What a quarter! Everything that could go wrong, that hadn’t already, did. The Chinese stock market took a major tumble, China attempted to prop up the tumble by purchasing gobs of stocks and in the interim sell their holdings of various currencies. The global market retreated as a result of their currencies being less valuable. In spite of the US economy doing quite well, the Fed decided to not raise interest rates because of global concerns (something they’ve never even hinted at before) keeping rates near zero for over 7 years. And then, one of the first disappointing jobs reports in a long time came out. This all led to quite the heinous quarter.
All that said, while I sit here writing this review, the US stock market is in yet another gang-busters day of trying to recoup those losses; oh yeah, and the historically low volume we typically see in the third calendar quarter of the year has already begun to pick up and will continue to do so. This doesn’t mean that all will turn around immediately, but there does continue to remain a meaningful bright-side.
Last month we discussed the Chinese issue, this month I’d like to call attention to the recent Fed decision. It is not exactly surprising that the Fed did not raise rates, but the reasons it cited were unexpected. Rather than focusing on the labor market (as it had in previous meetings), the Fed pointed to a lack of inflation, the strength of the dollar and global economic and financial issues as the reasons for its policy decisions. In making this shift, the Fed effectively moved the goalposts, indicating that the labor market and economy still aren’t strong enough to justify even a single rate increase. However, Janet Yellen’s comments did increase the odds that the Fed would raise rates later this year. Her speech two weeks back was clearer than the statement that accompanied the September policy meeting, moreover, she did cite a solid economy and an improving labor market as reasons to justify a rate increase, along with pointing out that inflation remains below target.
I know when most of us think about a rate hike, we think, “oh goodness, now my bonds will decrease in value and I’ll lose the money I have in the markets, ahhh!” The prospect of the first Federal Reserve interest rate hike in nearly a decade has been one of the most debated and discussed topics this year. Although rate increase cycles are usually accompanied by equity volatility, investors typically view the development as a sign that the economy is improving. As such, equities have historically performed well when rates start to rise. The current cycle is atypical, however. The Federal Reserve has waited so long to raise rates, making valuations and profit margins higher than they usually are at the beginning of rate increase cycles. As such, a rate increase may drive near-term volatility higher, but it may improve long-term economic growth and should boost earnings and equities.
Globally speaking, we are still facing some amount of bad news. Non-US growth remains uneven. China’s economy is weakening, Russia’s recession shows no sign of abating and Brazil is facing serious financial and political problems. The Eurozone has been improving, but business confidence and the refugee crisis are concerns. The US economy remains sound, but overseas headwinds may undermine domestic confidence.
Domestically, though, we’ve had a fair amount of good news emerging. August retail sales were favorable and point to stronger consumer spending. Strong retail sales typically lead to good GDP figures. Speaking of, second quarter GDP growth was revised higher from 3.7% to 3.9%, helped by improved retail sales figures. The negative is that we could see a small drag from a drawdown in high inventory levels.
However, we should continue to expect more volatility in the equity markets, though it will likely be calming down. While sentiment remains depressed, we should see additional volatility in the short term continue to moderate. Specifically, the near term direction of the equity markets looks uncertain, following the sharp pullback in August, markets appear to be trying to form a base.
Specific to US equities, they will likely struggle until it becomes clearer that China’s economy will stabilize and the Fed will start lifting rates. The good news is that we expect both of these to happen, but another risk lies on the horizon. The possibility of another U.S. government shutdown looms, and John Boehner's decision to resign likely increases the odds of a standoff over government spending. The current continuing resolution should keep the government funded through December 11, when the debt ceiling will need to be raised. This is an issue that could drive market volatility higher.
For now, the main focus for investors continues to be Fed policy. We think we’ll need to see clear indications from the Fed that it will begin moving rates higher for equities to sustain a rally. The delay in starting an increase cycle acts as a headwind for equities since it potentially fuels price imbalances, exacerbates the possibility of asset price bubbles, increases uncertainty and could force the Fed into tightening at a faster pace than it wants to. Ultimately, a risk-averse Federal Reserve attuned to promoting economic growth should be a positive for risk assets, including stocks. In the near-term, however, the delay and uncertainty is keeping equity prices in check and is putting downward pressure on bond yields.
Financial markets may remain choppy for some time, but we expect investors will eventually return to focusing on fundamentals, which should benefit equities. We believe the global economy should continue to grow unevenly and corporate earnings should improve. As a result, we continue to favor equities over bonds and cash. We also have a particularly positive view toward cyclical equity sectors and markets that are not tied to commodities.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of David Abuaf and not necessarily those of RJFS or Raymond James.
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