“No one goes there nowadays, it’s too crowded.” Yankees’ great Yogi Berra
The third quarter was notable for a number of reasons, including the passing of former Yankees’ great Yogi Berra. Berra was a 15-time All-Star and a 3-time AL MVP. His 10 World Series rings rival the 11 championships of Bill Russell of the Boston Celtics and Henri Richard of the Montreal Canadiens. Perhaps most impressive, Berra caught ‘both ends’ of 117 double-headers, back when they were played back-to-back (not day-night). We think ‘Yogi-isms’ are a great market guide.
Clearly, many markets became less crowded during the third quarter. Much of the news we’ve been expecting or waiting on has occurred, and the result was to take some of the wind out of China’s sails, as well as commodities and emerging markets. Just about every major asset class had a rocky quarter that pulled year-to-date returns into the red:
A lot is happening in the global economy right now. We’re seeing the effects of divergent approaches to restructuring after the Financial Crisis as well as a speed bump in the long-term China growth story. It’s often said that markets like certainty; we find this amusing, as there is little certainty in life, and none in the markets. Taking a broader interpretation of this comment helps us better decode what’s going on. Our take on the market climate is summarized by these four issues:
- China has had a rocky few months: its retail stock market went through a bubble and a crash in six months; it modestly devalued its currency; and released more data that indicate its transition to a consumer/services economy isn’t progressing as smoothly as hoped.
- The Fed has been waiting to raise short-term interest rates. The need to begin the increase is growing, but growth, employment and inflation data are keeping plans on hold.
- A number of countries, including Switzerland, withdrew support for their currencies.
- Spillover from the China slowdown and Middle East politics, as well as the strengthening dollar, has pushed oil and other commodity prices down. Many emerging markets are posting lower or negative growth rates, down from high single-digit levels just a few years ago.
This graph of Morningstar data provides a telling look at how various markets performed when a ‘perfect storm’ of news events roiled the markets in the spring and the summer. The U.S. dollar and U.S. high-quality bonds were the only areas that didn’t face some form of pricing pressure. As we noted last quarter, volatility rises when news becomes disassociated from underlying fundamentals.
“When you come to a fork in the road, take it.”
Two ‘forks’ we follow (graph below) are a slowing of the dollar’s rise (blue line) and some stabilization in commodities (green). Both are positive developments for the global economy for a number of reasons, not the least of which is more independence from China with respect to policy and market changes. This should promote value in the markets as well as a ‘floor’ for valuations and growth.
So, the question we come to now is, is the dog wagging the tail, or vice versa? Is a slowing China “tanking” emerging markets, commodities and currencies? Or is the strong dollar hurting China, emerging markets, commodities and currencies? Here’s what we see in three key data sets:
China’s miracle economy is slowing, without doubt. We’ve long been suspicious of the quality of their ‘official’ data as well as their ability to manage a ‘soft landing.’ Their stated GDP growth has fallen from 10% to 7% a year in a short period, during which the U.S. has been stuck between 2% and 3%. Other data shown here are clearly more volatile and sharply declining, too. China’s economic retooling is off-track, and the effects are far-reaching around the globe.
If — emphasize if — the Fed increases short-term interest rates, the effects may be exaggerated more than we normally expect given the current state of investor emotions. In the past, U.S. rate increases have been signs of a strong economy, and bonds and stocks did well after the program began. Despite the complexity of today’s global economy, we have no reason to think this time should be much different.
Energy-sector earnings are hurting the overall earnings picture. S&P 500 earnings have clearly been depressed due to issues with oil prices and earnings. Now, the effects from a strengthening dollar and lower foreign sales (about 40% of earnings) are expected to kick in for the third-quarter earnings season. Earnings growth for materials, technology and consumer stocks is expected to be negative. This is a bump, we think, not a sign of economic recession.
“It ain’t over till it’s over.”
We agree with Yogi. The markets started the year with a strong run, got the correction we’ve been waiting for, and are now retrenching. Investors are looking for signs that: China is back on track; oil is bottoming and demand is growing to meet lower supply; the dollar is pausing; and U.S. tightening is delayed while foreign monetary easing continues. Emerging markets (and China) still stand to be the big drivers and beneficiaries of these changes, but most regions should see positive growth.
There aren’t many areas we see as big concerns (‘overweights’ or ‘underweights’). We’re modestly bullish on stocks, think U.S. rates will rise (but not fast and not as high as in the past), and that the dollar will appreciate, but more slowly than it has been. We have exposure to many of the areas that will benefit from a global rebound, both in specific industries and regions. And, as we have often said, our bond portfolios are managed for a long-term view rather than short-term trading. Finally, we expect volatility to still be on the upswing, and more bumpiness is forecast in the coming quarter.
As always, we welcome your comments, questions and feedback.
–Your Wealth Management Team at JJ Burns & Company
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