Third-Quarter Market Update & Outlook
Author: Jeff Layman
Following a lackluster start to the year, the final revision to second quarter gross domestic product (GDP) came in at a robust 3.9 percent in real terms. The upward revision from prior estimates was primarily due to stronger consumer spending (up 3.6 percent) and nonresidential fixed investment (up 4.1 percent), according to the Bureau of Economic Analysis. When combined with the 0.6 percent increase posted in the first quarter, the overall pace of GDP growth for the first half of 2015 was 2.25 percent. This approximates the subpar rate of growth the U.S. economy has delivered since the recession ended in 2009.
The Institute for Supply Management’s (ISM) Purchasing Managers Index of manufacturing activity dropped to just above recessionary territory in August, causing concern about a decline in the broader economy. However, the ISM Service Sector Index simultaneously reached a 10-year high in July. Since the service sector represents nearly two-thirds of U.S. output, this implies the economy is doing well overall, despite weakness in manufacturing.
Six years of slow but steady growth have moved the economy toward full employment. At the end of September, the U.S. unemployment rate was just 5.1 percent. More than 12 million jobs have been created during this recovery, more than offsetting the nearly 9 million lost during the recession, according to the Bureau of Labor Statistics and JP Morgan.
Therefore, the Federal Reserve largely has accomplished half of its dual mandate: promoting full employment. The other, price stability, is still being pursued. Ironically, the Fed continues to fight deflation rather than inflation, with the target 2 percent rise in prices proving elusive. The strong U.S. dollar and declining commodity prices have created a disinflationary force, causing the Fed to keep interest rates lower for longer.
The Fed decided at its September meeting not to raise interest rates, as widening credit spreads and lower stock prices have had a tightening effect on the economy. Although many economists still expect the first rate hike this year, the consensus view is that this will occur during the Fed’s December meeting rather than at the next meeting in October.
Movements in the stock market diverged from trends in the U.S. economy during the third quarter. Despite improving economic results, stocks posted their worst quarterly results in four years on concerns about slowing growth in China and changing Fed policy. Here are the market returns for the third quarter and for the year to date:
The U.S. stock market experienced its first correction since 2011, declining more than 12 percent from the year’s high set on May 20 to the low on August 24. That day, the Dow Jones Industrial Average dropped dramatically by 1,000 points (7 percent) at the open, only to rally back to near even by midday. The CBOE Volatility Index® spiked above 50 intraday for the first time since 2009—evidence that investors were quite shaken by the market turmoil after several years of relative calm.
While the decline in prices improved valuation slightly by reducing the “P” in the P/E ratio, earnings unfortunately also have come down. Profits for S&P 500 companies declined year over year in the second quarter due to the impact of the strong dollar on foreign sales and the implosion in energy sector earnings, which are off more than 60 percent from last year. However, eight of the nine economic sectors (all except for energy) grew earnings over that time frame according to Standard & Poor’s, offering reason for optimism as we move forward.
Meanwhile, international stocks became appreciably more attractive in terms of relative value. Stock prices have dropped significantly in recent months, while earnings actually rose in both Europe—STOXX Europe 600 index earnings up 6 percent—and Japan—TSE Index earnings up 17 percent—in the second quarter. Lower prices and higher earnings drove P/E multiples back down into the mid-teens in these developed markets, representing fair to slightly cheap valuation levels.
The most inexpensive segment of the world stock market—the emerging markets—became even cheaper in the third quarter. At only 11 times earnings, these shares trade well under ordinary valuation levels. However, the growth of many of these economies is closely linked to growth in China, causing these markets to lead the way down with losses of more than 15 percent this year.
Core bonds fulfilled their role as a safe haven in a time of market turmoil, with the Barclays Aggregate taxable bond index gaining 1.23 percent and the Barclays Municipal Bond index gaining 1.65 percent during the quarter. Although unremarkable in absolute terms, year-to-date gains of 1.13 percent and 1.77 percent for taxable and tax-free bonds, respectively, served to mitigate market downside participation in balanced portfolios.
In the risk-off environment of the third quarter, satellite bond categories posted negative results. U.S. corporate high-yield bonds posted losses of 4.9 percent, while emerging markets debt lost 0.92 percent. For the year, high-yield bonds now have lost 2.53 percent, while emerging market bonds are up 0.05 percent. Corporate high-yield bonds were removed from our satellite bond allocation in the summer of 2014. At the same time, the satellite component of bond portfolios was reduced from 25 percent to 15 percent. Both of these changes have limited the impact of recent negative satellite bond results.
Despite the common notion that interest rates were bound to rise this year along with anticipated Fed tightening,
10-year Treasury note yields have actually declined, from 2.17 percent at the start of the year to 2.06 percent currently. Rates have been nearly as volatile as stocks this year, with the 10-year Treasury note falling to 1.65 percent by January 30, rising to 2.48 percent by June 26 and then declining to current levels. This volatility is an indication of the ambiguity surrounding the growth trajectory of the world economy and the timing of Fed actions.
Investors abhor uncertainty. In the short run it can create havoc, as strategies formed around the highest probability outcomes are upended by unexpected circumstances. Yet that same uncertainty often creates opportunity, which is why successful investing is a long-run process.
Uncertainty reared its head in the third quarter, as the plunge in Chinese stocks and concern over the slowing economy created anxiety around the globe. Chinese officials claim the economy is slowing toward a 7 percent pace of growth, but investors fear the actual rate might be much lower than that. Since China has provided such a large contribution to global economic progress over the past two decades, a significant slowdown there would have worldwide ramifications.
The Fed also contributed to investor uncertainty. As recently as a few months ago, the forgone conclusion was that the first Fed funds rate hike would occur in September, given the steady improvement in the U.S. economy. However, the Fed decided not to raise rates and the lift-off date now seems more unclear to investors than ever. Will the Fed raise rates in 2015 or wait until 2016? Changes in Fed policy add to market volatility.
One element of uncertainty was resolved during the quarter. There is no longer a need to wonder when the market correction will occur … it just happened! Of course this leads some to worry the correction is the start of a more damaging bear market. Upon considering several fundamental factors, our view is that the recent decline is more likely a typical corrective process than the beginning of a more significant market drop.
Assuming the economy continues to progress, recent market volatility presents an opportunity for investors. Our intent is to use this period of uncertainty to implement recent model changes in the U.S. stock, international stock and alternative investment allocations. Given the current level of asset prices, these changes may provide a favorable tax impact in many cases, in addition to improving portfolio positioning going forward.
Jeffrey A. Layman, CFA®
Chief Investment Officer
BKD Wealth Advisors, LLC is an SEC-registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.