The correction that finally came…and went.
Not since 2011 have we had a quarter as turbulent and volatile as the quarter ending September 30, 2015. The S&P 500 stock index was down nearly 7% for the quarter, while the Dow Jones Industrial Average, NASDAQ, and Russell 1000 were down 7.6%, 7.4%, and 7.8%, respectively. The Dow suffered its third consecutive quarterly loss and the S&P 500 its second straight quarterly loss. Hurt even worse were small company stocks, which were down 12.5% as represented by the Russell 2000 index. The pain was not limited to the domestic indices, as Japan’s Nikkei was down 14.5%, the FTSE 100 was down over 7%, and Germany’s DAX was down 11.7%, which was reflected in the 11.6% decline in the broader MSCI All Country World Ex-US Index. Simply put, the pain was distributed across global equity markets. The fact is that the S&P 500, which made a high in May of 2,130.82, went 1,326 days without an official 10% correction, until on August 24th when the Dow suffered a 1,100 point intraday selloff. The equity markets were well over-due for such a correction and it was fear of an economic slowdown in China, uncertainty over when the Federal Reserve would hike interest rates, and a general feeling of investor pessimism that finally buckled the market’s knees.
A closer look at the S&P 500 shows that the capitalization weighted index actually hides something far worse than the 12.5% drawdown from the market high in May to the trough on August 25th. In fact, at the close on Monday September 28th 253 of the S&P 500 stocks were trading down more than 20% from their highs, meaning more than half of the index was already in bear-market territory. Remarkably, the Nasdaq Biotech Index collapsed 20% in the span of eight trading days, which speaks to the extreme overvaluation of this particular index, but also the return of volatility to equity markets, something that has been conspicuously absent for several years. The equity market’s extreme fluctuations pushed the CBOE Volatility Index (VIX), otherwise known as the Fear Index, to a multi-year high. On August 24th the VIX hit 40.74 a 45.3% increase on the day, a level not reached since the 2008 financial crises and in August of 2011 during the debt-ceiling crises.
The third quarter of 2015 was broadly positive for global bonds, as bond investors read continued commodity price weakness and Fed hesitancy to raise rates as cause to find safe havens for cash. Moreover, the continued monetary accommodation by global central banks, including the Chinese central bank, pushed global government bond yields almost universally lower in Q3. Yields on longer Treasury notes and bonds closed the quarter near the low end of the last two-year trading range with the 10-year Treasury closing at 2.03%, down from 2.35% at the beginning of the quarter. The Barclays Global Aggregate Bond Index and the Barclays US Aggregate Bond Index both managed positive returns on the quarter, up 0.51% and 1.2%, respectively.
Government securities and high quality corporates were the standout sectors, while the credit heavy sectors such as High Yield (-4.9%) and Bank Loans (-1.2%) were noticeably weak. Continued deflationary pressures pushed inflation protected TIPS lower (-1.2%) on the quarter. Municipal Bonds, insulated from global market volatility and falling commodity prices, finished the quarter up 1.7% in Q3, outpacing their taxable peers.
In the second quarter of the year oil prices increased significantly with WTI trading above $60 for most of May and June. Oil prices ran up due to a combination of escalating geopolitical issues as well as a report from the Energy Information Administration forecasting that US crude production was peaking earlier than expected, which would serve to lower inventories and reduce the downward pressure on oil prices. However, notwithstanding a reduction in rig counts, oil production in the US continued to be strong longer than expected and inventories remained high going into and throughout Q3. In addition, the Saudi production policy remained unchanged in an effort to maintain market share and the geopolitical environment did not worsen. Moreover, there was little evidence that global economic growth would spark an increase in demand and alleviate the inventory glut. Accordingly, Q3 saw oil prices drop from the $60 level to a low of $37.50 at the end of August, testing the lows last seen in 2009. WTI finished the third quarter at $48 a barrel down 20% on the quarter. The supply/demand dynamic remains in place with little change seen in the months ahead.
While the US economy had some mixed economic news in Q3, the perception was that on balance the economy was continuing to improve. Second quarter GDP data showed a meaningful rebound (3.9%) from the weak 0.6% reading in Q1, which was driven by a tailwind of strong consumer spending and uplift in business investment. GDP growth in the first half of 2015 left the US well above most of the growth-challenged global economy, but the question remains whether the US will remain economically decoupled from the rest of the world. The Federal Reserve Bank of Atlanta’s well-regarded GDP model is now predicting 0.9% GDP growth for Q3. If true, YTD 2015 GDP growth will be 1.8%, a remarkably low number considering we have had zero bound interest rates for nearly eight years. Moreover, inflation remains stubbornly low, especially outside of the US, notwithstanding global central banks exercising the most radically accommodative monetary policy ever seen. While the financial markets prior to Q3 celebrated such a policy by rising to new heights, global economic fundamentals have largely failed to respond to such unprecedented stimulus.
In Q3 it seems that investors woke up to the fact that financial markets were well ahead of the underlying global economy and that fissures in the current economic landscape were beginning to appear, facts that were recognized by Christine Lagarde at the IMF and publicly shared via her cautionary comments to Fed Chair Yellen not to be too quick in raising interest rates. Ms. Lagarde’s comments combined with volatile financial markets, suppressed economic growth outside of the US, notably in Europe and China, as well as weak commodity prices and tepid inflation readings, convinced the Fed to hold interest rates at the zero bound for yet another meeting. Of course, Chair Yellen repeated her obligatory comment that she had confidence in the US economy and expected to raise rates by the end of the year.
Well, it didn’t take long for investors to reassess the importance of underlying fundamentals supporting rising asset prices and their conclusion was that it’s not so important. Since the end of Q3 equity investors resumed the zero bound interest rate policy party and in a matter of three weeks have largely erased the pain of Q3. As of the close on Friday October 23rd the broad US equity market indices now stand within 3.5% of their all-time highs. The bio-tech bloodbath still leaves the small cap Russell 2000 10% below its all-time high and the All Country World Index is 7% from its all-time high. However, bond market investors have remained circumspect of economic conditions with yields rising very modestly as the equity market has recovered.
In our last quarterly commentary we noted our concern regarding the lack of global growth and that equity and bond valuations were relatively rich. The broad equity markets now stand slightly above where they were at the end of Q2, so our opinion has not changed relative to valuations. In addition, underlying economic conditions remain relatively uncertain. Moreover, increased volatility indicates that investors are not so sure of themselves and that caution is indeed warranted. While we are confident in the diversified nature of our portfolios, we remain keenly focused on changing financial market and economic conditions. Despite our concern we are not making any changes to our equity holdings at the current time. We believe that continuing low oil prices have created an opportunity in the mid-stream MLP energy space (pipelines), where we have been invested for a number of years. Revenue and profit of companies in this space are more impacted by throughput than crude prices, which has created a mispricing of these assets. As a result we made the decision to add to our MLP positions. As always, we appreciate your continued partnership with us and welcome your questions, comments, and insights at any time.