The last month presented a challenge for equity markets as the S&P 500 Index slid 5.42 percent in the month ended September 15. Currency depreciation and economic weakness in China, the potential for a change in U.S. interest rate policy and a long lull since the last meaningful correction provided good rationale for a slump in equities. Among the Model Portfolios, only the ETF Global Portfolio underperformed its benchmark, which it missed due to its currency hedged positions. The U.S. dollar weakened slightly as both the yen and euro rallied, but it should rebound and again challenge its 2015 highs.
The Fed decided against hiking rates at the September 17 meeting due to the slowdown in China and financial market sell-off in August. Fed officials also released their estimates for economic growth (the so-called dot plot) for the years, and there was a general shift toward lower expectations. In the interest rate expectations dot plot, one Fed official shifted their expectations to negative interest rates for 2015 and 2016. It is hard to reconcile that forecast with domestic economic growth. Besides passing on rate hikes, the Fed also didn’t signal an intention to change policy at the next meeting.
Only a few days before the meeting, there was a relatively high probability of an increase, but the odds fell in the wake of the August CPI report, which showed consumer prices deflation of 0.1 percent. Falling prices are good news for American consumers, but since the Federal Reserve desires at least 2 percent annual inflation, it was interpreted as bad news for rate hikes. Most of the drop is due to falling oil prices though, and those losses will begin to shrink in the coming months as year-over-year comparisons improve. Oil was still $90 a barrel in September 2014, and prices didn’t tumble until November. In mid-September, oil is selling for the same price it was in January 2015, so if prices hold steady, the deflationary effect of low oil prices will be eliminated in four months.
Motor vehicle sales were strong in August and above estimates, while the unemployment rate dipped to 5.1 percent. Retail sales increased 0.2 percent in August, the sixth consecutive monthly gain. The stronger U.S. dollar weakened the resource sector, but it is having a positive effect on consumers as lower gas prices are starting to have an impact. The Atlanta Federal Reserve’s GDP Now forecast for third quarter GDP growth held at 1.5 percent on September 15. This number has risen as economic data rolls in throughout the quarter.
One of the brightest spots of the summer has been the quiet rally in home builder stocks. Returns have been muted due to the overall market’s poor performance, but home construction ETFs have been relative outperformers. Over the past three months, iShares U.S. Home Construction (ITB) has gained 5.13 percent and SPDR S&P 500 Index (SPY) has declined 4.63 percent, a gap of nearly 10 percent. This outperformance is remarkable considering investors began to price in an interest rate hike during this period. The common wisdom is that a rise in interest rates is bad for the housing market because it will result in higher mortgage payments. Historically, this hasn’t been true though, at least not at the start of a rate hike cycle. Housing tends to do well as rates begin to rise because wages are also growing. Another factor helping the housing market is the rising cost of the rental market, which makes buying a home more attractive. Home builder confidence reached a 10-year high in September, which exceeds the prior 10-year high hit in August.
Earnings season will begin in a few weeks, with major banks such as J.P. Morgan (JPM) set to report on October 13. FactSet Research reports analysts currently 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 forecast decline of 4.7 percent. Only two sectors reported earnings declines for the 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, but the massive losses in the energy sector weighed on the index’s earnings. The estimates for the third quarter are a repeat of the second, 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.
While the U.S. dollar weakened in the wake of the Fed’s decision not to hike interest rates, from the view of European, Japanese and other governments that are trying to weaken their currencies, the Fed’s decision may force them to take additional measures. The European Central Bank may decide to increase quantitative easing as a result. The Fed’s decision may keep a lid on the dollar for several weeks, but eventually the greenback should edge higher once more. Long term, the factors pushing the U.S. dollar higher are unchanged.
Despite the sell-off, equities should respond well over the weeks and months to come. Domestic economic growth is solid, the housing market is doing well and consumers are spending. Weakness in China and emerging markets is the only thing standing in the way of a bull rally through the end of the year; a degree of caution is still warranted since there’s no sign yet that capital outflows have slowed in China. Data for September will be released in a few weeks. If it shows another large decline in reserves, pressure on the yuan and emerging market currencies could reignite. If it declines meaningfully, confidence will rise and bulls will have a clear path to push the market back to its highs.