The Federal Reserve had its chance to raise interest rates and opted to hold steady instead, unleashing another round of selling as investors interpreted the move as predicated on a negative assessment of the global economy. Although U.S. economic growth remains solid, weakness in emerging markets is weighing on investors’ minds. China remains a sore spot for the global economy and continues to weigh on commodity and emerging markets. Chinese economists see growth bottoming out in the current quarter and rebounding next year, while currency outflows need to slow to avoid a potential currency crisis for the yuan. Emerging markets and resource companies may be either undervalued or at significant risk of bankruptcy.
Economic growth remains strong in the U.S., but a six-month improvement trend snapped at the end of September. Growth was estimated to be as low as 0.60 percen during the third quarter, though the Atlanta Federal Reserve’s GDP Now model predicted growth as high as 1.80 percent on the back of strong domestic consumption. This number was cut in half on October 1, following the release of August trade data. The U.S. trade deficit jumped more than 10 percent from July, which also exceeded estimates by 10 percent. A strong U.S. dollar, solid domestic economy and weakness overseas all contributed to the August jump.
The consumer discretionary sector is doing well and expected to report some of the strongest growth in earnings for the third quarter; however, we also saw signs on October 2 that weakness overseas and in commodities are having an impact. Job growth was weak in September, with only 142,000 new jobs created. In spite of a rise in the availability of part-time jobs, the number of full-time jobs declined. Unemployment remained level at a misleading 5.10 percent; those not actively seeking employment are considered “missing workers” and are not reflected in the data. The government also revised job growth in July and August to the downside due primarily to job losses in areas such as oil drilling. Rate hikes may be less likely at this juncture but could be impacted if the prior trend of positive data resumes over the coming weeks.
Earnings season will begin shortly and analysts are forecasting an earnings-per-share decline of 4.5 percent versus 2014 for the S&P 500 Index. While the number is negative, FactSet Research reports that analysts, who typically reduce their estimates as the earnings reporting season draws near, have been less pessimistic about this quarter. The outlook is less than optimistic for the materials sector, however, which has seen earnings estimates slashed from negative 1.50 percent to negative 13.1 percent as commodity prices have crumbled.
Currency changes are also having an impact. The average euro/U.S. dollar exchange rate in the third quarter is down 17 percent. That is a double-digit headwind that multinationals will have to make up just to keep European revenues flat versus last year. FactSet Research estimates 12 percent of S&P 500 Index revenue comes from Europe. Currency declines in emerging markets have been even larger, but sales totals are smaller. The real story driving earnings lower is commodities, with energy forecasting an earnings-per-share drop of 64.40 percent. Materials and industrials are also forecast to decline. These three sectors account for nearly all of the expected decline in S&P 500 earnings. While it is speculated that technology, utilities and consumer staples may decline as well, it will likely be de minimis. Over the past few years, analysts have been too conservative in their estimates heading into earnings season. Odds are favorable that all three of these sectors will see positive earnings growth. Telecom, consumer discretionary, financials and healthcare are all projected to see a rise in earnings, with forecast growth ranging from 7.40 percent to 17.60 percent.
Financials had a rough month due to the Federal Reserve’s decision to leave interest rates unchanged. Investors started the year expecting a rate hike in 2015, but at the close of the quarter, speculators are predicting interest rates won’t rise until 2016. Still, with solid earnings growth, financials are in a good position, with the potential for rate hikes in December if economic data firms up.
Healthcare is also due for a rebound after a brutal end of September as biotechnology holdings stung many funds. Fidelity Select Biotechnology slid 12.4 percent on the month and was down 18.8 percent from its September 17 high. This drop followed a small pharmaceutical company’s decision to raise the price of a drug from $13.50 to $750. This led to comments by presidential candidate Hillary Clinton about high costs, which in turn sparked heavy selling in the volatile sector. This is very similar to the drop in spring 2014, which sent FBIOX down about 18 percent after three congressmen raised issues about the pricing of Gilead’s (GILD) hepatitis C drug. We could see biotech stocks slide further if the broader market needs time to find its footing, but the panic phase of the selling has likely completed and we could very well see a significant rebound.
In Fidelity news, Small Cap Discovery (FSCRX) manager Chuck Myers will take a six-month break from March through September 2016. While he’s spending time with his family, the manager of Small Cap Value (FCPVX), Derek Janssen, will manage the fund. There’s no reason to adjust the position if you hold the fund. Janssen has a strong track record and Myers will be back next year. FSCRX has a very low turnover of 13 percent, and Janssen is unlikely to stray from the buy-and-hold strategy over that period.