Island Light Quarterly Commentary (September 2015)
“Human misery must somewhere have a stop; there is no wind that always blows a storm.” (Euripides)
The third quarter of 2015 in review
Equity markets had their first correction in nearly four years in the third quarter, beginning with a drop of more than 10% in a seven day span in mid-August. Markets immediately recovered nearly half of the losses, but then fell back at quarter end, re-testing the lows set in mid-August, eliminating all gains of the last year and causing investors to revisit their tolerance for risk. The drop in US equity markets appears to have been caused by worries about slowing global growth, particularly in China and other emerging markets, fears of a Fed monetary tightening and the strong dollar’s impact on emerging markets pegged to the US. Other factors that contributed to the general feeling of misery included fears of lower profits in the bio-tech sector from proposed price regulation, a dip in corporate earnings due to wage pressure, the impact of the strong dollar and lower earnings in the energy sector.
Fixed income markets were positive in the quarter, as the Fed did not raise interest rates as expected at quarter end, and intermediate and long term rates dropped. The Fed cited a lack of inflation, trending around 1.5% in 2015, caused in part by low oil and commodities price and non-US factors for its retreat from previous statements. Longer-duration treasuries benefited as the ten-year interest rate on treasuries dropped to 2.06%.
While equity markets weakened and fixed income increased on the bad news, the latest market movement does not mean that the end is near or that we’re facing another recession. A falling stock market will damage confidence, but most people are not harmed by short-term declines in their investment portfolios. Our view is that the US economy is in pretty good shape, not growing rapidly, but still growing. We note that recovery often follows market corrections and that fundamentals remain solid. We expect that the storm winds of August should abate and that markets will recover, although we will not be surprised if this takes some time.
Domestic equities were punished by a quick succession of price corrections as the S&P 500 dropped 6.4% for the quarter, giving up all its gains for the year and returning a year-to-date (YTD) loss of 5.3%. Growth stocks outperformed value stocks by 3.5% for the quarter, continuing a multi-year trend. Mid and small cap stocks dropped even more, as the Russell 2000 small cap index fell -11.9% for the quarter (-7.7% YTD) and the Russell 800 MidCap Index dropped -8.0% (-5.8% YTD).
All sectors of the S&P 500 fell in the quarter, with the exception of utilities, and all sectors except consumer discretionary are off for the year. Energy and Materials are the worst performing sectors, reflecting the impact of low oil and commodities prices, while consumer-driven sectors (staples, discretionary, healthcare) posted better returns. US REITs had positive performance for the quarter and are off modestly for the year.
Fears of a decline in earnings are offset by hopes for future earnings growth. While FactSet estimates that earnings will be down consecutive quarters this year, dropping -4.5% year-over-year in quarter 3, the S&P expects earnings to grow materially (33%) over the next six quarters. We expect that the drop in oil should manifest in better earnings for sectors that benefit from lower materials cost (industrials/utilities) and from increased consumer spending (consumer discretionary).
The compounded annual rate of change in US GDP increased in the second quarter to 3.9%, a positive sign for the economy. According to the Bureau of Labor Statistics, non-farm payroll employment is up 173,000 in August and unemployment is down to 5.1%. The unemployment rate for workers who have been unemployed for more than 27 weeks remained at 28% of the total unemployed and the number of discouraged workers is falling. This encouraging albeit slow growth in employment figures indicates that companies in the US are optimistic for the future.
Non-US markets also dropped significantly in the third quarter, with the MSCI All Country World Index ex-US off 9.5% in dollar terms. In dollar terms, developed markets (MSCI EAFE) fared somewhat better, than emerging markets (MSCI EM). Lower demand for oil and other commodities combined with dollar strength caused a plunge in those emerging markets that peg their currencies to the greenback.
At the beginning of 2015, US investors piled into foreign stocks, anticipating European and Japanese monetary stimulus. Investors were rewarded with above average returns in both dollar and local currency terms.
Easy monetary policy translated into modest economic growth, with the European Union GDP returning 1.9% year-over-year in the second quarter and Japanese GDP returning 0.8% year-over-year. However, both major regions equity markets returned to earth in the third quarter as the concerns that brought about a US drop (slowing global economic growth, China woes, uncertainty brought on by Fed) impacted market sentiment.
Geo-political issues that contributed to market uncertainty did not help European markets as Russia remained mired in an undeclared war in the Ukraine and an influx of refugees from the Middle East dominated the headlines. This uncertainty leads to a drag on markets and on economic growth as it appears safer to sit on the sideline, awaiting further developments. From here, we should expect some European and Japanese recovery in equity markets, as the contagion from emerging markets growth should be low. European equities outperformed their Asian counterparts.
China merits its own discussion. Much of the market turmoil comes from dismay about the Chinese economy. Investors do not believe government statistics of 7.0% GDP growth and fear that an economic slowdown is greater than it appears. Chinese government actions to stimulate the economy and support the stock market have been met with indifference, although powerful fiscal and monetary tools remain at their disposal, including huge foreign exchange reserves. The effort to devalue the yuan in August was certainly a contributing factor for the market demise in the third quarter. Signs of a slowdown abound, from manufacturing (the China Caixin Manufacturing Index dropped below 50 in March and ended at 47.2 in September (below 50 is considered contraction). Light vehicle sales dropped to 2014 levels, housing starts dropped 18% and exports and imports fell more than 5% and 10% respectively. The decrease in productivity has weighed heavily on not only China but also countries that rely heavily on China for trade, including Korea, Japan and other emerging markets such as Brazil.
