In last quarter’s update, we identified four issues that were weighing on investor confidence: 1) the economic crisis in Greece; 2) the Fed’s timetable for raising interest rates; 3) sluggish first half economic growth in the U.S.; and 4) increasing concern about the slowdown in China. Since then, a default on Greek bonds was avoided by another bailout from the European Central Bank, and the U.S. economy has picked up steam. As the third quarter ended, investors were still speculating on the timing of the Fed’s first rate increase, and the situation in China had moved to center stage.
Ending a long period of relative calm in equity markets, the People’s Bank of China (PBOC) shook investors in mid-August by devaluing their currency, the yuan (also known as the renminbi, or RMB). While the move was relatively small, it was an important signal to the markets that the PBOC felt more drastic steps were necessary to counter the slowing Chinese economy. The action set off a period of violent stock movements, punctuated by a 1,000-point drop in the Dow Jones Industrial Average Index on August 24 and sending the S&P 500 Index into official “correction” territory – a decline of more than 10%.
Third quarter equity market performance was disappointing. The S&P 500’s 6.4% decline was its worst result since the third quarter of 2011, when the markets were spooked by the imminent threat of a U.S. government debt default (legislators in Washington are gearing up for a similar fight next month). However, as bad as the S&P 500’s third quarter performance was, it was among the better-performing equity markets around the world. The MSCI EAFE Index of developed market stocks fell 10.2% (USD) and the MSCI Emerging Markets Index slumped 17.9% (USD). Commodity prices continued their multi-year downward slide, exacerbated by slowing demand from China.
As risky assets fell, bond prices rose. Long-term U.S. Treasury bonds gained 5.1% in the quarter and the Barclays Aggregate Bond Index rose 1.2%. Gains were led by high grade bonds, as the turmoil in the equity markets led to widening spreads and negative returns for high yield bonds. Emerging market debt also fell, as investors fretted over the ability of issuers to service their dollar-denominated debt in a strong dollar world.
Investors were divided over whether the Federal Open Market Committee would begin its long-awaited “rate normalization” process during its September meeting. Over the past several years, every move by the Fed that delayed the monetary tightening process was greeted by a strong rally in stocks on the theory that low interest rates were a continuing boon for corporate profits. This time, however, stocks fell after the Fed’s decision to stand pat on rates. Investors interpreted the Fed’s decision as a signal that the economy was not yet ready to absorb even a tiny increase in short-term interest rates.
As we move into the time of year usually more favorable to equity prices, we believe that continued strength in U.S. consumer spending and a rebound in corporate earnings will begin to lift stock prices in the months ahead. Last quarter’s declines have driven bearish sentiment to levels similar to the 2008 to 2009 market meltdown. As a result, even a minor shift in fundamentals could lead to a sharp rebound rally. Stabilization in energy prices could bring some of the much-awaited economic benefits (through more disposable income for U.S. consumers and lower input costs for energy-dependent industries) and fewer of the negatives (cutbacks in exploration and mass layoffs). We believe the extent of economic weakness in China and the possibility of it triggering a broader global economic slowdown have been overstated in the financial media. In addition, the recent pullback has returned equity market valuations to more attractive levels.
Overall, although the outlook has dimmed somewhat, we expect positive returns for equity investors in the months ahead.
City National Rochdale, LLC is a Registered Investment Advisor and wholly owned subsidiary of City National Bank.
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Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.
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There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible. Investments in below-investment-grade debt securities and unrated securities of similar credit quality, commonly known as “junk bonds” or “high-yield securities,” may be subject to increased interest, credit, and liquidity risks.
Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging markets bonds can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy and market risk. Investors of MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated Schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Tax Income).
As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.
Returns include the reinvestment of interest and dividends.
Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk.
Past performance is no guarantee of future performance.
The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The Dow Jones Industrial Average Index is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.
The MSCI EAFE Index is an equity index which captures large and mid-cap representation across developed markets countries around the world, excluding the U.S. and Canada. Developed markets countries in the MSCI EAFE Index include: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The Barclays Aggregate Bond Index is comprised of U.S. government, mortgage-backed, asset-backed, and corporate fixed income securities with maturities of one year or more.
Producer Price Index measures the average changes in prices received by domestic producers for their output.
Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.
J.P. Morgan’s Corporate Emerging Markets Bond Index Broad Diversified High Yield (CEMBI BD HY) is a market capitalization weighted index consisting of US-dollar-denominated emerging market non-investment grade rated corporate bonds. According to J.P. Morgan, this index limits the weights of those index countries with larger corporate debt stocks by only including a specified portion of these countries’ eligible current face amounts of debt outstanding.
Alerian MLP Index is the leading gauge of large- and mid-cap energy Master Limited Partnerships (MLPs).
Barclays U.S. Corporate BBB OAS Index is the Baa component of the U.S. Corporate Investment Grade index. The U.S. Corporate Investment Grade Index is publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.
Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.