Markets drop around the world
August was the worst month in years for U.S. and international markets. Though steady for most of the month, in the face of weak Chinese economic data and fears of a pending global slowdown, markets experienced substantial losses at month-end.
Declines were widespread, with every major equity index down and many fixed income indices down as well. The S&P 500 Index closed out August down 6.03 percent, the Dow Jones Industrial Average was down 6.20 percent, and the Nasdaq declined 6.86 percent.
The losses came despite reasonably strong current fundamentals. With 98 percent of companies on the S&P 500 reporting results by the end of August, per FactSet, almost three-quarters had beaten earnings expectations and half had beaten sales estimates. An overall earnings growth rate decline of 0.7 percent was not great, but it was significantly better than the decline of 4.6 percent expected at the start of the quarter. Nine of 10 sectors ended the quarter with better-than-expected earnings growth.
Although the earnings surprise level was consistent with past quarters, the sales surprise level was much lower, suggesting that companies may be making up for top-line growth with financial engineering. This moderately strong but softening sales growth was very likely a contributor to current market weakness.
Technicals turned strongly negative by month-end. All three major U.S. indices finished August well below their 200-day moving averages, a typical sign of a change in trend. All are now also well below their long-term support levels and will face resistance as they try to recover above those levels, suggesting that further weakness is possible.
Developed international markets were hit by the same factors as U.S. markets, with the MSCI EAFE Index posting a 7.36-percent decline. Just as with the U.S. indices, the EAFE held steady at the beginning of the month but then dropped on news of weakness in China. The feeble market performance notwithstanding, fundamentals for the European economy continue to improve in most countries and in the eurozone as a whole. Further, political risks appear to be in decline, suggesting that the market drop was systemic and not linked to Europe itself.
Emerging markets, as represented by the MSCI Emerging Markets Index, did worst of all, losing 9.20 percent in August. The substantial market declines in China were one major reason, but other contributing factors included continuing low commodity prices—which hurt many emerging economies—and rolling currency devaluations.
The global nature of the declines in equity markets during the month can be seen in Figure 1, which shows the daily performance of several major indices indexed to their respective starting prices on August 3.
Figure 1. Global Equity Market Declines During August 2015
Fixed income also suffered in August. The Barclays Capital U.S. Aggregate Bond Index lost 0.14 percent, hit by declines in credit sectors of the market. In addition, the Barclays Capital U.S. Corporate High Yield Index was down a significant 1.74 percent, largely due to an ongoing decline in oil prices, which continued to erode the credit quality of energy companies.
Much like other markets, volatility was noticeable in the fixed income arena toward the end of August, as investors moved into perceived safe-haven assets. This rotation to safety drove the 10-year Treasury rate to 2.01 percent on August 24, a level not seen since last April. Still, despite this dramatic decrease in rates during the height of equity market volatility, 10-year Treasury rates ended August at 2.21 percent—comparable to their 2.20-percent level at the end of July.
August revisions show U.S. economy growing even faster
U.S. economic reports in August were strong. Most notably, second-quarter gross domestic product (GDP) growth was revised upward, from a respectable 2.3 percent to a strong 3.7 percent, based on continued consumer spending growth. Consumer confidence dropped by one measure early in the month before fully recovering at month-end, and consumer spending continued to accelerate in July. Business confidence went along for the ride, with the major survey of the service sector reaching an all-time high. Housing starts increased, with upward revisions to previous months. Additionally, prices continued to rise as mortgage foreclosures and delinquencies fell further.
Employment growth was strong. Initial jobless claims stayed under 300,000, a sign of strength. The unemployment rate was stable, while the underemployment rate continued to decline, also a sign of strength. July's increase of 215,000 jobs was slightly below expectations, but upward revisions of 14,000 jobs to the numbers for prior months more than made up the difference. Another sign of strength—average hours worked rose by enough to potentially signal demand for another 300,000 jobs.
