Economic Update 8-24-2015

• Economic data in the U.S. was again mixed, with regional manufacturing surveys offering conflicting results, while housing metrics turned out well and showing some moderate improvement. However, the story abroad was the problem, as Chinese manufacturing survey figures showed continued contraction.

• Equity markets globally reacted with the strong negative returns, in response to global growth concerns.  Consequently, bonds fared well in the risk-off environment as interest rates fell sharply. Crude oil fell to new multi-year lows in the $40 range, while gold rebounded somewhat as a safe haven.

U.S. stocks struggled during the week, with additional volatility from Asia carrying over to our shores.  Particularly, losses on Thursday and Friday wrapped up the worst market week in four years. Technically, the Dow hit -10% correction territory based on highs in May, while the S&P fell just short of that result.  From a sector vantage point, utilities led with minimal losses of a percent, while energy and technology were hardest hit—the former losing -8% in line with much weaker oil pricing.

The catalyst for all this was an advance PMI report from China showing further economic weakness—in the measure for July falling by more than half a point to 47.1 (under 50 is considered contraction territory), as well as the revelation that the near-term Chinese GDP target could be lowered from 7.0% to 6.5%.  (It’s probably already fallen to that; they’re just hesitant to admit it.)  This led to renewed sell-offs in the Chinese Shanghai stock markets that carried over elsewhere.  Of course, as the primary global growth engine of the past decade, slowing here lowers overall world GDP growth targets, which has intensified the broader concerns about already-lackluster global growth.  At the same time, the U.S. economy is less dependent on China than the headlines would have you believe.  So, it’s important to put this in context (more on this below).

These selloffs can feed on themselves for a time, as we all know.  From a charting perspective, selling pressures were exacerbated in normal fashion, as S&P prices hit and fell below the newsworthy round 2000 level (which shouldn’t matter, until it ends up on the evening news), and dropped below the 200-day moving average, which is a key technical marker utilized by many momentum managers.  How quickly or not quickly markets respond back will demonstrate the key differences/risks between momentum and other investment strategies, such as valuation-based or buy-and-hold.

Foreign stocks generally performed in line with domestic equities, with developed market areas ending up a bit better than emerging markets.  The dollar weakened by about a percent on average, so USD-denominated indexes tended to outperform the local variety.  Losses here were just a matter of severity, so additional detail isn’t worth much.  In keeping with expectations, China A shares and export competing nations in the Asia-Pacific region fared worst, while oil exporters such as Russia weren’t far behind.  Despite the hugely negative sentiment, valuations for several emerging market areas have turned quite low, prompting additional interest from a variety of asset allocators who look at such opportunities from a 5-10+ year perspective.

U.S. bonds gained on the equity risk-off trade for the week—just when everyone is primed for sharply higher bond yields, they surprise once again on the lower side with a 0.10-0.15% point drop in yields across the curve.  Naturally, the longer the duration of the bond involved, the stronger the effect, so long treasuries performed especially well, while high yield lagged, as a smaller energy sector component has been sold off due to oil price fears.

Developed market foreign bonds generally gained on a weaker dollar, in relative terms due to stronger exports in Europe and higher inflation and tightening pressures in the U.K.  Emerging markets generally widened, while several other emerging nations have taken China’s lead to weaken their currencies—notably last week, Kazakhstan announced a policy change away from a peg towards traditional inflation targeting instead, causing their currency to fall by -20%.  Vietnam has weakened its currency for the second time in a week.

Real estate also declined, but held up relatively well compared to equities, helped by lower interest rates (better than the converse of being penalized by higher rates, which can affect REITs near term).  European and Japanese REITs came in better than the U.S. variety, where healthcare barely budged while industrials suffered.

Commodities continued to struggle on the back of lower oil prices, which tumbled another -4% to right above the $40 level—the lowest price since the recessionary lows of 2009.  This capped an 8-week losing streak, which hasn’t happened in 30 years.  For the technicians out there, relative strength in crude is adequately poor enough to perhaps even signify an ‘overshoot’ to some degree.  While weakening demand in China and related regions is one headline reason no doubt, high supplies remain, which appear to have kept possible recoveries at bay.  On the other hand, precious metals experienced gains of +4% as investors sought out gold as a traditional safe haven asset (a weaker dollar over the past week helped its cause).  Agriculture and industrial metals were much more tempered, by comparison.  Interestingly, a recent survey put out by a large bank/brokerage noted a record underweight position in the commodity sector and energy in particular.

On a market structure note, the SEC fined Investment Technology Group (ITG) a record $20 mil. for admitted wrongdoing involving high-frequency trading in dark pools.  Essentially, it appeared the firm used client information to its own advantage by trading ahead of them for its own benefit, even if by milliseconds.  The effect is really no different from the client ‘front-running’ activities that have been banned for some time, yet the traditional form is more obvious to spot with the human eye than the high-frequency variety.  So, while the tools are different, the issues are the same.  The question becomes a key one for the high-frequency trading world:  how to define that gray area between competitive information advantage and illegal anti-competitive activity.

One final market note.  After an extended run, markets generally need to take a breather and there is a contingent who’ll sell just because they want a reason to sell (which is why some news that already seems obvious is acted on dramatically, when in other weeks it can be surprisingly brushed off).  Flattish markets of the summer up until now with low volatility haven’t shown a pattern towards bullishness or bearishness, as noted by the high levels of self-proclaimed ‘neutral’ investors from the weekly AAII survey.

For perspective’s sake, from the lows reached in March of 2009 through this week, the S&P has gained +230% (20.4% annualized).  We’ve moved from overly cheap valuations (remember the companies with price/book less than 1, that were ‘worth more dead than alive’ temporarily back then?) to ranges that are more typical of long-term averages.  It probably isn’t surprising that we’re seeing higher levels of market volatility, given the backdrop of these more ‘normal’ conditions and that ‘easy’ growth getting harder to come by.  But it doesn’t necessarily mean that the trend upward is over.  Again, in normal conditions, stock prices tend to follow predictable patterns—movement can originate from dividends, earnings growth and price ratio expansion/contraction.  While the ratio expansion part doesn’t leave us much (unless things get bubbly), earnings growth is slated to recover in coming years to more typical 5-10% levels, based on current economic estimates.  If even the lower end of that scale, add a dividend yield to that (call it 2%), as well as implied dividend growth, and longer-term returns begin to look acceptable.  All that aside, classic valuation metrics peg the S&P at close to fair value, or even a bit below after this week, based on current earnings, payout ratios, interest rate levels and conservative risk premium estimates.

Compared to bonds, where a good estimate for forward-looking total returns is your starting yield, stocks continue to offer attractiveness in relative terms as well.  While -10% corrections occur roughly once a year, we haven’t had one since Oct. 2011, so about four years of a bull market.  In fact, even -15% corrections happen once every few years, and shouldn’t be entirely unexpected. From the base of a large multi-year gain, these are merely a blip on the chart and remain the unavoidable and yet unpredictable byproducts of normal market participant behavior.  In fact, this several steps forward-one step back pattern can provide a ‘pause that refreshes,’ allowing markets to enter a new phase by washing out any marginal speculative excess.  Up until now, despite the recovery, this hasn’t been a very well-embraced bull market.  Considering the upheaval in the recent decade, this stands to reason as recessions that deep can have generationally-pervasive effects.  It’s important to look at anecdotal information as well as quantitative when looking at such things—if everyone were quitting their jobs to day-trade again, it would be a lot more concerning.  The classic ‘topping’ characteristics from a behavioral and economic standpoint just don’t appear to be present quite yet.

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.                                                                               

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.