Market Data for the quarter ended September 30, 2015:
• S&P 500 Stock Index: 1920, down 6.9%
• Ten-year Treasury Note Yield: 2.06%, down 0.28%
• Gold: $1,115 per ounce, down 5.3%
• Oil: $45 per barrel, down 23.7%
Global and American stocks experienced elevated levels of volatility and downward pressure in the third quarter of 2015. Economically sensitive shares such as those of industrial, automotive and commodity firms were sold particularly hard. The driving factors were twofold: 1) The Chinese economy, which has been the largest single driver of global growth over the past decade, has rapidly decelerated, and 2) the U.S. Federal Reserve appears intent on raising overnight interest rates, which would likely weaken the American and global economies. With the prospect of slower economic growth, long-term interest rates were suppressed along with stocks, while commodity prices deteriorated substantially across the board.
For much of the preceding decade China has been the driver of global economic growth. It rapidly industrialized to meet the world’s demand for cheap consumer goods and build a modern infrastructure for its own economy. Recently, however demand for its goods has weakened in the face of subdued growth in the economies of the developed world, e.g. the US, Canada, Australia, Western Europe, and Japan. Additionally, its rapid building of infrastructure was taken too far, resulting in massive overcapacity and a heavy load of debt. The net result has been a significant slowdown in the Chinese economy, putting a strain on countries and industries that have helped fuel its growth.
Particularly hard hit have been suppliers to China, such as emerging market economies, energy and mining firms, and the industrial companies that supply miners and oil drillers. There currently exists a glut of raw materials on the global economy, ranging from oil, to copper, iron ore and fertilizer. This glut, along with Chinese manufacturing overcapacity, imposes serious deflationary forces on the global economy. As we have discussed before, deflation, i.e. lower prices for goods and services, although seemingly benign, is dangerous because it weakens consumer demand, pressures corporate profits and wages, and increases the burden of debt.
The threat of deflation brings the monetary policy of the U.S. Federal Reserve into focus. In response to the financial crisis and recession of 2008-09, the Federal Reserve has maintained overnight interest rates at nearly 0% in order to stimulate the U.S. economy and support financial markets. While the U.S. economy has moderately improved, and financial markets have substantially recovered, wage growth and inflation have remained weak, with inflation remaining well below the Federal Reserve’s stated target of 2%. (The latest reading of annual inflation was 0.3%). Despite the Federal Reserve failing to achieve their inflation target of 2%, they state that they are keen to raise overnight interest rates. Although they balked at doing so at their most recent meeting citing global financial market volatility, they insist that an increase in overnight interest rates will take place before the end of the current year. This apparent enthusiasm for raising interest rates is a distinct negative for the U.S. and global economies because it signals that the Federal Reserve is comfortable with inflation levels that dangerously border on deflation.
There is little visibility on how the China and Federal Reserve issues will resolve themselves, and as such, we would expect continued market volatility. While shares in commodity and industrial companies have been sold down to, and in some cases beyond historically attractive valuations, we anticipate the possibility of further weakness in the near term. On a longer-term basis, however, we expect financially sound firms to pull through and produce above average returns from today’s deeply depressed levels.
An additional concern in the near term is the possibility of yet another shutdown of the federal government, and, more ominously, the threat of the U.S. defaulting on its debt due to a failure by the Congress to raise the federal debt ceiling. While the resignation of House Speaker John Boehner at the end of October makes the possibility of an imminent government shutdown less likely, the issue will likely be revisited before 2015 draws to a close along with a potential crisis over the raising of the federal debt ceiling. Such political drama has always been a negative for stocks, and we so no reason why this iteration will be any different.
For the remainder of the year we see the US stock market, as represented by the S&P 500 stock index, to trade in a range of 2050 to 1800. The index closed the third quarter at 1920. As always, we appreciate the confidence you have placed in us and please do not hesitate to contact us with any question or concerns.