Investment Review for Third Quarter 2015

Concerns surrounding excess supply and weak prices for commodities, disappearing profits in the energy sector, a general contraction in corporate earnings, and evidence of slowing growth in the Chinese economy led to increased levels of anxiety in the financial markets. Global stocks declined and experienced their worst quarter since the fall of 2011. While losses occurred both domestically and abroad, emerging market stocks were particularly punished and fell 17.9%.

Major asset class returns.

Stock market price swings.

Lately, daily price swings of 2% or more have become a regular occurrence in China. This is largely due to increased uncertainty surrounding excess valuations on locally traded Chinese shares. As of September 30, locally traded Chinese shares have experienced 71 days of elevated price movements. In contrast, more reasonably valued shares of Chinese companies traded on the Hong Kong exchange have experienced only 31 days. Outside of China, the general level of unease led to increased levels of volatility in domestic markets, as the “fear index” (CBOE VIX Index) reached 40, a level not seen since 2011.

The strong U.S. dollar and earnings.

U.S. exporters are beginning to struggle as the strong dollar causes their products and services to appear expensive overseas. Also, foreign revenues of major U.S.-based multinational corporations are now worth less when converted back to U.S. dollars. These factors have contributed to a general slowing of earnings and revenue growth that have now seen year-over-year declines for a few quarters in a row.

The Federal Reserve holds off.

In an effort to spur economic growth and increase employment, the Fed has kept short-term interest rates near zero since December of 2008, a level well below historic norms. Despite an unemployment rate that has fallen to 5.1%, the Fed refrained from raising short-term interest rates during its September meeting. The committee cited an increase in financial market volatility and a deterioration in risk sentiment, due to concerns about the downside risk to Chinese economic performance and slower global economic growth. This is the latest signal from a global central bank that economic activity may be weaker than most believe.

Policy-based devaluation or market-based depreciation.

Historically, the Chinese yuan’s exchange rate has been set by the central government and loosely pegged to the U.S. dollar. This has caused the yuan to appreciate significantly versus many of its trading partners, including Europe, Japan, and Australia. With China’s intention to make the yuan a more globally accepted currency and receive reserve currency status from the International Monetary Fund, reforms would be necessary. As such, on August 11 China announced a new exchange rate mechanism that will introduce more market forces to determine the currency’s pricing and will require the currency to depreciate vs. some of its trading partners. Unfortunately, many viewed this as a desperate move by the Chinese government to increase exports rather than a positive step toward more open currency markets.

Emerging market stocks.

Lately, emerging market stocks are the asset class everyone loves to hate. Over the past few years, performance has been less than impressive and the financial press is quick to highlight the connection between emerging economies and falling commodity prices. Emerging economies, however, have come a long way over the past few decades. They are involved in numerous industries beyond commodities, they manufacture many of the products we use in our daily lives, and as a group they produce 37% of the world’s total goods and services. Also, with stock valuations that are more attractive than their peers in the developed world, this asset class should not be ignored.