The past month saw global financial markets hit with a double whammy. The first blow came on August 11, when China allowed the yuan to depreciate. The drop in the currency rattled commodities and sent some emerging markets, along with their currencies, into a tailspin. The second jolt came in late August, when investors anticipated a potential Fed rate hike and began selling ahead of a decision.
Every end to quantitative easing (QE) has resulted in a correction in stocks. The first QE program ended on March 31, 2010, and stocks experienced a flash crash in May 2010 as part of a larger correction that saw losses of roughly 17 percent. QE2 ended on June 30, 2011, and stocks fell nearly 20 percent from their April 2011 highs to their August 2011 lows. In May 2013, the Federal Reserve announced QE3 would end later that year. The S&P 500 Index saw a small loss, but emerging markets, bonds and interest-rate-sensitive stocks, such as utilities and REITs, suffered significant corrections in what was dubbed the “Taper Tantrum.” Ahead of the end of QE3 in October 2014, stocks experienced a 10 percent correction from mid-September to mid-October. Now, ahead of a possible rate hike in September, stocks again corrected, with the S&P 500 Index falling approximately 10 percent from its July high to August low. In each case stocks went on to achieve new highs.
Muddying the waters this time is the slowdown in China. Its economy began slowing several years ago but gained even more downward momentum in 2013. The situation that has investors suddenly worried isn’t new, but most investors ignored the warning signs and took the 7 percent GDP growth as a fact. The seeds of today’s slowing economy were planted seven years ago. After 2008, China was poised to experience a slowdown in growth as the repercussions from that year’s financial crisis worked their way across the global economy.
Instead of adjusting, China launched a massive stimulus program that avoided rebalancing and restarted the global economy. Equivalent to more than 10 percent of GDP, the stimulus program pushed banks to lend and local governments to spend, leading to incredible credit growth. It took the United States 15 years through 2008 to build up as much private debt (as a percentage of GDP) as China built up in the five years through 2014. China’s economy is less efficient, with fewer market signals than the United States. A great deal of investment was funneled into real estate development, both residential and commercial projects, as well as the building of steel mills and concrete factories to serve infrastructure development. Emerging markets and resource exporters such as Canada and Australia benefited as Chinese demand appeared insatiable.
Odds were high that something would break in China. The slowdown to this point has been very orderly, with the government able to avoid a major systemic crisis. Even the government-created stock market bubble, an attempt to swap debt for inflated equity, was contained; however, the currency depreciation in August may be a sign that the slowdown can no longer be controlled by the government.
While not a perfect parallel, the crisis in China bears a resemblance to the Asian Crisis of the late 1990s. Then, as now, Asian economies with a multi-decade record of rapid development ran into trouble. Credit bubbles, currency pegs and global imbalances all came unglued at once. The currencies of Malaysia, Thailand and Indonesia, among others, collapsed. Commodity prices collapsed as well, with oil falling below $10 a barrel, eventually causing Russia to default on its debt. Currently, Brazil’s economy and currency are in trouble, the Canadian and Australian dollars recently hit fresh multiyear lows, and countries as far apart as Turkey and Malaysia are seeing their currencies reach their lowest point in over a decade. Oil hit a low of $38, well below its high above $100 only a year ago, and copper prices are at their lowest level since 2009.
At the same time emerging markets are trembling at the prospect of serious weakness in China, our domestic economy is strengthening. Motor vehicle sales were strong in August, above estimates, and the unemployment rate dipped to 5.1 percent. On the back of a series of positive data releases, the Atlanta Federal Reserve’s GDP Now forecast for third quarter GDP growth continues to rise, currently at a rate of 1.5 percent. Second quarter GDP was revised higher to 3.7 percent, significantly ahead of the initial 2.3 percent estimate. Recent data suggests this number may be revised higher yet again when the third and final estimate is released at the end of September.
The United States is relatively immune to trouble in emerging markets due to its large domestic economy and will even benefit from capital inflows as investors flee emerging markets and resource producers. That said, it will not be impervious to gyrations in global financial markets; during the late 1990s bull market, a number of corrections were caused by turmoil in Asia.
Earnings season will be ready to kick off a month from now, and FactSet Research reports analysts forecast a 4.4 percent decline in third quarter S&P 500 earnings. Although four companies have yet to report, second quarter earnings fell 0.7 percent, better than the estimated decline of 4.7 percent. Only two sectors reported earnings declines in the second quarter: industrials (down 4.7 percent) and energy (down 55.7 percent). Healthcare, consumer discretionary, telecom, utilities, technology, financials and materials all reported earnings increases that were well ahead of analyst estimates. The estimates for the third quarter are very similar, with analysts forecasting a 63.7 percent drop in energy earnings. If the recent historical pattern holds, analysts are being overly pessimistic with their forecasts, but another decline in S&P 500 earnings is possible due to losses in the energy sector.
It is impossible to know definitively whether the Federal Reserve will hike interest rates next month. The economy is strong enough for a hike, the stock market appears to have priced it in, speculators are betting on it, and financial ministers and central bankers from around the world have told the Fed to raise rates. A hike would be ideal for the U.S. economy as it would signal a return to normalcy. Many people, ranging from homeowners to business owners, have delayed investment due to concerns about the direction of the economy.
A rate hike of up to 0.25 percent will have little impact on borrowing costs, but it will have a major psychological impact, signaling the lingering effects of the 2008 financial crisis are finally over. One sign that investors are already anticipating a change is the rise in homebuilder stocks. Investors are betting an increase in interest rates will push homebuyers off the sidelines. If business owners react the same way and begin investing in new plants and equipment, economic growth is likely to pick up.
While volatility over the past month may have been unnerving, our economy is on sound footing and stocks should rebound in the near future. Such corrections are normal during a bull market and should not be viewed as the first step toward the next recession. Should you have any questions about your holdings or allocations, please call me at (888) 252-5372 for a personal consultation.