But there were areas of weakness. Business investment declined during the second quarter, due largely to the strong dollar's effect on manufacturing exports and continued declines in energy investment because of low oil prices. Pending home sales pulled back a bit on a month-over-month basis. In addition, there were two surprisingly negative statistics—in industrial production and consumer confidence—which indicated substantial declines. Even though later data suggested that these indicators were outliers, they are worth noting.
The Federal Reserve remained ambivalent about rate increases. It remains to be seen what effect, if any, the recent market turmoil will have on the Fed's decision. At this point, a rate increase in the near future appears to remain on the table.
Overall, the U.S. economy continues to grow and fundamentals remain strong. The robust upward revision of GDP growth for the second quarter, combined with continued improvement across the board in economic data, suggests that growth in the second half of 2015 should be as strong as—or stronger than—in the first.
International risks return to the forefront
Although the U.S. economy is growing and Europe has done well, China has suffered from a slowdown and financial market turmoil. Along with a slowing economy, which may even be tipping into contraction in some sectors, China has endured a stock market crash. In fact, recent U.S. market turbulence pales when compared with Chinese market declines.
The problem that China faces is one of eroding confidence. Its government has failed to stabilize its stock markets and stimulate growth. These factors, combined with the recent explosion in Tianjin, have many observers starting to question the government's competence. This matters because, for the first time ever, it is China that has contributed the majority of global growth in the most recent recovery. Should China's growth continue to slow, it is very possible that the rest of the world might move closer to recession.
In addition, policy actions that China has taken, notably the recent devaluation of the yuan, have rattled global economies and markets. By devaluing its currency without warning, China has raised the suspicion that it was making a desperate move to rekindle export growth, further decreasing international confidence. This could lead other countries that compete directly with China to adjust their currencies—a scenario reminiscent of the Asian financial crisis of the late 1990s.
Because the loss of confidence has come from China, instead of the U.S., the solution has to come from it as well, which means that the uncertainty will likely continue. But even though the U.S. is undeniably exposed to China, because we are a relatively closed economy and have relatively little direct exposure to China's financial markets and economy, the damage to U.S. markets may be limited and short lived.
Though China is the primary source of economic risk, other hotspots, like Syria and Iraq (because of the ISIS insurgency), still simmer. In addition, oil markets continue to shake economies, with extreme volatility, making it hard to plan and consequently curtailing investment worldwide. Finally, although Europe's growth has improved substantially, questions about the sustainability of its recovery remain.
Thus far, U.S. markets have suffered from uncertainty overseas, but given the lower political uncertainty and stronger economic growth we have here, that may not continue. With markets still priced at historically high levels, though, risks remain, and these risks could result in continued declines if situations worsen overseas.
A difficult August could lead to a difficult fall
Where does this leave us? U.S. fundamentals are strong (e.g., good economic and employment growth, stronger-than-expected earnings growth), so the uncertainty is coming from elsewhere, suggesting that the volatility may go on.
China's economy still seems to be weakening, and we can see storms forming in emerging markets following the devaluation of the yuan. Europe is growing but remains politically fraught, with the migrant crisis only the latest to shake European unity. The U.S.-Iran nuclear deal continues to destabilize relationships throughout the Middle East.
Here in the U.S., we have largely been insulated from these trends. But as August has shown, that may not continue to be the case. In addition to international problems, we face the prospect of the Fed deciding to increase interest rates. This move would ratify the U.S. recovery, but it could also rattle financial markets.
Looking at the big picture, however, the U.S. is still the most politically stable and economically solid of the major economies. Given the strong economic fundamentals in the U.S., and the relative lack of exposure to the rest of the world, the outlook for the medium and longer term remains solid. Short-term volatility may rock the boat but not enough to affect longer-term outcomes. As always, a properly constructed portfolio may lead to positive returns in good times and provide a stable framework in bad times, regardless of sunshine or stormy weather.
Authored by Brad McMillan, senior vice president, chief investment officer at Commonwealth Financial Network.
All information according to Bloomberg, unless stated otherwise.
Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below.