging Market mutual fund flows were negative $828 million for the last two weeks of September but a positive $936 million during the first week of October and the MSCI Emerging Markets Index gained 6.9% during the first full week of October.
In reviewing selected headlines during the third quarter, there were many positive stories about the U.S. economy while market participants dealt with declining bond yields, much lower commodity prices and forecasts of slower global growth.
Fixed Income markets during the third quarter were strong for high quality bonds as yields declined across all maturities, except the very short end, which is anchored at zero. The yield on the 5 year Treasury note dropped 25 basis points to end the quarter at 1.38%. The yield on the 10 year Treasury note dropped 27 basis points to end the quarter at 2.06%. Even the 30 year bond dropped 22 basis points to end the quarter at 2.88%. This parallel shift down in the yield curve is a flight to quality into safe bonds and away from the more volatile asset classes. The U.S. Aggregate Bond Index is positive for 2015 and the Long US Government Bond Index now has moved back to a positive return for the year. High Yield bonds are negative for the past year due to widening spreads over high quality bonds. This is a concern because much of the growth in jobs is funded from the high yield sector and it is now more expensive for smaller companies to issue debt to fund growth. We will take a deeper look at high yield bond spreads with the chart in the next section.
A Deeper Look
During the third week of August, LTWM sent out a client communication to help explain the sudden jump in volatility and decline in stock prices around the globe. We pointed to the breakdown in China’s stock market and a lack of effective policy response, the expectation of the start of the Federal Reserve tightening cycle (moving from zero short term rates), and high asset valuations. The S&P 500 index low on August 25th was tested on September 28th and the index did not set a new low. Equity markets are now moving higher off this base of support. Outside of the U.S., Euro area stocks were hit hard in September with another announcement of weaker than expected commodity demand from China (a major trading partner) at the same time that one of the most respected large cap companies in Europe, VW, admitted to cheating on clean diesel emissions tests. The crash in China’s stock market has stabilized as new government policies have reduced volatility. The Shanghai Stock Exchange (in blue) is now trading in line with the S&P 500 (in red), after its wild ride of up 60% this year and crash down to -10%. The Shanghai Index has now moved up to positive 1.64% (year to date price chart from Yahoo Finance).
Although China is an important manufacturing center and has the second largest economy in the world, as measured by GDP, the total Chinese stock market is a fraction of the size of the U.S., which represents just over 50% of the total global market cap. China’s stock market may not be an accurate barometer of China’s economy and now it appears investors have turned their attention away from China and toward third quarter earnings season for an indication of global economic health.
The Federal Reserve apparently disappointed many analysts and investors with their decision not to raise short term rates off of zero for the first time as expected in September. One interpretation of the Fed's communication is it introduced another level of uncertainly concerning the global growth story. The forces of deflation or declining prices strengthened around the world during the third quarter, much of it due to the lower price of energy and other commodities, which declined again. The much lower price of oil is good for energy consuming nations and not so good for energy producing nations. The U.S. economy, as an energy consuming nation, continues to do well with strong consumer spending. Retail sales, especially restaurant sales are up 8% year over year, which is a good short term indicator of the strength of the American consumer and a likely destination for savings from lower gas prices. A more intermediate term measure of the U.S. consumer is auto sales, which are also setting new highs since the last recession. The seasonal adjusted annual rate is expected to be above 18 million units in 2016, a nice jump up from the recent August average of 17.1 million units and the 16.4 million units sold in 2014. A longer term measure of consumer health is new home sales since a home purchase requires a much higher level of confidence than buying a car. New home sales transactions and raw units are strong year to date and new construction is also showing no sign of weakness. Offsetting the strong consumer are weak exports due to the strength of the dollar and weak overseas demand. Weaker global demand and significantly lower oil prices are negatively affecting corporate revenue growth. This may have impacted the latest jobs report, which was weaker than expected.
Analysts have also pointed to an increased savings rate as the destination of more disposable income from lower gas prices. The personal savings rate, is measured by the Bureau of Economic Analysis as personal disposable income minus personal consumption expenditures divided by personal disposable income. When U.S. consumers save more, less is available for consumption. There was a spike in the savings rate in the first few months of 2015 while few wanted to brave the harsh winter and the savings rate reached levels above 5%. It has since moved down to the mid four percent range. We believe this to be balanced level of savings and expect continued strong consumer spending. The following chart is available at (https;//research.stlouisfed.org/fred2/series/PSAVERT )
A useful chart to determine the beginning of a recession (in combination with other data points) is the 4 week moving average of initial unemployment claims. The chart shows an upward turn in unemployment claims prior to each past recession (the shaded areas).
