The market had a challenging third quarter, with the S&P 500 falling by over 6%. In our view, turbulence out of China and an uncertain monetary and political environment in the U.S. rattled investors. While we do not expect stocks to weaken considerably from current levels, these headwinds may make it challenging for the market to meaningfully appreciate over the near term.
China’s economic weakness and financial market turbulence had a significantly negative impact on stocks across the globe during the quarter. The Shanghai composite declined by 29% during this period, its steepest quarterly drop since 2008. It appears that China’s economy, particularly the manufacturing sector, may have weakened considerably. In this regard, we note that the country’s official manufacturing purchasing managers index fell to its lowest level since September 2012, and industrial profits for August dropped by 8.8%, the largest falloff in four years. Moreover, we believe that investors were taken aback by the central bank’s currency intervention which resulted in the yuan’s largest single day decline in a decade. All else equal, a weaker yuan puts other countries which compete with China for exports at a disadvantage, and it also hurts resource rich nations which have come to rely on Chinese demand for their commodities. While we remain concerned about potential ripple effects from China, there are important offsets which keep us from taking too dire a view of the situation. First, their consumer and service sectors appear to be holding up relatively well. Both Nike and Apple in their quarterly earnings calls noted robust growth in their Chinese businesses, and other global companies shared similar views. Perhaps this is not surprising given the government’s desire to reduce the nation’s dependence on exports, in part by boosting domestic consumption. Second, we believe that the government has plenty of tools at its disposal to stimulate its economy. One needs to look no further than the country’s massive foreign currency holdings as evidence of this.
In the U.S., the Federal Reserve held interest rates steady at its most recent meeting. Many economists had anticipated that the central bank would begin to normalize policy by raising rates for the first time in nearly a decade, or at least telegraphing that a hike was imminent. Stocks fell on the news, as investors may have taken this as a sign that the Fed lacked conviction on the strength of the economy. However, in a subsequent speech, Fed Chair Janet Yellen laid out the case for a rate hike later this year based on her view that an expanding economy was likely to lead to an increase in inflation going forward. Our view is consistent with Yellen’s message that the Fed will likely begin the normalization process within the next few months. We believe that a further delay would damage the central bank’s credibility. Market response has demonstrated that sentiment around monetary policy has begun to shift. Whereas in recent years dovish policy has nearly always been positive for equities, it seems that investors are now more concerned with the unintended consequences of zero rates for such a prolonged period, and the implied message that an unwillingness to raise rates sends to markets. We expect that absent deterioration in economic activity or international financial conditions, the most likely scenario is a modest initial near-term hike, followed by another pause as the Fed awaits further data to dictate the pace of its tightening campaign.
Political concerns may have also negatively impacted markets during the quarter. Several presidential hopefuls who have thus far polled rather well have taken positions that we view as negative for stocks. Examples include significant increases in top tax rates, anti free trade rhetoric, and plans to cap prescription drug pricing, the latter of which has already hit biotech stocks. Elsewhere in the political arena, we believe that Speaker Boehner’s resignation may increase the possibility of a government shutdown in December. While we still do not see a strong likelihood of this occurring, the potential for elevated levels of political brinksmanship could lead to an anxious stock market environment.
During the quarter we became increasingly concerned about the possibility that the Chinese financial turbulence could impact stocks elsewhere. This was particularly the case after the yuan’s devaluation, given the potential for this to materially impact other economies, as discussed. China’s economic deceleration, in our view, also may have played a large role in the significant decline in energy and other commodity prices, which directly impacted many large multi-national companies across the globe. We also believed that with market technical indicators flagging in the U.S., and the fundamental picture in question given the less than stellar second quarter earnings results, that domestic stocks were increasingly vulnerable to external shocks. For these reasons, we began to take a more defensive posture.
As the quarter progressed, volatility declined significantly from its late August peak and corporate management teams generally presented a fairly optimistic tone during September investor conferences. We therefore began to lessen the defensive stance we had adopted earlier. However, given China’s economic slowdown and continued uncertainty pertaining to U.S. monetary and political circumstances, we maintained a slightly elevated level of cash as a buffer against further volatility.
As we look forward we have a balanced view on the market. With stocks having recently corrected, and multiples now more in line with historical norms, we do not expect to see much further downside from current levels. August’s disappointing jobs report notwithstanding, we continue to view the U.S. economy as better positioned than most of its global peers. The housing market continues to improve, with new single family home sales recently hitting their best level since 2008, and homebuilder sentiment at a high for the current cycle. Auto sales have been robust in recent months, and in September reached an annualized pace of over 18 million vehicles sold for the first time since 2005. Generally speaking, consumption has been strong, and in the most recent revision to Q2 GDP, personal consumption came in at a healthy 3.6% clip.
While the consumer sector has been a source of strength, to a certain degree this has been mitigated by weak exports, as the strong dollar and flagging international economies have taken their toll on trade. Therefore, while the U.S. economy is growing, it is doing so at a below average pace compared with previous expansions. Consequently, we are skeptical that companies can meet current expectations for earnings growth of approximately 10% next year, and this gives us pause about taking too bullish a stance on stocks currently. Another concern we are monitoring is the recent widening of credit spreads, both in high yield and investment grade bonds, and we continue to watch the fixed income markets as tighter credit conditions can have spillover effects onto equities. For these reasons, in addition to an uncertain political environment, we currently hold a somewhat cautious near-term outlook for stocks.
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