From worries over a slowing worldwide economy, decelerating emerging markets and their currencies, uncertainty over the next move on interest rates and a retreat in commodity prices, our stock market had a lot to contend with in the 3rd quarter. The weight of these issues resulted in a negative quarterly return for the first time since 2012. Corrections of 10% usually take place every 18 months and we had gone four years without one. Corrections like this one are unpleasant and impossible to predict yet they can restore order in the market, allow valuations to moderate and provide attractive entry points for stocks on our wish list. As such, while we dislike the outcome as much as you do, we view this summer’s market retreat as a healthy correction within a bull market.
China is slowing, but not collapsing or headed for a recession. Emerging markets are important as their growth rates in the long run far exceed those of developed markets. However, the US only exports about 10 % of our GDP, with half of that going to Canada, the European Union and Mexico. China itself represents less than 1% of US exports. Interest rates are poised to go higher, but the slow and deliberate pace indicated by the Fed will still leave policy incredibly accommodative for the foreseeable future. Falling commodity prices are negative for resource rich economics such as Brazil, Canada, Russia and others, but the US is a net beneficiary as we import more commodities than we export. In addition, with an economy that is 70% consumer driven, lower energy prices are a significant positive.
Beneath these headlines we see the fundamentals of our economy remaining strong led by solid job growth, strong auto sales, a housing comeback, lower oil prices and a steady service economy. Manufacturing remains the weakest part of our economy, which now represents less than 10% of our GDP. In addition, valuations due to the 3rd quarter stock retreat have fallen to levels we deem very reasonable, with the S&P 500 trading at 14.7x 2016 earnings.
For the market to move higher from here, we need several important issues to clarify. First, the Chinese market needs to stabilize. China remains one of only a few countries with additional means to stimulate their economy, and is too far integrated with the world economy to not do everything in their power to maintain or improve their growth prospects. Second, oil also needs to stabilize as supply and demand are brought into better balance. While we believe oil will remain volatile for now, production in the US has started to decline as a result of lower prices. The unknown factors are production targets set in the Middle East that may be independent of market signals due to political or other influences. Fortunately, worldwide demand is still growing and we believe we are moving closer to a sustainable supply/ demand balance.
At the conclusion of the Federal Reserve’s September meeting, Chair Yellen announced their decision not to begin policy normalization by raising interest rates at this time. She also provided ‘forward guidance’ that thirteen of the seventeen Committee participants expect normalization to commence in 2015 and that once normalization begins, monetary policy will remain extremely accommodative over the next three years.
The reaction within fixed income markets was to move interest rates down further. Despite Chair Yellen’s ‘forward guidance’ the market effectively priced in an initial rate increase sometime mid- 2016, not in 2015.
Committee participants opposed to beginning normalization are seeking greater confidence that inflation will reach their 2% target. They tend to cite that their favorite inflation measure, the PCE deflator, has declined over the last year to the current .33% level.
An increasingly vocal minority of Committee participants are making a strong case for raising rates. They tend to cite that the unemployment rate of 5.05% is nearly full employment and that core inflation measures are running between 1.6% and 1.8%. Thus, it is time for the Committee to back off of the ‘emergency mode’ setting as their goals have essentially been met. We agree.
We believe that it is important for policy makers to appreciate how far they have gone past normal. In response to a slowing U.S. economy and ultimately the 2008 Financial Crisis, the Federal Reserve took overnight rates from 5.25% to 0%. When that didn’t seem to be enough downward pressure on rates, they embarked on an unprecedented quantitative easing program in which they purchased a total of $3.6 trillion of U.S. Treasury Notes and Mortgage backed Securities.
Monetary policy will remain very accommodative no matter if the Committee raises rates at their December meeting or sometime in 2016. We expect that the unemployment rate will continue to decline, inflation will rise as the transitory effects of the declining energy prices recede, and fixed income markets will continue to price in ‘policy inaction’ until proven otherwise.