This chart has a strong trend line down and is now at a level of jobless claims below the lowest levels of 2006.
Another item to look at for reduced economic risk taking is a widening high yield spread and the increasing trend line since last summer is a concern since a higher spread makes it more expensive for smaller companies to borrow. However, the current spread of 6.52% is well below the 9% peak during the European debt crisis of October 2011. The increase in the spread over the last year does coincide with the drop in oil prices and the highest spreads are contained within the energy sector’s non-investment grade bonds.
In addition to the spread between high quality and junk bonds, the yield curve can indicate trouble if it starts to flatten across different maturities. Currently, the yield curve is steep, although it has moved down across all maturities, except the very short end of the curve.
While nominal yields have moved down (top two lines), real yields have moved up over the last quarter. This is because inflation expectations have declined due to the falling prices of commodities (oil) and the reduction in global growth expectations. The curve is far from inverted, where short term rates are higher than long term rates, which has been used in the past as a leading indicator of a U.S. recession.
The real question to answer is if the current decline in stock prices is the long awaited bull market correction of 10%, which is now behind us, or the start of a bear market with a recession looming. Given the support of Central Banks around the globe, the positive slope of the yield curve and the employment rate in the U.S., it is difficult to consider the recent price volatility the start of a bear market. With that said, we also like to look at the value we are receiving in the market by examining asset valuations. In all measures, asset price valuations have come down from recent highs. The P/E 10 or Shiller CAPE ratio, which smooths earnings over a 10 year period, is now 59% above its geometric mean, down from 75% last quarter. The latest analysis can be viewed at http://www.advisorperspectives.com/dshort/updates/PE-Ratios-and-Market-Valuation.php. The problem with the PE10 or CAPE ratio is that it has very little predictive power in the short term. The least corporate manipulated data point is the price to sales ratio (or the S&P 500 market cap to revenue). This ratio is now 1.6, down from a decade high of 1.79, and still above the mean of 1.4, see http://www.multpl.com/s-p-500-price-to-sales. The value of stocks is certainly better in Europe and Emerging Markets than the U.S. and a great map to view this is at: http://www.starcapital.de/research/stockmarketvaluation
Attention is moving back to third quarter earnings and the outlook from public corporations. There is some concern over revenue as current expectations call for the third consecutive quarter of negative corporate earnings growth as companies in the S&P 500 are about to provide third quarter results. Here is the data for the four quarters of 2015 from Factset (courtesy of CNBC) for S&P 500 revenue growth:
Q1: down 2.9%
Q2: down 3.4%
Q3 (estimate): down 3.3%
Q4 (estimate): down 1.4%
The last time we had four quarters of negative earnings growth was the 2008-2009 financial crisis. Although, the strong dollar and steep drop in the price of oil explains a lot of the drop in corporate revenue growth. If we see a strong Q3 earnings season and movement in Q4 estimates up above zero, the fear associated with declining global growth will abate substantially.
Lake Tahoe Wealth Management is still cautious due to equity valuations but optimistic about the U.S. consumer. Although Central Banks have reduced options for stimulus in this low inflation environment, we do believe that Central Banks can continue to support the current below trend but positive GDP growth rate. However, as the Central Bankers themselves have pointed out, Monetary Policy can only go so far; and it is Governments around the world who have failed with their lack of Fiscal reform and policy.
While asset valuations are still elevated from historical levels, they are down from recent highs and supported by low interest rates. Central Banks have shown resolve to do whatever it takes to beat deflationary pressures. It is very difficult to have a global recession when the U.S. consumer is doing so well, and anecdotal stories of Chinese consumer behavior show they have no worry of a recession in China. We are watching the European Central Bank (ECB), Bank of England (BOE), People’s Bank of China (PBOC), the Bank of Japan (BOJ) and Federal Reserve closely as the lenders of last resort and providers of liquidity to the global financial system. The Federal Reserve is expected to raise rates off of zero at some point in the next 6 months based on U.S. economic strength but will likely keep the zero interest rate policy in place until the data points to diminished forces of deflation.
1. Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2014, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2014, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2013 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2014 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
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