- Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
- Jeff Clark, CFA, CFP® - Manager, Investments & Wealth Management
- Kent Anderson, CFA - Senior Investment Officer
- Andy Finks, CFA - Investment Officer
- Todd Bunton, CFA - Investment Officer
- Chelsie Moore, CFA, CFP® - Investment Analyst
- Jonathan Strok, CFA - Investment Associate
After nearly two and a half years of historically low volatility and minimal U.S. stock market pullbacks, the third quarter of 2015 was a rough one for the U.S. (and global) equity markets. There was a little bit of everything thrown into the quarter as investors worried over China, global economic growth and when the U.S. Federal Reserve might begin to raise short-term interest rates. Most investors have seemingly forgotten that Greece narrowly avoided an exit from the Eurozone during the quarter as well. The controversies that plagued the financial markets during the third quarter are not going to disappear overnight. So investors should be aware that increased market volatility will likely continue to be the norm going forward.
During the third quarter, stocks experienced their first “correction”, a pullback of 10% or more, since August of 2011. The S&P 500® fell 12.5% from its alltime high on May 21 and ended the quarter down 6.4%. International and U.S. small cap stocks fell as well, down 10.2% and 11.9% respectively during the quarter.1 As is often the case, when investors are fearful, they flee to perceived safer asset classes, such as U.S. investment grade bonds. Generally, bond investors benefited from falling yields in the quarter as U.S. investment-grade bonds were up 1.1%.2 The U.S. 10-year treasury yield fell 0.3% during the quarter to 2.1%. While most asset classes have rallied over the first week of the fourth quarter, most risk asset classes, such as stocks, commodities and lower quality fixed income, are still largely in the red for the year, while safer asset classes, such as investment grade and U.S. government fixed income have eked out small gains. (Figure 1)
Indexes used for Figure 1: U.S. Investment Grade Bonds – Citigroup Big U.S. Broad Investment Grade Index, High Yield Bonds – BofA Merrill Lynch High Yield Master II Index, Developed International Equities – MSCI EAFE Index, U.S. Large Cap Equites – S&P 500 Index, Commodities – S&P GSCI Commodity Index, Emerging Market Equities- MSCI Emerging Markets Index, U.S. Small Cap – Russell 2000 Index. Spot prices used for Brent Crude Oil and Gold. U.S. Dollar Index used for U.S. Dollar.
1. MSCI EAFE Index used for international stocks and Russell 2000 Index used for U.S. Small Cap Stocks
2. Citigroup Big U.S. Broad Investment Grade Index used for U.S. investment grade bonds
China continues to look to avoid an economic “hard landing.” While China’s economic growth has been slowing for several years as it has been transitioning from an infrastructure -led to a consumer -led economy, worries of an extreme slowdown of economic growth caused a Chinese stock market sell off during the quarter. (Figure 2) It’s easy for investors to overlook the fact the Chinese stock market had appreciated 150% in the year prior to its current selloff. (Figure 3) This is reminiscent of the technology boom subsequent bust in the U.S. stock market in March of 2000. In an effort to support the Chinese economy and stock markets, China’s central bank has responded by devaluing the country’s currency, the Yaun, and lowering interest rates and bank reserve requirements. We think ultimately these measures will help improve confidence in China.
Despite the Chinese -led global growth concerns, the U.S. economic growth picture has remained relatively steady. The well -documented first quarter slowdown is behind us, and the position of the U.S. consumer remains a tailwind. Consumer Confidence readings remain high, unemployment is at cycle lows and consumer spending has been a solid contributor to economic growth. (Figure 4) It’s ironic that the challenges in China have led to lower commodity prices and have actually appea red to be a net positive to the U.S. economy. We think that the U.S. economy has not yet fully realized the benefits of low oil prices, and as such, oil prices remain a tailwind to the economy. One can always find things to worry about, but the bottom line for us is that the economy appears stable and continues to have multiple tailwinds for sustained growth.
At odds with our optimistic outlook for the U.S. economy were Fed actions, or to use a better term, inactions, in September. While many economists felt that the Fed would raise interest rates during its September meeting due to underlying economic conditions, they did not. We think the Fed missed an opportunity to start the normalization of interest rates and demonstrate confidence that the economy was finally strong enough to not warrant a zero -interest rate policy. The Fed cited global economic developments as the main reason for not increasing rates. However, Chairperson Yellen later said that the first hike would still likely be this year. We shall see, as market implied odds of a December hike remain a coin flip. The reality is that if the economy still cannot handle a 25 basis point increase in short -term interest rates, when will it be able to? We think it can, but apparently (9 -year) old habits die hard.
In regards to asset allocation, we find ourselves continuing to favor equities relative to fixed income for most long -term investment strategies. If the U.S. economy continues to grow, stocks should remain relatively attractive. In the short term, aggregate U.S. corporate earnings have been under pressure due to weakness in the energy sector and from international profits for U.S. multinationals. In recent years, around half of the revenue generated by S&P 500 companies is from outside the U.S. We think these headwinds should dissipate and that, outside of a recession, U.S. stocks will offer reasonable return potential moving forward. However, stock market volatility will most likely accompany those returns as this market cycle ages.
Having quality fixed income investments in portfolios often helps buffer against stock market losses, as has been the case this year. However, longer-term challenges to fixed income total returns remain. (Figure 5) If our forecast of sustained U.S. economic growth holds, then U.S. interest rates should move higher, putting pressure on bond prices. Factors such as strong institutional demand for investment grade fixed income, low foreign bond yields and demographics headwinds are likely to prevent rates from moving dramatically higher, but we believe rates are likely to move modestly higher nonetheless. Even so, we continue to see value in the potential diversification benefits of fixed income investments regardless of our expectations of very modest returns from the asset class.
The S&P 500® Index is an unmanaged index that contains securities typically selected by growth managers as being representative of the U.S. stock market.
The MSCI EAFE Index is broadly recognized as the pre-eminent benchmark for U.S. investors to measure international equity performance. It comprises the MSCI country indexes capturing large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada.
The MSCI Emerging Markets Index captures large and mid-cap representation across 23 Emerging Markets (EM) countries*. With 836 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The Citigroup US Broad Investment-Grade Bond Index tracks the performance of US Dollar-denominated bonds issued in the US investment-grade bond market. Introduced in 1985, the index includes US Treasury, government sponsored, collateralized, and corporate debt providing a reliable representation of the US investment-grade bond market.
The BofA Merrill Lynch US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market.
The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The combination of these attributes provides investors with a representative and realistic picture of realizable returns attainable in the commodities markets.
The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true smallcap opportunity set. The Index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.
The U.S. Dollar Index is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners.
Chart data comes from Thomson Reuters Datastream a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis
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Past performance does not guarantee future results. All investing involves risk, including risk of loss.
All information as of the report date unless otherwise noted.
All indexes are unmanaged and returns do not include fees and expenses associated with investing in securities. It is not possible to invest directly in an index.
This material is provided for informational purposes only and should not be used or construed as investment advice or a recommendation of any security, sector, or investment strategy. All views expressed are based on the information available at the time of writing, do not provide a complete analysis of every material fact, and may change based on market or other conditions. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the analysis and opinions provided are those of the COUNTRY Trust Bank investment team identified above and not necessarily those of COUNTRY Trust Bank or its affiliates.
Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in asset backed and mortgage backed securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments.
Diversification, asset allocation and rebalancing do not assure a profit or guarantee against loss.