A Difficult Quarter (and an understated title)
October 13, 2015 byJustin Sautter
For many reasons it is nice to say Happy October! A very difficult Third Quarter is behind us and the Fourth Quarter is off to a resilient start. As of this writing, markets are nearly back to even for the year after big losses in the recently ended quarter. While this is certainly good news, it is instructive to understand how the different asset classes fared and what the key causes of weakness were in the period.
*Source: JP Morgan GTM 4Q2015
| Fixed Income||1.1%|
|High Yield Bonds||-1.9%|
|U.S. Large Cap||-5.3%|
|U.S. Small Cap||-7.7%|
|A typically diversified asset allocation portfolio returned ||-4.4% |
Root causes of the weakness and the bottom line:
Bottom Line: 1) While we do not necessarily believe the numbers coming out of China regarding the slowing of its economy, the situation is controllable by the government. 2) The exposure of developed economies such as the U.S., Europe and Japan to the Chinese economy is not large (not so for more commodity exposed countries like Australia and Canada). 3) Emerging markets and countries tied closely to China like Taiwan will feel the brunt of the slowdown but this is not likely to cause a global meltdown.
Cause: The Federal Reserve
Bottom Line: 1) Markets hate uncertainty. 2) Lack of a rate rise in September and the focus on China and Emerging economies clouded the Feds message, added to uncertainty and caused turmoil in securities markets. 3) An initial 2015 rate hike and several more in 2016 remains possible. If the Fed can clarify its intent it will go a long way towards reducing volatility.
Cause: Energy Sector Weakness
Bottom Line: 1) Oil was over $100 a barrel in the spring of 2014 and is now below $50. The drag on earnings created by this has been large and has negatively impacted the domestic fixed income and equity markets. 2) The equilibrium price of oil is likely above $50 and if 2016 gives us flat or appreciating oil prices then earnings from related companies will rebound, a potential positive catalyst for markets in Q4 and 2016.
Cause: The U.S. Dollar
Bottom Line: 1) The U.S. dollar is up 17.9% over the last year (as of September 30th). With nearly half of S&P 500 revenues coming from abroad this has hurt exports and earnings and in turn hurt the stock market. 2) So far in October the dollar is lower for the month. 3) The last 3 times the Fed raised interest rates the dollar rose in anticipation and then fell after rates increased. 4) If the dollar eases this quarter and into next year it sets-up the domestic markets for a rebound in earnings, helping valuation. A strong dollar is great if you are travelling abroad but can be awfully tough on your stock portfolio.
So what does this all mean?
A scenario of rate increases and higher earnings augur for investment in equities with a weight towards developed economies until the weak commodity cycle ends (emerging markets are very sensitive to commodity process). U.S. equities still appear attractive and earnings in Europe remain 40% below the 2007 peak indicating there is further room for growth and expansion.
On the fixed income (bond) side of the equation, High Yield sold off quite a bit lately and looks more attractive than Treasuries. However, with the uncertainty surrounding the FED, a diversified approach to Fixed Income still appears to be the best approach at this juncture. A healthy mix of alternatives can also dampen volatility and reduce interest rate risk.
I hope this helps clarify what happened in the quarter and what that might mean for the future. I regularly post investment thoughts on my LinkedIn, Twitter (@JustinSautter), and our Russell Capital blog found at www.russcap.com.