Last week saw more pressure on risky assets: developed market indices declined between -1% and -3%, emerging markets fell more than -5% and emerging-emerging markets (aka frontier markets) were off by more than -2%. The biotech industry was particularly hard hit last week as the Nasdaq Biotech Index plunged -5.1% on Friday, capping a -13% decline on the week (note: the biotech index is down-22% from its all-time high in July and is in bear market territory). Most of the broader indices are in the red not only for the month, but also for the year at this point. U.S. Treasuries offered little respite from the sell-off as the price of US Treasury notes and bonds declined modestly (pushing the yields up); the yield on the US 10-year Treasury rose +0.03% to 2.16%. Notably, the yield spreads over US Treasuries on both high grade and junk debt continues to widen, implying a broader move away from risky assets. Reflecting some of these concerns, the VIX Index rose 6% on the week to 23.6. Additional market detail can be found here.
EM in the crosshairs: As summarized by research firm Evercore ISI, any action taken by the Fed will serve to depress commodity prices and hurt emerging market countries.
· If the Fed tightens the US dollar strengthens and commodity prices decline, which puts pressure on commodity exporting emerging market countries.
· If the Fed doesn’t tighten, it raises concerns about global growth, which puts downward pressure on commodity prices and commodity exporting emerging market countries
With emerging market equity indexes down about -15% this year, it remains to be seen how much of this negative feedback loop has been recognized and priced into the market.
Surprised?: Perhaps the negative year-to-date performance of US equity markets should not be such a surprise. Aside from the fact that up until 2015 the S&P 500 had risen at the unsustainable pace of 20% per annum, economic data as measured by the Bloomberg Economic Surprise Index has been disappointing relative to expectations. This Bloomberg index measures the degree to which economic analysts under- or over-estimate the trends in the business cycle (a reading above 0 implies the economy is outperforming expectations, and a reading below zero indicates underperformance). As can be seen plainly in the chart below, data has been below forecasts for all of 2015. That is not to say that every economic data point is missing forecast levels (i.e. payrolls have been strong as has housing), but taken in the aggregate the data has been reflective of an economy that is not hitting on all cylinders.
Economic Wrap-Up: Second quarter GDP growth was revised upward to 3.9% annualized (from 3.7%) as Q2 Personal Consumption was adjusted up to 3.6% annualized (from 3.2%). Dragged down by the transportation sector (aircraft and autos), August orders for Durable Goods declined 2% month-over-month. Existing Home Sales in August were 5.3mm (vs. a forecast of 5.5mm), however New Home Sales exceeded forecasts at 552k (vs. 515k).
Markets got what they wanted from the Fed, or at least what they had wanted from each previous Fed meeting over the last nine years….namely that the Fed refrain from raising interest rates. That happened again last Thursday, only this time the equity markets did not rally as they had in the past. Whether equities behaved differently as a result of additional uncertainty about when the Fed might actually raise rates, or because investors are concerned that the Fed knows something about looming weakness in the economy that we don’t, may never be known. Nevertheless, what began as a nice week for equities, reversed hard following the Fed announcement and afternoon press conference as shown in the following chart of intraday performance of the S&P 500:
In spite of the decline over the last day and a half of trading, domestic large caps closed the week with only a modest loss, while small cap and tech stocks managed to make gains. Emerging and Frontier market equities posted the strongest performance on the weak up 3% and 1%, respectively. The yield on traditional fixed income instruments declined on the week with the 10-year UST falling 0.05% to 2.13% and the 30-year UST declining 0.02% to yield 2.94%. Precious metals snapped , while the energy complex was mixed (the price of WTI crude oil rose and natural gas prices fell). Additional market detail can be found here.
Housing Sector Strength: Under the radar earlier this year, strength in the housing sector is increasingly difficult to ignore. The latest sign of recovery in this pillar of the American economy came Friday when data showed that during the second quarter home mortgage debt increased by 0.5% from the prior year. According to data from Bloomberg, this was the first annual increase in mortgage debt since 2008.
The growing base of mortgage financing is being driven by increasing demand for mortgages (on the back of an improving labor market) and moderating lending standards making loans available to more would-be borrowers. A headwind to growth since the Financial Crisis, a turnaround in this sector would provide a much needed boost to the U.S. economy growth as housing (and its related sub-sectors) is estimated to make-up 13% of GDP.
Economic Wrap-up: The headline for August’s Retail Sales number was fairly weak at +0.2% month-over-month (m/m), however looking beneath the hood the headline number was dragged down by a 1.8% decline in gasoline station sales. The control group (sales ex-autos, gasoline, building materials) increased by 0.4% and is on track for solid 2.5% – 3% growth in Q3. Industrial Production declined 0.4% m/m in a continuation of a sideways trend for manufacturing output. Inflation remains weak as Core CPI for August indicated a 1.8% annualized rate (below the Fed’s 2% target).
After a tough run in August (-6%) and the beginning of September (-3%), equity markets rebounded last week with developed and emerging market equity indices posting gains of +2% to +3%. In spite of these advances, global equity indices remain broadly negative on the month. Interest rates were relatively unchanged last week, and the yield on the 10-year UST is 2.19%. Energy commodities declined as WTI crude fell by more than 4% to $44.76 per barrel and natural gas dropped by 1%.
Decision Time (again): This week, the Federal Open Market Committee (FOMC) meets again to discuss the economy and appropriate monetary policy. The question of whether the FOMC will raise rates or not this week (for the first time in nine years) has been asked of hundreds of analysts and if you thought the level of discussion on this topic in mainstream media circles was overbearing last week, it will be downright annoying this week. There are compelling arguments supported by current economic data points for why the FOMC should raise and for why the FOMC should not raise interest rates this week. However, the decision as to the timing of the first rate hike is misleading in its importance… the truly important factor for the economy is the rate at which future hikes may be implemented. With nearly unanimous agreement amongst members of the FOMC and non-FOMC economists that the path of interest rates will be shallow (i.e. interest rates will rise very gradually), remind me why the timing of the first hike is so important again?
