Emerging Markets

Rough Start to a New Year

Stocks sold off today putting a cap on what has been an ugly first two weeks of 2016 for global financial markets. Let's take a look at what has driven the markets lower:

1) Oil- Crude prices fell to a twelve-year low of $29 a barrel. This is a decline of over 20% in January alone. There is no question that excess supply has been a significant factor in the decline in oil prices over the past eighteen months, but there still are very few signs that supply has been reduced in a meaningful way anywhere around the globe. Also, there continues to be no increase in demand and that is not good news for the global economy that already has it's hands full with adjusting to a slowing Chinese economy. Which takes us to point #2.

2) China- Last August China took financial markets by surprise when they devalued their currency, leading to stock market declines of more than 10% in many regions. After that decision authorities in China made a point to say there would be no reason for further devaluation. Fast forward to the first week in January and the People's Bank of China again devalued their currency, the yuan. This action has investors around the globe asking the question, is Chinese economic growth much weaker than Chinese authorities have acknowledged? The Chinese have projected 7% GDP growth for 2016. However some economists feel that growth will fall well short of 7% and that authorities in China will continue to devalue their currency to try and spur exports and increase growth.

So why would this cause so much pain for stocks in the U.S.? For the past four - five years the fast pace of economic growth in China has really helped the global economy overcome weak growth in Japan, Europe, Latin America, etc. If, and at this point it is still an if, China is dramatically slowing that will have a negative impact on the global economy and many U.S. companies. Also, as a result of the devaluation Chinese goods will become cheaper for U.S. importers. But when combined with plummeting commodity and oil prices, this will put significant deflationary pressures on the U.S. economy, which is a challenge our sluggish economy does not need.

On a side note, the Chinese stock market, The Shanghai Composite, is down over 18% so far in January. As we have said before action here should not be overplayed as the market does not have the same connection to the Chinese economy as Western markets have to their economies.

3) U.S. Retail Sales-  The Commerce Department reported that Retail Sales grew just 2.1% in 2015, down from 3.9% in 2014 and from an average of 5.1% from 2010 - 2014. Even though the U.S. economy has seen average GDP growth of only 2% during this recovery, the U.S. consumer has been the bright spot up until now. The question is will this prove to be a temporary blip or is this the start of a slowdown? When taking a deeper look at the report there are pockets of strength and this is just one of many snapshots of the U.S. economy.

4) Federal Reserve- The Federal Reserve raised interest rates by .25% in December, ending the unprecedented run of seven years of 0%. While a .25% increase is a very small number, it isn't the size of the increase that has had an impact on the markets it is the psychology. Financial markets are now adjusting to the fact that after seven years of 0% interest rates and $4 trillion added to the Fed's balance sheet, the Fed is now in a tightening cycle. There is no way to measure how much impact the Fed rate increase has had on the volatility of the past few weeks but it is healthy for markets to adjust to higher interest rates.   

We entered the year with a cautious stance and nothing has changed our position. The Federal Reserve projected four interest rate increases this year and we believed we would see no more than two. A March increase is probably off the table due to the current state of markets and especially the deflationary pressures that are increasing. We are entering the heart of earnings season and this will give us a very good look at not only the current state of the U.S. economy but also the impact the Chinese economic slowdown is having on U.S. companies. Stay tuned.    

Markets Fixate on Chinese Economy and The Federal Reserve

The volatility that engulfed currencies, commodities and stock markets around the globe in August has continued into September. Spikes in volatility are a normal part of the markets but we want to keep you updated on the reasons behind these spikes. In this case there are two primary causes of the increased volatility. Let's take a look:

1) The continued unease over the economic slowdown in China. 

Since 2010 China has been responsible for almost half of worldwide economic growth. China's growth filled a void created by abysmal growth in Japan and Europe, as well as the sluggish growth we have seen here in the United States. When diving into China's economic data, a fact that jumps out is total Chinese debt has grown from $7 trillion in 2007 to over $28 trillion as of mid-2014.

This increase in debt puts China's total debt/GDP ratio at almost 300% of annual GDP. The only country with a higher ratio is Japan. Japanese growth has been anemic for several decades, weighed down by their debt-load. Back to China- so much of their growth in the past seven years has been thanks to an almost unprecedented credit boom. Due to China's tight capital controls most of this debt is held within China. Earlier this summer BlackRock Investments summed up the problem:

“China has been taking on increasing amounts of debt to maintain growth. Yet it has been getting less bang for its yuan as growth has edged down. Credit growth is not just losing its potency; it is turning into a poison. Debt is growing faster than borrowers’ ability to service it. The resulting debt mountain stood at $28.2 trillion at the end of 2014, according to a McKinsey report. The debt cannot be rolled over indefinitely. China’s debt-to-GDP ratio has reached almost 300%. Government debt makes up a relatively small share of the total, with the bulk in the corporate sector”.

