Economic Update 9-08-2015

• Economic data was mixed with weakness seen in manufacturing, while services remained strong, albeit weaker than last month.  The monthly employment report disappointed relative to expectations, although it contained some positive revisions.

• Equity markets continued to experience heightened volatility, losing ground on net for the week.  Bonds benefitted from the risk-off environment, gaining as interest rates fell back.  Oil prices ticked upward on the week, despite volatility there as well.

U.S. stocks started the week down sharply again, as manufacturing data in China experienced its sharpest decline in three years and sentiment remained shaky around the growth situation as a whole.  Some recovery towards mid-week netted out some of the earlier moves, in a similar situation to the prior week, before lagging again Friday with a lackluster jobs report that left participants wondering again about Fed timing.  Some of the positivity was perpetuated by comments from ECB president Draghi indicating that the European quantitative easing program could be extended—with an increase in the cap they’re allowed to purchase of any given member nation’s sovereign credit from 25% to 33%.  Also, last week, the IMF downgraded global growth forecasts a bit—offsetting some of this ‘good’ news—to 3.3% this year, down a tick from 2014’s 3.4%.

From a sector standpoint, telecom, consumer discretionary and staples outperformed with smaller losses than the broader market, while utilities and health care lagged.

Foreign equity returns were largely negative in line with the U.S., but no clear regional pattern came into play, other than commodity producing countries like Australia, Brazil, South Africa and Russia continuing to experience higher volatility with uncertainty about global growth and mixed weakness among Asian nations seen as most dependent on Chinese strength.  On the other hand, Eurozone PMI improved to above 54, which likely helped sentiment there in relative terms, along with the ECB announcement about additional easing capacity.

Canada, an economy we don’t talk often about despite its proximity, fell into recession during the 2^nd quarter (at -0.5%), although economists expect this to be a short-lived event.  Like Australia and Russia, the Canadian economy is very dependent on commodity activity, and lower pricing plays a strongly negative role, although it’s not as sensitive as it used to be.  More importantly, Canada represents just under 20% of U.S. exports, so continued weakness could play a role with domestic earnings.

U.S. bonds gained on the week with risk-off sentiment and negative equity results, and credit (including high yield) outperformed governments by a few basis points.  Fears of slowed global growth translated through to lower prices for TIPs as well as a sell-off in emerging market debt, more directly related to China from a sentiment standpoint.  The dollar was little changed on the week, so didn’t contribute much as a factor.

In a recent conversation with our global fixed income management team, in a market segment that has been disappointing over the last few months due to the China issue, it was clear that underlying long-term themes haven’t changed.  Demographic growth and economic evolution from base manufacturing to next-state service-type activity, as well as steadily increasing wages and higher consumption, point to emerging markets continuing their trend of convergence with developed markets.  It’s also important to remember the differences in critical conditions for equity and fixed income—the former requires earnings growth to justify valuations ultimately, while bondholders just need their loans paid back.  Fundamentally, such nations are in much better shape than they were during prior crisis, such as the late 1990’s, when pegging currencies to the dollar was much more common.  So, instead of nations taking on the currency risk themselves, this is now being passed on to bondholders (if they own local currency debt—increasingly the most common variety), which explains the bouts of volatility in this asset class as of late.  However, opportunities here remain much more attractive, particularly in the nations lying on the cusp ‘in between’ EM and DM than in the low-rate regimes of the Japans and Germanys of world, with rates at or under 1%.

Munis were boosted by an agreement between Puerto Rico’s electric utility company and big muni issuer and bondholders—the utility had likely hoped for deeper debt forgiveness while debtors had pushed for full payment.  As a solution, an offshore special purpose vehicle was established to collect payments on behalf of bondholders and debt itself was restructured at a price of 85 cents on the dollar.  While less than par, granted, this was expected, and pricing had been as low as the 50’s and 60’s, which implied a much more negative outcome.  Consequently, this solution was a boost for muni sentiment, with the high yield muni index rising by over a percent on the week.

U.S. real estate experienced sharp losses on the week, while European and Canadian names fared significantly better.  Residential and regional malls were the weakest segments, while mortgage REITs held up far better with lower rates and potential for postponed Fed easing.

Commodity indexes as a whole only suffered slight losses on the week, as all segments lost ground with the exception of energy, which rose a bit.  Despite a risk-off week, gold lost ground, while industrial metals continue to suffer under China growth concerns.  Crude oil bounced around mid week as rumors of OPEC concerns over low pricing spurred possible discussions with other non-cartel nations about production levels caused prices to spike by 7%, before Asian economic concerns reset prices dramatically lower the following day—after all this, per barrel prices settled higher on net at just under $46.

On an updated note about ETF liquidity, as we expected in a few cases, some of the smaller, less-popular products have begun to experience closures.  The smaller providers featuring nichier ‘themed’ strategies struggled from the outset, especially as low asset bases and continued high fees caused a self-fulfilling prophecy of failure—relative to the broad market exposures available to investors for a little as 5 or 10 basis points.  Now, even large providers have begun shuttering strategies that have failed to garner sufficient interest, such as in Canadian small-cap stocks, Asian tech sector companies, or various sectors of the real estate market (like distinct exposure to office or retail REITs).  It’s unfortunate, since these products were useful for gauging sector characteristics and sentiment, but it seems the next wave of ETF consolidation is happening.  No doubt more to come as investors focus increasingly on low costs, and, increasingly, liquidity. The difficult reminder of the past few weeks is that smaller ETFs in nichier areas aren’t a foolproof way to obtain exposure in a less liquid bucket of stocks, but the products themselves can experience twists and turns when market behavior gets more erratic.

We’re again entering a volatile time of year, as trading desks are getting back to full staff from summer vacations and volumes traditionally pick up.  There have actually been some academic research papers on the topic of why trading activity and volatility pick up so dramatically around this time every year, but the ‘vacation’ hypothesis is about as good a story as any researcher has been able to come up with.  You would think these types of things would allow for better answers than they do.

Since 1950, the average day in the S&P experienced an absolute (either up or down) change of +/- 0.66%.  When reviewing sessions that ended +/- 2%, we end up with only the most volatile 5% or so of days over that time—so roughly about one per month.  Volatile days have been shown to be ‘stacked’ together in distinct periods, as are periods of low volatility.  So, long-story short, we could see more of this as we enter into the most volatile months of the year.

As we should have expected, this vol caused the VIX implied volatility index to shoot sharply higher, hitting 40 the prior week before ‘settling’ into the 30’s and upper 20’s last week. Regardless, far higher than the 10-15 range we’ve been used to for much of 2015.  One interesting tidbit is that every time VIX has exceeded 40 over the last 25 years (7 times), the market ended up positively over the following 12-month period.

While the stock market correction and volatility is certainly a change of pace from the slow summer and has been/continues to be unsettling to some clients, context is critical.  One is always reminded of this when looking back upon familiar charts of famous stock market drawdowns.  Seeing names like ‘Pearl Harbor,’ ‘Cuban Missile Crisis,’ ‘Volker inflation fighting,’ and ‘Dot-com bubble’ point to critical geopolitical or valuation mania events with unsurprising volatile outcomes.  It remains to be seen whether a title of ‘Chinese growth slows from a very robust 7% pace to a more sustainable 5-6%’ warrants the same reaction and similar level of concern in the long-term picture.

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.