Political Entrepreneurs Needed: Had the opportunity to hear ABC News Analyst Matthew Dowd speak at an event last week and his comments on modern day politics resonated strongly with me. You see, for a long time I have believed the problem with the political system and politicians is simply that we do not have enough people in office that want to be there for the right reason: namely to lead and to continue to advance the ideals of America. Rather, in my view, most politicians seek to be elected because of two key perks of the job: power and respect. Moreover, to continually be re-elected (and keep their political career on track) politicians avoid introducing revolutionary ideas that might seem controversial even if they are in the best long-term interest of America and American citizens. This dynamic has created a void of true leadership and a widening gap between what most believe America should be and where we are today as a society. Compare today’s politicians to America’s Founding Fathers like George Washington, John Adams, Thomas Jefferson and Benjamin Franklin. These were wealthy and successfully people who would continue to be wealthy under British rule and had little incentive to change anything. However, they were willing to risk everything, including their lives, to rebel against Britain in an effort to start a new nation that would offer the potential for success to a larger portion of the population. As Matt remarked, these political entrepreneurs were willing to pursue the ultimate start-up….a new nation. Importantly, they were willing to lead the process toward becoming a new nation. Unfortunately, since the original formation of our nation, political entrepreneurial vigor has been on the decline. Today our political leaders are largely followers – they use study groups to determine where their community or voter base wants to go on particular issues, and champion those causes in a well-choreographed illusion of leadership. To close the gap between the ideal America and where we are today, Americans needs to identify, support and elect to office the next wave of political entrepreneurs to lead this country. We don’t need a new nation this time around, but we do need visionary leaders.
Weekly Economic Data Summary: Job openings in July reached an all-time high of 5.8mm; the number of workers employed reached a record level of 122mm; and the number of part-time workers reached its lowest levels in four years implying that full-time employment is available for those that seek it. Equity market volatility negatively impacted the Consumer Confidence index which fell to a 12-month low of 85.7 (note that at this level the index is in-line with its long-term average).
September got off to a rough start for risk assets, with developed and emerging markets alike declining 1% to 2% in the first four days of trading. For the first time in a long time, most major equity markets are negative year-to-date, with only Europe and Japan clinging to small positive values. Facing little pricing pressures and disinflationary trends, hard assets also declined last week, with WTI Crude falling more than 6% to $46.05 per barrel. The long overdue market volatility that appeared in August is unlikely to fade quickly, and the VIX Index closed the week at a relatively elevated level of 27.8.
Separating signal from noise – An article in the WSJ last week reported that pension funds have been reducing their investment return assumptions from levels of 8% to 8.5% per year to an average level of 7.68% (which still seems high in today’s environment). By comparison, a recent survey of Fortune 1000 companies conducted by Towers Watson puts the average return assumption at 7.1% (down from 9.2% in 2000). According to Barron’s Magazine, a group of pension specialists believes a more achievable annual return level is 6.4%. The variance in return expectations amongst the different parties is to be expected – it is rare that any two people or groups will share the exact view on the future, be it which team will win the Super Bowl this year or the price of oil two years from now. The variance in projections is noise, but the widespread reduction of return expectations is a legitimate signal about the future….. Institutional and retail investors alike should recognize that financial markets will be less forgiving going forward. Appropriately, I expect conversations about effectively managing downside risk (i.e. protecting what you have) in a portfolio will become more prevalent than they have been since the bottom of the Financial Crisis more than six years ago.
The non-war currency war – A section in last week’s synopsis (“A Rose By Another Name”) suggested that even though central banks are engaged in a widely acknowledged currency war, central bankers would never publicly utter the words “currency war”. So it was an interesting admission this past Saturday when finance ministers and central banks from the G-20 met and pledged to “refrain from competitive devaluations”. That is probably as close as a group of central bankers, when sitting in the same room, will ever come to conceding the obvious currency war they are all party to. China’s recent devaluation of the yuan was a centerpiece of the meeting, but the U.S., ECB, U.K., and Japan have all played active roles in devaluing their currencies since the Financial Crisis. As the U.S. and U.K. prepare to shift monetary policy from toward raising interest rates, they are uniquely keen for other countries to play nice so as not to exacerbate the relative strength of their currencies (rising interest rates typically cause a currency to appreciate). However, amongst central bankers a pledge is merely a collection of words that may or may not serve as guidelines for how they will act. It is common knowledge that each central bank will behave in a manner that is best for their sovereign economy. As such, expect unconventional monetary policy to remain a key feature of central banks for the foreseeable future as different economies grapple with the slower growth prospects of the post-Financial Crisis world.
Economic Data Wrap-up: The ISM manufacturing index declined to 51.1 (two-year low) in August from 52.7 in July due to headwinds from a strong US dollar and weak global demand. However, the non-manufacturing sector (which is a larger part of the U.S. economy) remains on solid footing as indicated by the latest ISM non-manufacturing index which is near a 10-year high. The August payroll report was mixed: the number of new jobs added was slightly below expectations, but the official unemployment rate dropped to 5.1% (a 7-year low and a level the Fed considers “Full Employment”). Of course, the labor market is not as strong as the official unemployment rate would indicate as the unemployment rate is skewed by the low labor participation rate of 62.6% (vs. 66% prior to the Financial Crisis).