For the past thirty-five years China's GDP growth has averaged almost 10%. However, China's per capita GDP is only $7,572. As a comparison, the per capita GDP in the U.S. is $54,678. What that means is that China needs many more years of high growth in order for prosperity to continue increasing. China's ruling party is the Communist Party and they know strong economic growth is critical to their stability as a ruling party. In recent months we have seen signs of panic from the Chinese government like devaluing their currency, cutting interest rates for the fifth time since December 2014, spending over $500 billion to try and prop up stock prices (something that hasn't worked) and now arresting over 200 people for alleged rumor-mongering related to sharp decline in stocks.

Just because China has $28 trillion in debt does not mean a crisis has to develop, look no further than Japan for proof of that. Also, we are not saying that the Chinese growth story is coming to an end. But if China tries to deleverage and not rely so heavily on debt for new spending what will that do to global economic growth? The China story is going to be very interesting to watch in the coming months and years.  

2) Speculation and debate about whether the Federal Reserve will or will not raise interest rates at their September meeting. 

The Fed has kept interest rates at near-zero since the 2008 crisis. While the decision to lower rates to zero was a wise one at the time we believe the Fed has made a mistake by waiting this long to have their first rate increase. The U.S. economy is at a point where it can clearly handle a .25% increase in rates. While 2.2% GDP growth in the first-half of the year does not make for a thriving economy certainly current conditions such as fifteen-year lows in jobless claimsa strengthening housing market, an uptick in business investment and strong corporate balance sheets illustrate that the economy is not on life support and can handle higher interest rates. Now to be clear we are not talking about the Fed normalizing interest rates. If the Fed were to raise rates by .25% in September and another .25% in December, rates would still be less than 1%, a figure that is still extremely accommodating. 

The Fed's easy-money policies since 2008 have been a boost to asset prices, including real estate and stock prices. It is no surprise that as we get closer to the Fed potentially increasing rates that market volatility has picked up. Once the Fed begins to raise rates there is no question that the pace of increases will be extremely slow. But the market will still have to adjust to the fact that rates will be going higher. As of today the market puts the likelihood of the Fed raising rates on Sept 17th at 27%. Put us in the camp hoping the Fed does move forward with raising rates this month, just the fact that they get the first increase out of the way could help calm the markets.

In the near-term we expect that economic news out of China will continue to be heavily scrutinized as global markets try to digest developments in the world's second-largest economy. Here in the United States, the Fed will have to decide if the recent turmoil in China is going to push back the first rate increase or if stronger U.S. economic data gives them the cover to move rates higher. The world will be closely watching.

Chinese Economic Turmoil Hits U.S. Markets

I was asked on a call this morning if I was thinking about jumping out my window due to the market turmoil. The question was tongue-in-cheek but it got me thinking and and ultimately I did make the jump. After the two-foot drop into the flower bed I realized I preferred to be back in the office and stepped back in through the window. Moving on...  

Investors have been unnerved by the economic pullback in China. Among other things China has seen poor manufacturing data, weak auto sales and a plummeting stock market. The U.S. market sell-off has been a response to the bad news out of China as well as the major declines in other Emerging Market stocks and currencies. I would not categorize what we have seen as an Emerging Market crisis just yet but it is possible that if currency declines continue it would be a real challenge for developed markets(read: U.S, Europe, Japan). 

Here are some stats that illustrate how challenging recent market action has been:

  • The S&P 500: Down 11.3% from mid-July, its first decline of 10% since 2011
  • The Dow: Down 13.1% from May, its first decline of 10% since 2011
  • Apple: A stock that has been a favorite for retail investors and hedge funds is now down over 23% from it's high in mid-July
  • Chinese stocks (Shanghai): Down 38% from June
  • German stocks (Dax): Stocks in Europe's strongest country are down 22% from April
  • Oil (WTI): Breaks below $39/barrel after a 5.6% decline today
  • Copper: A metal whose price is often viewed as a proxy for global economic growth is down to its lowest level since 2009
  • European stocks (Stoxx 600): Down 5.3% today, the worst daily percentage decline since 2008
  • Commodities (Bloomberg Index): This commodity index fell to its lowest level since 1999

Despite all of this negativity I have seen investors remain calm. Having said that, there are real questions as to how far this market decline will go. The stock market crashes in 2000 and 2008 were triggered by conditions in the U.S. - the tech stock bubble in 2000 and the financial crisis in 2008. Current market conditions are much stronger than either of these periods. If we look a bit deeper we find that in the summer of 1998 the S&P 500 declined just over 18% in response to the Asian financial crisis. In the summer of 2011 the S&P 500 again fell over 18% in response the financial crisis in Europe. Obviously no one can predict with certainty how much further U.S. stocks will fall but the recent stock market declines appear be closer to a buying opportunity than a time to head for the exits. I do expect volatility to continue for several more weeks and there is potential for further losses. However our indicators are pointing to the idea that this is part of a long-overdue correction here in U.S. stocks, not the beginning of a market crash like 2008.

