Economic and Market Overview: Third Quarter 2015
The following commentary summarizes prior financial market activity and uses data obtained from public sources. This commentary is provided to financial advisors and their clients as a resource for the management of assets and evaluation of investment portfolio performance.
The domestic economic landscape remained on a slight uptrend in the third quarter of 2015, characterized by steady but unremarkable growth. The U.S. economy faced significant challenges from global economies and financial market distress. The Bureau of Labor Statistics raised its second estimate of second quarter 2015 gross domestic product (GDP) to +3.9%, above both the prior estimate of +3.7% and the first quarter’s +0.6% reading. The positive rebound, driven primarily by consumer spending, occurred despite a continued fall in energy prices. Employment was strong, with an average of about 221,000 jobs added each month. The unemployment rate declined to 5.1%.
The global situation was less upbeat, as both developed and emerging economies sputtered. September saw consumer prices decline in the Eurozone, the first time that has occurred since the European Central Bank (ECB) initiated its asset-purchase program earlier this year. The decline sparked fears that the region would devolve into a deflationary cycle, and investors called on the ECB to step up its stimulus measures. The region also must determine how best to handle effectively the influx of Syrian refugees and their impact on the economy.
In China, growth continued to moderate, which, along with the country’s currency devaluation and significant drop in stock prices, created considerable concern for market participants. Emerging markets economies again reeled as commodity prices suffered their worst quarterly decline in almost seven years.
The Federal Open Market Committee (FOMC) did not make any changes to its interest rate guidance at its September meeting, choosing not to begin the so-called “lift-off” of rates. Concerns about China’s problems and resulting financial market distress, coupled with low inflation, likely swayed the Committee. In addition, the FOMC slightly lowered its economic outlook, but most analysts still expect it will begin normalizing rates before yearend. However, a growing number assume the severity of global economic issues may delay the initial rise in rates until sometime in 2016.
Highlights and Perspectives
GROSS DOMESTIC PRODUCT (GDP)
The Bureau of Economic Analysis released the second estimate of the second quarter 2015 real GDP, a seasonally adjusted annualized rate of +3.92%. This was up from the prior quarter’s +0.6% annualized growth, and was an increase from the prior +3.7% growth estimate. The results were an indication of the economy’s strength, although analysts caution that a buildup of inventories may be a negative harbinger for third quarter results. But, the growth was encouraging, particularly following the lackluster number posted last quarter, and many economists continue to look for continued expansion soon. (One complication may be China’s economic downturn and its global implications). Consumer spending was the primary growth driver, and investment, trade, and government spending each made modest contributions. Corporate profits jumped by +3.5% (not annualized) after a -5.8% decline in the prior quarter. Low energy prices kept inflation in check in the second and third quarters, but the personal consumption expenditures (PCE) index of prices nevertheless rose +2.2% , following a -2.2% drop in the prior quarter.
Portions of the housing segment recovered well : existing-home sales for August (the latest monthly data available) advanced at an annualized rate of 5.31 million units, down about -4.8% from July’s 5.58 million unit rate, but still up more than +6% from August 2014. The inventory of existing homes loosened somewhat to about 5.2 months of supply. Existing-home prices in August declined slightly from May, but rose by about +5.1% from year-ago levels. The NAHB (National Association of Home Builders) Housing Market Index, a measure of new homebuilding activity, ended the quarter at 62, up slightly from the prior quarter’s reading of 60--the, highest level in the last decade. The rise was broad-based regionally, with all regional indexes at least maintaining levels from the prior month. Analysts have stated that the housing industry is in its best shape in years. Although the prospect of higher interest rates may dampen future growth somewhat, the underlying strength should allow the housing recovery to continue well into 2016.
