August 25, 2015: We are writing to share our thinking on the past two weeks’ stock and bond market activity, and the wild swings in both stock and bond prices.
As always, we want to base our decisions on an analysis of the future: How might changes in economic growth and policy, both in the U.S. and internationally, affect corporate profits, interest rates, and inflation, and how might these changes affect market valuations? And, in the case of a sudden surge in volatility, we want to know what has changed – and is that change material?
In our Quarter 2, 2015 Economic and Market Outlook, we commented: “While the economic and valuation underpinnings of the U.S. stock market are reasonable, several areas of increased risk are likely to increase day to day volatility…” During August, this increased risk and volatility manifested itself, with a 10.5% decline from its May 20, 2015 high, including a 10% decline from July 31 to August 24. This brought us into an official “correction”, i.e., a drop of 10% or more in market value. Similarly, the Morgan Stanley Europe, Asia, and Far East (EAFE) index lost 11.8% between its May 22, 2015 high and the close on August 24, 2015.
Why the sudden volatility and declines? In our recent Market Outlook we wrote about the effects of an economic slowdown in China, and the unwinding of a very frothy stock market bubble in China that began in mid-June. The Chinese government has put in place a variety of measures to support stock prices, with limited success. After June 30, 2015, oil prices began to decline again, dropping over 30% between June 30, 2015 and August 25, 2015. In a surprise move, China unlinked its currency, the renmimbi, from the U.S. dollar, and let the renmimbi depreciate against the dollar and the Euro. Other countries, including Thailand, Vietnam, and Kazakhstan followed suit, raising at least the possibility of a round of competitive devaluations, which would have a deflationary impact. Investors outside of China put together the evidence of falling oil prices, devaluations, and falling Chinese stock prices and concluded, at least briefly, worldwide economic growth was declining, selling stocks and fleeing to bonds. Selling of stocks intensified on Thursday and Friday, and then peaked on Monday, August 24, 2015 with equity markets down worldwide.
Has anything changed since June that would merit a change in outlook? We don’t think so. We knew that Chinese economic growth is slowing. Depreciation of the renmimbi relative to the dollar is a reasonable response to the dollar’s appreciation relative to the Euro, and has just brought the renmimbi/Euro exchange rate back to early January 2015 levels, which should help to modestly stimulate Chinese exports to the Eurozone. Declines in the price of oil reflect a typical seasonal decrease in oil demand, seen regularly in July, and continuing increases in supply. We do not read this as an indication that worldwide Gross Domestic Product (GDP) growth is falling. A slowdown in China will likely affect its trading partners, but with world economic growth running at a 3% rate, even a fairly significant effect is unlikely to derail global growth. US economic activity is solid, as evidenced by increasing consumer confidence, continuing strong growth in employment, and rising industrial production. Eurozone economic activity is also responding to the significant monetary stimulus of the European Central Bank.
From a valuation perspective, the 10% decline in stock prices from May 20, 2015 through August 24, 2015 has increased the attractiveness of stocks relative to bonds. In spite of this correction and sudden increase in volatility, we remain positive on stocks, and are keeping our current allocation to stocks, although we continue our cautious stance on energy and commodity-related stocks. The stock and bond market volatility may push the time for the first increase in the Federal Fund rate from September to December or possibly early 2016, but it will not eliminate it. The Federal Reserve has indicated that it is closely watching monthly employment and wage growth trends, which have been positive.
As always, we are happy to hear from you with any questions or issues you’d like to discuss. Please do not hesitate to contact your Investment Manager.
The views expressed are those of the authors as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. These views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the authors on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is for informational purposes and should not be construed as a research report.