Fixed Income, Interest Rates and the Dollar
Interest rates dropped to lower levels in the third quarter as investors sought the safe haven of the US Treasury. The Federal Reserve maintained its zero-interest rate policy. Short-term interest rates remained near zero while the 10 year Treasury rate dropped from 2.4% at the end of the June to 2.06% at the end of September, causing Treasury prices to rise. Credit spreads also widened, hurting high yield and corporate bonds, as concerns about fixed income liquidity manifested itself in lower prices, particularly in the energy sector. The longest duration US Treasury securities, which were up nearly 9% through January before falling -16% for the next five months, recovered 5.3% in the third quarter to end September essentially unchanged for the year, off -0.2%. The core US Aggregate Bond Index also recovered from second quarter losses and finished 1.2% for the quarter and 1.1% YTD.
At the beginning of the quarter, most analysts assumed that the Fed would raise the Federal Funds target rate from 0.25% to 0.50% in September. However the plunge in equity markets caused the Fed to blink. The flip-flop in Fed policy increased uncertainty in the marketplace and created new volatility. It appears more certain that the market will welcome a rate increase as an indicator of US economic strength. Some speculate that the zero-interest rate policy of the Fed is having a negative economic effect. Bill Gross of Janus, in his market commentary of September 23 argues that the zero interest rate policy “destroys existing business models such as life insurance company balance sheets and pension funds, which in turn are expected to use the proceeds to pay benefits for an aging boomer society.” Further, “Zero bound interest rates destroy the savings function of capitalism”. We agree that such low interest rates punish savings and distort normal business activity. For now, it is anybody’s guess what the Fed will do, despite Janet Yellen’s comments in late September making the case, again, for a rate increase this year.
We also witnessed a rapid widening of option-adjusted credit spreads from 1.4% to 1.8% in the third quarter to their highest levels in three years (BAML US Corporate Master). Credit spreads are the additional yield above Treasuries an investor can earn from corporate bonds due to their higher risk and wider credit spreads hurt the returns of all credit instruments. The widening of spreads can be attributed primarily to woes in the energy sector, as lower oil prices are having a material negative effect on corporate earnings and influencing energy companies’ ability to pay back or refinance debt.
Overseas developed market fixed income performance was also generally positive, with falling interest rates in the quarter. The German Bund 10 year yield fell 20 basis points (0.20%) to 0.6% for the quarter and the Japanese Government Bond 10 year yield dropped from 0.5% to 0.3%. Both the European Central Bank and the Bank of Japan maintained their quantitative easing programs. The Chinese Government dropped the Chinese official lending rate to 4.6%, another record low.
The spread and direction of foreign and US interest rates continue to impact the US dollar. The dollar’s continued strength is indicative of the policy differences between the US, where we expect rates to increase with a growing economy, and Europe and Japan, who are stimulating monetary policy. When and if the US raises rates, we expect that US fixed income instruments of longer duration will suffer more.
While global equity markets have fallen off significantly, our longer term views on the equity markets remain in place. We believe that this fall-off is a temporary market correction in a bull market that is in its sixth year. Since World War II, the average bull market has lasted nearly nine years and the longest ran more than 12 years from 1988 to 2000. Reasons to be optimistic include; a continuation of the US economic expansion (GDP growing at 2.5% or so), expanding corporate earnings both in the US and in Europe, a benign credit environment, and an increase in consumer disposable income as lower unemployment and low oil prices are reflected in the larger economy. On the flip side, exogenous shocks such as a flare-up in the Middle East, decelerating Chinese demand and debt and currency pressures in emerging markets related to the strong dollar could act as a drag on equity growth. Fears of a China contagion are, we believe, somewhat overblown, as the Chinese government has a variety of tools at their disposal to right the economic ship.
From a valuation perspective, US equities are now more attractive on a variety of measures. The earnings drop may be temporary should oil prices and the dollar stabilize or reverse direction. The real dividend yield of equities is also favorable when compared to the real yield on fixed income. We think that people are not recognizing current earnings growth, which could be favorable in this quarter and in 2016. In any event, we remain overweight the US relative to non-US equities and are not far from our target stock/bond ratios.
When the Fed elected to keep the federal funds rate unchanged on September 17th, it cited international economic stability and its impact on US inflation. If the Fed is worried about overseas activity, then so should investors be worried. While we are listening to the Fed, we believe that developed markets are fairly valued and below long-term average valuations. While earnings have been disappointing, we expect some of the factors driving weak earnings to be temporary. We are not so sanguine about emerging markets, as we have outlined above.
There are certainly indications that markets may be in for a rough patch, and some of our technical indicators show current assets at higher risk levels. We may indeed become somewhat more defensive in our tactical portfolios in order to ride out the current volatility, as we did during the third quarter, but we suspect that positive earnings in the upcoming quarter will help US equity growth. Overseas developed market economies should improve as monetary stimulus, low commodity prices, and weak local currencies will help export-dependent economies. We fear, however, that emerging markets may well continue to drag non-US performance. Here, commodities weakness and a strong dollar have more negative impact than in developed economies. Fixed income may benefit from the recent widening of credit spreads, which we do not expect to continue (except in energy), as yield hungry investors seek out the new, higher returns from risky bonds. Markets often over-react to good and bad news and today, the dominant emotion of the markets is fear of the future. Clever investors may use this pull back to rebalance their portfolios to take advantage of new opportunities. While investment risk is back in the markets (as if it ever left), we believe that diversification of global assets remains the best method for ensuring long term stability and consistent growth of assets.
Matthew V. Pierce, President
October 6, 2015