Economic Update 8-31-2015

• From a domestic standpoint, economic data last week was decent, with durable goods orders stronger than expected, decent housing gains and a sharply-revised second-quarter GDP number.  Much of the economic concerns continued to reside abroad, namely in China.

• Market experienced one of their more volatile showings in years, with an early-week drawdown followed by a sharp recovery by Friday—U.S. stocks ended higher while foreign stocks were mixed. Along similar lines, bond yields plummeted early in risk-off trading before recovering higher later in the week, resulting in negative performance for many investment-grade bond indexes.

U.S. stocks began the week quite ugly, with losses approaching -5%—the worst few hours in recent memory—resulting in the culmination of the -12.4% S&P correction (5/21/15-8/25/15 for those keeping track).  While the early week action remained negative, it improved from that low point through several strongly positive days and an oddly flat Friday.  From a technical standpoint, pricing for the S&P remained below the 200-day moving average, so conditions remain negative from a  particular chartist point of view; this is of no concern to fundamentalists, but changes in these signals can explain some degree of market flows.  JPMorgan also noted that changes in options hedging positions explained some of the trading volume as well (we call that ‘volatility because of volatility’).  From a sector standpoint, energy and technology/semiconductors led, but gains over +3%, while utilities lost -4% as the flight-to-quality trade wore off and interest rates rose.

The terrible start on Monday was somewhat blamed on China’s lack of policy action (rate cut) over the weekend in response to last week’s volatility.  So, China responded to the early week market struggles by lowering interest rates by 0.25% to 4.6% and bank reserve requirements by 0.50% to 18.0% (the latter effectively injecting 650 yuan into the economy) in attempts to calm markets, noting, however, that there is no basis for further devaluation of the yuan.  Further specific actions remain to be seen, but China’s persistent, albeit inconsistent, economic stimulus appears likely to continue in their efforts to avoid a hard landing.  There are no doubt some policy growing pains happening.  Last week, in keeping with these measures, peripheral Pacific nations and Chinese trading partners such as Indonesia and Taiwan gained, as did energy-intensive nations, such as Russia, Mexico and Brazil.

Many are comparing this market event to the type seen in 1998, when several emerging markets were hit especially hard.  Things are different today, though, and that could soften the effect (crisis never seem to repeat in identical ways, regardless).  Compared to that time, more emerging market nations are allowing their currencies to ‘free-float’ rather than pegging them to the dollar.  (As we’ve discussed in the past, this is risky due to the fact that if the value of their currency vacillates dramatically, as emerging nation currencies are prone to do, central banks require ample reserves to make up the difference and keep the peg intact.  Many have ran out of funds, causing the peg to break and often resulting in some degree of crisis, so this practice has become much less popular.)  This doesn’t mean conditions are easy, and emerging market outcomes have become more nations-specific.  Recently, commodity/oil exporters, particularly those who’ve catered to the voracious Chinese appetite for such products, such as Russia and Brazil, have suffered; while, on the other hand, less Chinese-sensitive nations and those who benefit from cheaper commodities, like India, have done comparatively much better.

U.S. bonds initially rallied on Monday’s volatility, with the 10-year treasury falling below 2% again in an extreme risk-off move, until it recovered a quarter-percent higher to end the week. Consequently, higher-quality bond indexes suffered.  On the other hand, high yield and emerging markets showed gains, with better equity sentiment and stronger energy prices.

Real estate fell in price upon higher interest rates.  Asian and Australian names lagged a little less than U.S. holdings, while Europe and the U.K. suffered a bit more.  We’ve seen additional volatility in the REIT space due to fluctuations in interest rates.

The GSCI commodity index gained +5% as sentiment continues to be driven by crude oil pricing.  Last week’s surprise came as the per barrel price of West Texas first dropped to below $40 with Monday volatility but later rebounded back to above $45, in a sharp reversal of the recent downtrend—thoughts were that a short squeeze was a partial cause.  While not much in dollar terms, it represents a +10% gain from the low point.  Industrial metals also reverted higher in keeping with Chinese stimulus action, while gold fell a few percent as fears abated and interest rates rose.

How do market corrections affect Fed policy?  Based on historical examples, it appears that, after a -10% stock correction, the effective fed funds rate would be about 0.15% lower than it normally would.  However, results are not conclusive.  But it does tend to lower the chance of a September rate hike (proven by changes in fed funds futures implied probabilities and comments last week by NY Fed President William Dudley), pushing the base case out to December, and in the worst case (should weaker economic data warrant it), even January.  Foreign instability doesn’t make or break policy by any means, but consideration of side effects certainly can weigh on timing.  To put this into perspective for U.S. companies, exports represent about 13% of total U.S. GDP, of which 5% are emerging markets in total, and under 1% directly to China (they export much more to our shores than we do to theirs).

On another side note, apparently there were some pricing problems last week with a number of mutual funds and ETFs.  While the first assumption by many was that it had to do with early week market volatility, the issue stemmed from a more mundane cause of a software upgrade by a key custodial accounting system provider, which was repaired by mid-week and prices restored.  Press releases noted ‘minimal’ impact, but actually, quite a few tickers were affected.  As we’ve seen with the NYSE, big software upgrades have become their own idiosyncratic risk factor from time to time.

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.