By now we’ve all likely caught a glimpse of the headlines and realized that the quiet that dominated the U.S. investment markets since 2011, is over. Until this month, the S&P 500 had gone more than 60 consecutive days without a 1% move in either direction, the longest stretch since 1995. While we’ve already bounced off recent lows and the pull back for large cap stocks did not qualify as a “correction” (a loss of 10% or more from a recent high), the small-cap Russell 2000 index had fallen over 14% from its July peak and broad market indices remain off recent highs.
It’s certainly unsettling to watch account balances and market indexes decline; however, the increased volatility comes as no surprise. Not only is October historically among the most volatile months of the year, but as we went so long without any meaningful decline, stock markets became generously valued relative to historical levels. Toss in the increased uncertainty resulting from upcoming mid-term elections and the shifting liquidity from the end of the Fed’s quantitative easing efforts and there was bound to be a few bumps.
Given the recent declines, it is important to take stock of the recovering U.S. economy and reaffirm that much is unchanged. While we review the positives, we’ll also highlight one major change that is also playing a role globally: the rising U.S. dollar, which has been strengthening against other major currencies at an unprecedented clip.
- The U.S. economy is growing. Second quarter GDP growth was 4.6%, clearly providing evidence that the negative GDP figures from the first quarter were an anomaly related to a colder than average winter. Also in the second quarter we saw revenue and earnings growth at 4.0% and 8.5%, respectively. As we head into earnings season, revenue and earnings are forecast to grow at 3.8% and 4.5%, respectively, for the third quarter.
- The U.S. economy added an average of 220,000 jobs per month over the past year, bringing the unemployment rate to less than 6% for the first time since July 2008. Despite new job creation, excess labor supply has kept a lid on wage increases; wage growth has only increased by approximately 2% over the past year.
- Interest rates are still very low domestically and are even lower overseas. The U.S. 10-year Treasury is near its lowest rate of the year; hovering around 2.2% from 3.0% at the start of the year. Earlier in the month, the Federal Reserve signaled interest rates would stay low for the foreseeable future and, globally, interest rates are falling as major central banks are expanding monetary policy (i.e. ECB, Japan, and China).
- Commodity prices are falling. Oil prices are down to under $85, a two year low, and corn prices are down nearly 21% this year after a 40% drop last year – providing the economic equivalent of a tax cut for U.S. consumers.
- Stocks are trading at reasonable valuations and the divergence within the indexes is significant. As investors with a strong bias to fundamentals and reasonable valuations, volatility has offered us attractive entry points for many new investments and, in contrast, the opportunity to take profits throughout the year.
What has changed?
It was not too long ago the falling U.S. dollar had many concerned it would lose its global prominence as a safe haven. From 2003 to 2008 the dollar fell by 40% against most major currencies and, at the time, many economists predicted the euro might supplant the U.S. as the favored reserve currency. Fast forward to October 2014 and the dollar has now logged its longest winning streak in more than 17 years, rising against a broad basket of currencies for nine straight weeks on its way to a 7.4% rise in the third quarter.
This stronger dollar is a reflection of the recovering U.S. economy and the diverging paths of central bank liquidity, most notably the ending of the U.S. Fed’s quantitative easing program versus the increased stimulus by the European Central Bank (ECB) and the resulting expectation of further falling European interest rates.
The rise in the dollar has also figured prominently in commodity markets, as many major currencies are priced in U.S. dollars. Traditionally, commodities have an inverse relationship to the dollar. This means when the dollar falls, commodities rise. For example from 2004 to 2008, when the dollar was falling, gold more than doubled and we feared oil would rise to $140 per barrel. Conversely, as the dollar has recently strengthened, the DB Commodity Index has fallen; off 7.3% in September and 12.5% for the quarter.
Crude oil futures are also down and closed September around $97 per barrel, and are now approaching $80 per barrel as we write this. Remember the fears over dampened consumer spending when oil was trading at over $100 per barrel and gasoline prices were surging? Well, the opposite is true today and falling energy prices, having made their way to the neighborhood gas stations, are like a tax rebate with a stimulating impact to consumer spending.
The rising dollar has a broader impact than just commodities as it also plays a role in exports and sales for U.S. multinationals. A stronger dollar means American exports look more expensive versus locally based suppliers, which in turn dampens sales for U.S. based companies. While S&P 500 companies still generate the majority of the sales domestically, close to 20% of sales are derived from Europe and Asia. In the Federal Reserve’s September policy meeting, they expressed concern that weaker growth in Asia and Europe are likely to continue to curtail exports.
It is also important to note that the U.S. dollar’s gain is not necessarily Europe’s loss. While imports from the U.S. become more expensive to Europeans, the relatively weaker Euro makes exports from Europe more attractive with European products becoming more competitively priced in the growing U.S. economy and allowing these profits to be more additive in this upcoming earning season.
A stronger dollar is also a check on U.S. inflation, keeping it from rising ahead of the Fed’s 2% target. Two years after it was first launched, the Federal Reserve is expected to purchase its last bonds this month; thus ending quantitative easing. While this means the Fed will no longer be injecting additional liquidity into the economy, this does not mean, however, they are therefore now intent on raising rates. The Fed has been quite clear they intend to keep rates low for a “considerable” time, and is now likely to wait until 2016 before raising short term rates.
The Fed’s ability to transition monetary policy and the impact on the rest of the world continues to be of concern, particularly as other central banks look to inject liquidity into their economies. In September the Peoples Bank of China (PBOC) injected $81 billion into the country’s five major state-owned banks to try to stabilize and counter slower growth. Similarly, the ECB recently announced liquidity plans structured similarly to the U.S. QE strategy. A strong dollar, falling commodity prices, labor market slack and benign inflation all will give the Fed additional flexibility to defer raising rates until later than first anticipated.
Where are we now?
Our portfolio positioning still focuses heavily on U.S. based companies, as we believe our economy is still the world’s strongest with solid fundamentals and modestly improving economic results that should continue to encourage solid revenue and earnings growth.
While Europe’s recovery is slower than we had hoped when we first entered this market a year ago, we are confident they are on the right path and the added benefit of additional ECB liquidity measures should further stabilize the EU economy and banking system. Current valuations across Europe reflect many of the challenges still ahead and the low valuations relative to the U.S. provide a wider margin of safety. Its worth noting that this margin has grown even wider over the past month: European markets are down 11% since the end of June as uncertainty around the ECBs ability to act quickly and effectively has grown.
Similarly, while we do believe that emerging markets represent a significant long term growth story, we are sensitive about the size of our exposure and continue to underweight China due to slower near term growth and credit concerns and the greater volatility related to emerging markets in general.
While we have been pleasantly surprised to see positive returns for many bond indexes this year, we continue to believe a short duration, high quality bond portfolio offers the best protection against broad market volatility and likely rising interest rates in the years ahead. We believe returns from bonds going forward will be largely driven by yield as opposed to the price appreciation that has been driving fixed income returns since 2008.
Finally, we continue to view gold as ballast against market uncertainty and a hedge against inflation, particularly as monetary policies across the globe continue to expand. As global equity markets sold off in October, gold proved a stalwart, bouncing more than $60 or 5% off recent lows.
This is certainly one of those times of rising investor anxiousness so we invite you to share any questions or concerns with us. We continue to have confidence that our disciplined approach will successfully navigate the inevitable bumps experienced in investment markets and believe this recent volatility will prove to be an attractive entry point in the long run.