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Tuesday, October 6, 2015

Third Quarter Market Review and Prospects

There is no way around the fact that 3Q 2015 was an ugly one for equity markets. After a second quarter of "boring” markets with little fluctuation volatility came back massively in the third quarter...and on the downside. This was the worst three month period for the equity markets since 2011.

Between February and mid-August the SP 500 traded in a range of less than 3%. That changed in mid-August including a one day drop in the first hours of trading on August 24 of 7.5%  for the S+P 500 (the market closed down over 4% that day) Throughout the rest of the quarter daily movements of 1.5-2.5% were extremely frequent in the US and international markets,

The rationale/explanation is tied to the collapse in China's stock market and issues related to it.

After a period of massive increases much based on local speculation, government policy to encourage stock investment and to a lesser extent foreign investors, the Chinese stock market took a sharp drop from "bubble territory" and dropped 22.1% in the third quarter.

 It should be noted that even with this decline the Chines market as measured by the ETF FXI is down just 5.7% in the last 12 months. The fall caused both forced liquidation of stock positions by leveraged investors, Government policies that attempted to prop up the market had the opposite of the intended result and led to liquidations by foreign investors.

The fall in the stock market led to "China experts revising sharply downward the estimates of Chines economic growth in some cases to as low as 3% vs. official figures in the 6% range. The estimate for by the IMF remains above 6% although it has been revised slightly downwards, Whatever the exact numbers it is clear that the Chinese economy will be moving from one oriented towards infrastructure to one geared to growing the consumer economy. The impact has been felt in sharp falls in commodities and the stocks and currencies of commodity exporting countries and companies.

The impact of the China selloff had the most extreme impact on emerging market stocks. 

The impact on commodity prices was immediate as it was on other emerging markets particularly the commodity exporting countries and their currencies.

The outflow from emerging market stocks was massive estimated as high as $1 trillion and 2015 the first year of net capital outflows in 27 years. The decline in emerging markets pushed the 10 year total return down from outperformance vs US stocks to underperformance. 

For 2015 the outperformance of 15% for emerging markets vs the US seen earlier in the year dropped to an underformance of 10%  It remains to be seen of course if this will be the case going forward and the large outflow an indication of oversold conditions. The fundamentals for Asian countries including China seem not be as bleak as current markets reflect.

Here is VWO (emerging markets) vs. SP 500 year to date with emerging markets crossing from outperformance to underperformance during the past quarter.

Even with lower growth expectations the massive outflows from emerging markets have produced historically low valuations that may be an opportunity for the longer term investor, The MSCI China index forward P/E is calculated at 7.8% vs a long term average of 9... GDP growth as estimated for China and the rest of emerging Asia even after being revised slightly downwards remains above 6%.  compares to  growth estimates in the 2- 2.5% range for the US.

The growth prospects for commodity exporting countries such as Latin America and Russia are far more uncertain. The argument for making distinctions between emerging markets particularly the distinction among the "Brics" Brazil Russia India and China seems stronger than ever.

Low interest rates in the US have underpinned the US stock market rally leading to high valuations vs historical levels. After the long rally and high historical valuations the US market was ripe for a decline and the developments in China provided a catalyst. The fall in the S+P 500 was 7.2% for the third quarter. With the prospect of higher interest rates, lower earnings due to a decline in exports and more mixed investor sentiment the potential for a further drop remains high although not of the magnitude seen in the third quarter.

The bullish case for US stocks is based on a continuation of low US interest rates and strength in earnings to be reported for the third quarter

European stocks  joined the global selloff with the European market (ETF VGK) falling 8.9% in the third quarter. They erased all of their outperformance vs US stocks which had reached as much as 8% . The European stock selloff reflects the view that European companies are more exposed to Chinese export markets than the US.

German stocks now trade at a roughly 3% discount in valuation vs the US . They have been hurt of late due to the crisis related to Volkswagen which has had impact on the entire market despite it's low weighting in the country index of 3%. For the first time in a decade German stocks have turned to an underperformance vs the overall European index. 

The Euro has also recovered from a low of $1.05 earlier in the year to the current $1.12 levels as the prospect for higher US rates has diminished most recently.  This pushed the performance of the currency hedged Europe Etf to -12.6% for 3 Q.

As far as the European Central Bank is concerned there is a near certainty the low interest rate policy will continue. Higher rates in the US would likely lead to a lower Euro reversing the recent Euro strength. A resumption of the Euro's long term downtrend (it is still down over 10% over the past 12 months) helping European exporters but cutting into returns for dollar based investors.

Performance of Selected Equity ETFs

3Q 2015
1 Yr
3 Yr
Total World Stocks (ACWI)
US S+P 500 (SPY)
Emerging Markets (VWO)
Europe (VGK)

Fixed Income

The US bond market continued to have difficulty gauging the timing of the "liftoff" from the Federal Reserve in raising interest rates. The Fed somewhat surprised markets by not raising rates in September citing uncertainties related to China and the global markets. This gave a lift to longer term bond prices/drop in yields. In statements after the September announcement Fed governor Yellen indicated the high likelihood of a hike in rates in December. But a disappointing jobs report on October 2 which some attribute to the impact of China has pushed back expectations of interest rate hikes.

The uncertainty for further interest rate increases and a ten year Treasury bond yield of 2% makes long term bond unattractive as an investment even if traders have managed gains in their trading of longer term bonds. Investors are better off keeping maturities short reducing volatility and the impact of rate increases on their holdings.

The extreme fluctuations in the US stock market created a "flight to quality" in the credit markets as spread as High Yield bonds increased in yields/fell in price vs Treasuries. HYG the intermediate term high yield bond index (ETF HYG ) fell 5.3% in the third quarter vs a gain of 1.4% for intermediate term Treasuries .The yield spread over US treasuries is now above 6.5% well above long term averages,.

Emerging market bonds suffered from poor economic prospects and the impact of depreciating currencies. EMLC the largest emerging markets bond ETF fell 9.7% in the third quarter. Continued weakness for the economies of commodity exporters and their currencies the outlook for emerging market bonds remains unfavorable. The prospects for recovery in the equity markets of countries with currency account surpluses such as China and much of Asia seems much greater than recovery in the bond or stock market of debtor countries such as Turkey, Brazil and Russia.

Performance of Selected Bond ETFs

3Q 2015
1 Yr
3 Yr
Aggregate US Bond (AGG)
High Yield (HYG)
Long Term US Treasury (TLT)
Short Term US Bonds (BV)
Emerging Markets (EMLC)

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