Volatility has been the watchword for global markets this year. That goes whether you’re talking about emerging market’s economies or currencies, China’s or America’s stock markets, or global commodities prices. This year Canada slipped into a shallow recession and Brazil’s recession deepened. China’s Shanghai Composite Index surged 60% before crashing over 40%. Copper and oil have fallen over 20%. And our own stock market just completed its deepest correction since 2011. The VIX Index, which measures investor fear, temporarily spiked to four-year highs. Yes, volatility, which was mysteriously absent through 2012, 2013 and most of 2014, is back.
By now, we all know the list of risks & issues that caused the correction. Various signs of financial instability in China made us wonder if perhaps the world’s second-largest economy might be slowing more rapidly than expected. Certainly the government’s pathetic response to stock market chaos spoke of desperation. And falling commodities prices hinted at widespread global economic weakness.
Since the US has been in relatively better shape, the dollar has appreciated strongly against many foreign currencies. At the same time, our Federal Reserve is poised with its finger on the button to begin raising interest rates. And this expectation compounded the currency move and added to financial fragility in emerging markets.
Finally, Saudi Arabia’s strategy to limit US shale oil production growth has largely succeeded. Simply put, Saudi is one of the lowest cost producers in the world, and took advantage of the fact that supply was rising much faster than demand. As a result, corporate profits within the US energy production sector are more than 50% lower than year-ago levels. Many oil rigs have been idled and jobs eliminated.
Through the summer, the world looked like a more dangerous place for investors. And then at the beginning of October, everything turned around. And here we are, having just enjoyed the best month for US stocks in four years. What gives?
First, while global economic growth is clearly tepid, we’ve had some recent announcements regarding further monetary easing from central banks in both China and Europe, which are supportive of asset prices. This pattern of economic weakness followed by monetary stimulus is by now very familiar, with a strong positive impact on stocks. In addition, our Federal Reserve continues to be patient, preferring a stronger growth environment before raising rates.
Second, China’s financial markets have stabilized. That’s admittedly a small step toward normalization, but it’s worth pointing out that we are no longer reading headlines suggesting a full-blown financial crisis in China. And by the way, haven’t we known for some time that the Chinese economy is in secular decline as it transitions from export-led growth to consumer spending-driven growth? So it looks as though traders overreacted to China’s stock market correction.
Third, oil and the dollar have also stabilized, and this is critical to our stock market recovery. West Texas crude oil bottomed near the end of August at about $38/barrel but since then has kept a tight trading range of $44-50/barrel. To the extent oil remains over $40/barrel, it will be constructive for equities. At the same time, we’ve seen the dollar back off from its highs. Our currency appreciated at a very strong pace (about 25%) against a basket of foreign currencies from mid-2014 through March, but here again, it has fallen back into a trading range ever since.
One reason oil and the dollar are critical is that they have negatively impacted US corporate earnings. Corporate earnings grew about 8-9% last year, but have cratered due to lower oil prices and a stronger dollar. So second quarter earnings growth for S&P 500 companies came in at -2%, and third quarter growth is expected to be about -5%. The big picture for earnings isn’t all that encouraging.
But remember, it’s not red across the board. While energy and basic materials sectors are expected to post third quarter earnings growth of -20% to -60%, other sectors like consumer discretion, healthcare, telecom and utilities are expected to report positive growth. And even though the tech sector doesn’t look wonderful as a whole, look at the stellar earnings announcements by Intel, Alphabet (Google), Amazon, Facebook and Microsoft.
And there are some very positive factors here at home that could sustain the stock market rally. Household debt is down, the savings rate is up, and if you exclude gasoline stations, retail sales were up 4.9% year-over-year in September. Lower oil (and therefore lower gasoline) prices will benefit consumer spending as we move into the holiday shopping season. Also, the housing market is zipping along with 8% y/y growth in existing home sales, and 4-6% growth in home prices. Finally, the labor market—despite energy sector layoffs—is rather strong. Initial filings for unemployment insurance are down to 15 year lows and the unemployment rate is down to 5.1%. Anecdotally, we’re seeing more headlines about wage increases (like Wal-Mart), and we’re hearing CEOs complain about the difficulty of finding qualified employees. In our view, there’s not much slack left in the labor market.
Therefore, our view continues to be one of cautious optimism for the US economy and stock market. The positives continue to outweigh the negatives. We expect US GDP growth to remain in the 2.5% range next year, and that oil and interest rates will remain low for an extended period. We also believe this slow but steady environment opens up more opportunity at home than abroad. Of course volatility will remain the side-kick of investors as a by-product of slower economic growth. And investment success will depend on staying the course in spite of short term market fluctuations.