Stocks returned a solid 1.2% in October, but it was quite a wild ride. At its lowest intraday point, the S&P 500 declined nearly 10% from its prior peak – only to roar back and close the month at another all-time high.
Initially, concerns over slowing global growth sent stocks spiraling downward, precipitated by weak economic data out of the Eurozone and Asia, and a sharp drop in the price of oil. For widely-held technology and energy stocks in particular, the specter of potentially stretched stock valuations also played a role in their October performance. We believe the prospect of growing deflation risks to the global economy, and in particular Europe, gave investors pause and led them to reevaluate their assumptions. Specifically, the assumption that slow but steady global growth would persist, sustained by the main dictum guiding markets over the past few years: when economic data indicates deterioration, global central banks intervene. Later in the month, when central banks did ultimately demonstrate a show of force, investor fears were assuaged and sentiment rebounded.
A number of weak indicators out of Europe rang the initial alarm bells – all the more so as much of the weakness was attributed to Germany, the continent’s largest economy. A widely-followed purchasing managers index suggested the nation’s manufacturing sector retrenched during the month. In addition, German factory orders experienced the largest drop since 2009, falling 5.7% month-over-month in August, while exports declined by 5.8%. Given these readings, it is not surprising that business sentiment in the country has now fallen for five consecutive months. Relatedly, the IMF trimmed its global growth outlook and forecast that the Eurozone has a 30% chance of falling back into recession over the next six months.
We believe investors took the steep drop in oil prices as further signal of declining macroeconomic demand, yet there are also supply factors to consider. U.S. shale production has reached 8.7 million barrels a day, which is a greater than anticipated increase of about an additional million barrels a day versus last year. In addition, Libya has recovered from infrastructure damage faster than anticipated, and production has rebounded. It remains to be seen how OPEC countries, with heightened political differences, will choose to proceed on managing the supply side. Yet for many domestic energy companies still profitable with oil around $80/barrel, we view price stability as more important for them than the absolute price level.
In the latter part of the month, sentiment shifted markedly, and we believe this was once again primarily attributed to policy actions by global central banks. In Europe, the European Central Bank (ECB) began its purchases of covered bonds and also completed its stress testing of the continent’s largest and most systematically important financial institutions. The results of the stress tests appear to have been taken positively by investors. The additional funding required to boost capital to adequate levels for the entire banking system is a rather modest $12 billion. During the month, it was also suggested that the ECB might consider purchases of corporate bonds, which could be a significantly positive development.
Central banks in Asia also followed suit. In a surprise move, the Bank of Japan (BOJ) significantly increased the size of its asset purchase plan. The BOJ is now on a pace to purchase 80 trillion yen in assets annually, up from its prior range of 60-70 trillion yen. Included in this increase is a tripling of its purchases of stocks and property funds. In China, the central bank eased mortgage standards and also made multiple injections of liquidity totaling 700 billion yuan into 25 of the country’s largest banks.
Domestically, we believe that corporate earnings also played a key role in the sentiment shift, as results thus far have come in nicely ahead of expectations. According to Bloomberg, the S&P 500 in aggregate grew earnings 8.8% in the quarter, nearly double the pace of analyst expectations. Moreover, investors appear to have taken comfort in comments by management from the country’s largest companies suggesting that by and large the business environment remains stable, despite the recent volatility in financial markets.
We currently hold a cautiously optimistic stance on the market. One of our prior concerns was how U.S. based multinationals would fare during this current earnings season, given weakness in many international economies and the strengthening dollar. By and large, most of these companies have successfully navigated this challenge so far, though U.S. business conditions continue to appear more favorable than those overseas. Consumer sentiment is at a multi-year high, and surveys of both the manufacturing and service sectors are pointing to continued growth. The labor market continues to improve as well. In recent weeks, unemployment claims reached another best for the current expansion, and readings on job openings were at 13-year highs. As a result of our view that the U.S. is outperforming most other major economies, we have pared back exposure to multinational cyclical holdings which may be vulnerable should weak international growth persist, and reallocated the proceeds to more domestically-oriented consumer centric companies. We are adding to companies focused on the U.S. consumer to reflect our opinion that strong sentiment, falling commodity prices, and improving labor conditions should bode well for the group.
Factors which temper our optimism include the weakness in many key international economies, and the likely inability of the U.S. alone to drive global economic growth. Significant challenges remain in Europe and Japan, and China’s growth has decelerated as well. Given recent inflation readings, which remain very low and are suggestive of an ailing economy, we also are concerned that the ECB’s most recent measures may not be substantial enough to boost growth and inflation across the continent. As demonstrated earlier in the month, there is a general nervousness in the market that can be swiftly unleashed at the threat of deteriorating economic conditions that are not met with immediate central bank support.
While we are generally pleased with the performance of the U.S. economy, consumer spending has disappointed. The latest reading showed a decline of 0.2% in September, the first drop since January. Given the economy’s reliance on consumption, this is a source of risk. That being said, considering the very high consumer sentiment readings, and gas prices that are at a four year low, there is reason to believe that expenditures may pick up in time for the all-important holiday season.
During the month, we kept a focus on several indicators to help guide our assessment of risk in the market. Some of these included Treasury yields, oil and other commodity prices, the U.S. dollar, and the CBOE volatility index. We remain alert to these and other key indicators, and continue to focus on minimizing downside risks. Going forward, we believe that our focus on broad diversification and active risk management will remain increasingly important.
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