One more topic- I think it is safe to say monetary policy alone has failed to drive economic growth. Over the past seven years we have seen unprecedented market intervention from central banks around the globe. The central bank intervention has focused on keeping interest rates at historical lows and expanding their balance sheets. As an example, the Federal Reserve has kept interest rates at near zero and expanded its balance sheet to over $4 trillion. The table below shows how U.S. economic growth has consistently fallen short of Fed forecasts during this period of extremely accommodative policies:

Source: WSJ

Source: WSJ

We have seen these actions by the Fed repeated by the Bank of Japan, Bank of England and the European Central Bank. Why then has growth continued to be so slow in the U.S. and almost non-existent in Europe and Japan? The answer is that there has been very little pro-growth reform in the past half-decade. In the U.S. excessive regulations have stifled economic growth and crippled many small businesses. Rarely a day goes by where there is not a new rule that must be followed. The U.S. has the highest corporate tax rate in the developed world. In Europe rigid labor markets, high tax rates and excessive regulations have made economic stagnation a way of life. 

Diving deeper into this topic is for another day. The takeaway is that this market correction has brought on calls for the Fed to not only delay raising interest rates into 2016 but even some have called for the Fed to launch another quantitative easing program. It is our hope that the Fed will ignore these calls and begin a slow increase in rates either in September or October. In a speech that occurred this afternoon, Atlanta Fed President Dennis Lockhart said that he continues to expect that the Fed will hike rates sometime this year. Lockhart is a voting member of the FOMC.

Stock market volatility is a part of investing and stock market corrections are normal. That said, we will continue to keep a close eye on developments in the coming days.

Pitfalls of the Unemployment Rate

Coming into 2014 the stock market was overdue for a pullback.  Concerns over a potential crisis in many emerging market economies ignited the January drop in the markets.  After a rocky start to the year, the S&P 500 has rallied over 5% since February 3rd to get back to break-even.  Economic data and earnings reports in February have not been especially good but stocks have bounced back as emerging markets have stabilized for the time being.

Dig a little deeper and a more interesting story is taking place in the bond market.  Last year bond prices fell, sending interest rates higher as investors became more confident in the economic recovery and on speculation the Federal Reserve would begin to taper its bond-buying program.  The yield on the 10-Year US Treasury rose from 1.83% on Jan 1, 2013 to 3.02% on Dec 31, 2013.

Now to 2014... as the stock market fell in January, investors ran to the safety of bonds sending the 10-Year yield down as low as 2.61%.  What is fascinating is that while stocks have recovered from the January losses we have not seen bond yields return to the 3% level.  In fact the 10-Year Treasury is currently yielding 2.64%.  In the past when there has been a significant variance between the stock and bond market it has been wise to follow what the bond market is telling us.  It is too early to make investment declarations based on the current variance between stocks and bonds but if bond yields continue going lower it will certainly be noteworthy.

Shifting gears, I came across an article this week in the Wall Street Journal that does a solid job in picking apart the over-reliance on the Unemployment Rate and explaining why this over-reliance is problematic.  While the jobs report from the Bureau of Labor Statistics may be the most important economic data released each month, it is the supporting data found in the report that is much more critical than the headline number itself. Check out the article from the WSJ:

"The unemployment rate, in short, is one of the most consequential numbers shaping our body politic. Unfortunately, it is also one of the most misleading.  The real problem is that the number, originally designed for limited purposes, has come to assume totemic status. Focusing so single-mindedly on this one employment figure has made it impossible to have a cogent discussion of labor in the U.S. and to design meaningful responses to our varied economic problems."

For full article click here:  http://on.wsj.com/1fIe0qG

Global challenges

For the third straight year, summer is being welcomed in by a slumping stock market. This is something we warned about in our update on April 3. Here is the latest on the situation:

Last week:

-By now I am sure you have heard plenty about the dreadful U.S. jobs report on Friday. There was an increase of just 69,000 jobs in May compared to expectations of 160,000 jobs added. http://www.ft.com/cms/s/0/0a3ed818-abe2-11e1-a8a0-00144feabdc0.html#axzz1wmgbTXND

-Manufacturing activity in Spain plummeted to a three-year low. Germany and France also posted manufacturing figures at or near three-year lows.

-European Union statistics agency Eurostat said there were 17.4 million people without jobs in the 17 nations that use the euro in April. This is the highest level of unemployment ever recorded in the history of the European Union. The rise in unemployment is likely to add to discontent with the austerity programs underway in the euro member states.

-Brazil's manufacturing sector showed contraction for a second straight month.

-Manufacturing activity in China slowed dramatically in May.

-This weekend, German Chancellor Angela Merkel doubled down on her opposition to joint debt sharing in the form of the euro bonds. If she does not change her mind it is hard to see how this crisis gets solved as it is apparent Spain, Italy, Greece and the others have no intention of real reform. http://www.bloomberg.com/news/2012-06-02/merkel-rejects-debt-sharing-as-obama-urges-end-to-crisis-cloud.html

On the horizon:

-It appears to be a matter of time before the European Central Bank or the Federal Reserve attempts to ride to the rescue with some sort of stimulus plan.

-Will Spain's 10 year treasury bond rise to 7%, a rate that would signal serious trouble

-Oil prices are down more than 20% in the last month. This should be a boost for consumers as well as for companies' profit margins.

As always, we will continue to manage risk and look for opportunities!