Stock markets throughout the world posted negative returns in the third quarter of 2015 as rising global uncertainty drove down equity prices. Renewed fears of a hard landing in China bore the brunt of the blame, yet in our opinion, the real culprit of renewed price volatility is simply the fragile state of the market. As we wrote in our August 24 commentary, “Volatility Is Not on Vacation,” the combination of waning earnings growth and full valuations makes the domestic equity market susceptible to overreact to external developments. We believe that concerns about China are overdone, as outlined in the feature article of this issue of , but we conclude that price volatility is likely to linger due to the lack of support from robust profit growth or attractive valuations.
The benchmark S&P 500 Index lost 6.4% during the period (including reinvested dividends), and at one point in late August stood more than 12% below the May peak. That loss of 6.4% for the quarter was, nevertheless, better than the 10.3% loss posted by smaller capitalization stocks (as measured by the Russell 2500 Index) and the 17.8% decline in the dollar value of emerging market equities. Returns from international equities – both in developed and emerging markets – have been constrained by the strength of the U.S. dollar, which has rallied 14% against a trade-weighted basket of other currencies over the past year. Hedge funds, at least in aggregate, provided little protection against market losses. The HFR Equity Hedge Fund Index dropped 5.8% in the quarter, thereby capturing 91% of the broad market downside. The damage in emerging markets is such that the three- and five-year trailing performance figures have now slipped into negative territory.
Traditional fixed income classes eked out modest gains in the quarter. Investment grade bonds added 1.2%, and municipals rose 1.7%. Economic concerns led to widening credit spreads, which drove high-yield bonds down 4.9% on a total return basis. Inflation-indexed bonds dropped a modest 1.2%.
The best performing asset class in the quarter, broadly defined, was the U.S. dollar, which rose 4.6% against a trade-weighted basket of other currencies and is up 8.8% for the first nine months of the year. This rally has sapped the return of non-dollar assets to U.S.-based investors while complicating the Federal Reserve’s decision about when to begin the long march toward a more normal monetary policy. All else being equal, a stronger currency leads to tighter monetary conditions, which in turn helped the Fed decide in September to leave the fed funds target rate at zero for the 54th consecutive meeting of the Federal Open Market Committee.1 The futures market now assigns a probability of only 32% that the Fed will raise interest rates before year-end.
The strong dollar has also weakened the earnings growth of large American companies – as represented by the S&P 500 Index – which derive around 40% of revenues abroad. Those revenues and profits don’t translate back into quite as many dollars when global currencies weaken. The result is lower dollar-based profits in an accounting sense, but to the extent that expenses and revenues are based abroad, the genuine impact on the fundamental value of multinational companies is muted. Nevertheless, the strong dollar adds a further headwind to earnings already suffering from the diminishing returns of cost-cutting and margin expansion in this seventh year of an economic cycle.
Having noted that, we continue to monitor the strength of corporate earnings closely, as they are the fuel of equity markets. In a modest economic expansion, unit volume growth is hard to come by, and the absence of inflation implies that pricing power is similarly hard to find. That doesn’t necessarily spell the end of a market cycle, although it does illustrate the increasing difficulty of finding investment opportunities that offer an appealing tradeoff of risk and return. Where most institutional investors would respond to rising market risk by diversifying, we prefer to manage that risk by concentrating into those investments that still offer an appealing tradeoff of risk and return and holding reserves in short-term fixed income instruments awaiting redeployment into more attractive investment opportunities.
The U.S. economy continues to expand at a moderate pace, fueled largely by strong personal consumption, which is in turn supported by improving housing and labor markets. GDP in the second quarter of 2015 expanded 3.9% at an annual pace, although that is likely to slow to around 2.0% in the third quarter. Wage growth has yet to accelerate, even though the unemployment rate of 5.1% is at a seven-year low, and unemployment claims are at a 40-year low. The labor market is in good shape, and we expect continued job gains to begin to support wage increases in the near future. That should provide an additional boost to personal consumption as well as corporate earnings.
Discipline is an important element of any investment strategy, but that importance is magnified when valuations are full and the support of earnings growth has begun to wane. To paraphrase Thomas Jefferson, eternal vigilance is the price of investment liberty and lies at the heart of our investment approach.
Equity Asset Classes:
Large cap U.S.: S&P 500 – index of 500 large cap common stocks actively traded in the U.S.
Small/mid cap U.S.: Russell 2500 – index of approximately 2,500 small-cap common stocks actively traded in the U.S.
Non-U.S. developed: MSCI EAFE – index of stocks from 21 countries designed to measure the investment returns of developed economies outside of North America.
Non-U.S. emerging: MSCI Emerging Markets – index designed to measure the equity market performance of 26 emerging economies.
Fixed Income Asset Classes:
Investment grade taxable bonds: Barclays Aggregate – benchmark designed to measure the performance of the U.S. dollar-denominated investment grade, fixed-rate taxable bond market.
Investment grade tax-exempt bonds: S&P Municipal Bond Index – index that seeks to measure the performance of the U.S. municipal bond market.
Inflation-protected: Barclays U.S. TIPS – index designed to measure the performance of inflation-protected securities issued by the U.S. Treasury.
High-yield: BofA Merrill Lynch High-Yield (Cash Pay Only) – index of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
Source: Bloomberg, BBH Analysis.
Past performance does not guarantee future results.
Index performance is not illustrative of any specific security’s performance. Indexes are unmanaged, and an investment cannot be made directly in any index.
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© Brown Brothers Harriman & Co. 2015. All rights reserved. 2015.
1 Refer to our September 17, 2015, commentary, “The Fed Punts,” for additional information on the Federal Reserve’s decision to keep interest rates near zero.