Markets Face Triple Threat

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The third quarter was tough. The S&P 500 index closed down 6.4 percent on the quarter – its worst quarterly return since the third quarter of 2011. In fact, at its lowest ebb, the S&P 500 was down 12.4 percent from its all-time high set on May 25th.

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Other asset classes struggled in the third quar­ter, as well. Small cap stocks fell 11.9 percent, international stocks fell 10.2 percent, and emerging market stocks plummeted 18.5 percent.  Commodities resumed their plunge dropping 19.3 percent.  About the only thing that rallied was market volatility as measured by the VIX index.  It spiked to over 40 percent on August 24th. You would have to go back to the fourth quarter of 2011 to find similar volatility levels.

Though generally unpleasant, market corrections are not unexpected, nor do they usually portend imminent disaster. As we discussed in an August 28th post on our Smart Nest Egg blog, the only thing abnormal about this correction was that it took so long to get here. Ten percent corrections happen on average every 219 days. Prior to August, we had gone 810 days.

Of course, we do face real challenges. Three, in particular, bear watching in the coming months—slowing growth in China, liquidations from sovereign wealth funds and flagging profit­ability at U.S. corporations. I do not believe these challenges will derail the market, but they will likely result in elevated levels of volatility and lower near-term returns.

China under economic pressure

Since the financial crisis started in 2007, China’s annual GDP growth has been ratcheting steadily lower. According to a recent survey by Merrill Lynch, fund managers expect the slowing to continue for at least three more years.

As the world’s largest consumer of most commodities, China’s slowing economic growth has a huge impact on commodity prices. In fact, much of recent commodity price weakness is a direct result of China’s sagging demand. Commod­ity price deflation thereby becomes the channel by which China’s economic woes spread throughout much of the rest of the world. As we saw in the 1998 Asia crisis, contagion within the emerging markets can rapidly spill over into developed economies. Remember Long-term Capital?

Perhaps of greatest concern is the potential for China’s policy makers to take actions that have unintended consequences.  Chinese authorities draw a close link between economic progress and social stability and slowing economic growth has made them nervous. The July 31, 2015 edition of Hong Kong’s South China Morning Post ran an article which made this interest­ing statement: “Keeping unemployment low is a top policy priority for China’s stability-obsessed govern­ment, a task that it has admitted will become more difficult as growth grinds toward a 25-year low this year.” More ominously, the same article went on to say, “In a rare acknowledge­ment of the challenges ahead, state media quoted the decision-making body of the Communist Party as saying China had yet to find new drivers of its econo­my at a time when old engines were flagging.” Less than two weeks later, China devalued the yuan—a surprise move that sparked the August rout in global stock markets. If the Chinese economy continues to weaken, Chinese authorities will likely take other “targeted actions,” some of which could provoke further volatility in the capital markets.

Sovereign wealth fund liquidations

You will probably hear a lot more about sovereign wealth funds in the coming months. Sovereign wealth funds are state-owned investment funds that invest in financial assets, real estate, and alternative assets like private equity. These funds have deep pockets, long investment horizons and sophis­ticated manage­rs.

Many of the largest funds are sponsored by oil-exporting countries. With the fall in oil prices, many of these countries have come under tremendous fiscal pressure. Some, including Norway and the United Arab Emirates, have recently announced they will tap their sovereign wealth funds to help fill budget holes.

How these sales will affect financial markets is a matter of debate. Some say the amount of dollars involved is too small relative to the size of the capital markets to make much difference. However, in recent years, sovereign wealth funds have been huge marginal buyers of financial assets. A report by UBS estimates that financial asset purchases by these funds have totaled approximately $2.3 trillion over the past ten years. If that is anywhere close to being accurate, just the absence of new buying is bound to have an effect.

Sluggish corporate profit growth

After the 2008 recession, much of the growth in corp­orate profits came from margin expansion as com­pan­ies vigor­ously cut costs. Reve­nue growth also con­tri­buted, but to a much smaller degree. Since 2012, with a very few exceptions, margin expansion has contri­buted very little to corporate profit growth.

Worker productivity has a lot to do with this prob­lem. A number of economists have noted, with some con­cern, that the average growth in real output per worker for the 10 years ended 2014 was only half that of the prior decade. It is hard to see what might increase productivity, but as long as it remains sluggish, corp­orate profit growth is likely to remain sluggish, also.

An encouraging word

I know dwelling on these challenges may sound pessimistic, so I want to assure you that I remain confident in our approach and optimistic about the future. Remember the old adage that “markets climb a wall of worry.” Our investment approach is designed to weather market storms. Our quality is high; our portfolios are well-diversified. We consistently work to reduce and manage risk within the parameters of each client’s investment policy. While we are keeping a close eye on these and other developments, we encourage you to please call us if you have any questions or concerns. As always, it is a privilege to work with you.

Steven Merrell CFP®, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: smerrell@montereypw.com.