Employment, on average, was stronger than in the second quarter, and the uptrend remains intact. Employers added 173,000 jobs during August, although below consensus expectations. The three-month moving average was 221,000, slightly higher than the average for the period ending in May, but below the levels of each of the prior two months. Service industries such as professional/business services, healthcare, and leisure/hospitality led the way, adding 63,000, 58,000 and 57,000 jobs, respectively, in August. The August unemployment rate was 5.1%, below May’s 5.5%, and also a post-recession low. Average hourly earnings increased 2.2% in the past 12 months, a reasonable growth rate, but not so rapid so as to create inflation concerns. Analysts expect average employment gains of 200,000 through the end of the year, and many projections anticipate average monthly additions of 250,000 in 2016.
The FOMC ended its September meeting with no changes to its interest rate policy. Despite this widely anticipated decision, some analysts had expected the FOMC to initiate the “lift-off” of interest rate normalization at this meeting. The Committee’s statement noted that recent global economic and financial market developments potentially could result in a slowdown of economic activity, causing inflation to drop below its target level of 2%. The FOMC’s economic projections release lowered the median estimate of 2016 real GDP to 2.3% from 2.5% in the June release. Most economic analysts expect the FOMC will begin raising rates sometime in 2015, as delaying action risks accelerating and overheating the economy, thereby offsetting the advantages that a rate hike can provide.
Fixed income securities were buffeted by several issues this period, including anticipation of potential FOMC action on interest rates, fallout from China’s stock market decline, the subsequent currency devaluation by its policymakers, and a global slowdown in economic growth.
Earlier this year, the economic trajectory resulted in consensus among analysts and market participants that the FOMC would raise rates at its September meeting. As the summer progressed, however, it became less certain that “lift-off” would occur that soon, given questions about China’s growth, the continued decline in commodity markets, and the distress in U.S. equity markets. In the end, the FOMC postponed a rate increase, and the consensus now is that rate normalization will begin sometime in the fourth quarter.
The shape of the yield curve flattened, and yields on intermediate- to long-term maturities declined more than those on the short end of the curve. By the end of the quarter, the yield on the benchmark 10-year U.S. Treasury dropped to 2.04% from 2.36% on June 30th. Yields steadily trended lower, amid questions about economic strength and a cloudy outlook for equity prices.
The magnitude of yield changes was somewhat varied along the yield curve. For example, yields on the shortest maturities dropped, but those of one-year maturities rose slightly. The yield changes in the 7-year to 30-year segment were similar, resulting in a parallel downward shift in the yield curve relative to June 30th. The yield on the 3-month T-bill settled at -0.01%, down from 0.01% at the end of the previous quarter. The yield on the five-year Treasury declined, ending at 1.36%, compared to 1.65% on June 30th, and as mentioned above, the yield on the 10-year Treasury fell to 2.04% from 2.36% over the same period. Concurrently, the yield on the 30-year Treasury also dropped to 2.86% from a high of 3.12% during the quarter. Inflation expectations continue to be fairly well contained, with the Fed’s gauge of five-year forward inflation expectations closing at 1.73% on September 30th, up from 2.16% on June 30th.
Fixed-income securities generally posted positive, but modest, total returns. The Barclays Treasury 5-7 Yr. Index gained +2.27%, and the Barclays U.S. Corporate 5-10 Yr. Index advanced +0.88% . High yield securities performed very poorly, and, along with emerging market debt, constituted one of the only major fixed-income segments to post negative returns, shedding -4.86%. The Barclays Municipal Bond Index was one of the best performing fixed-income asset classes, gaining +1.65%. Non-U.S. fixed-income also fared well, as the Barclays Global Aggregate ex-U.S. Index posted a +0.64% return. However, the index still has a negative year-to-date return. Emerging market debt suffered from the drop in commodities prices, and the JPM EMBI Global Index gave back -2.04%.
This period was a tale of two environments. In the first half of the quarter, equity prices continued to trend higher, in part due to steady, if not robust, domestic economic growth. In addition, investors seemed to shrug off the early declines in China’s stock market and to acclimate to the idea that the FOMC would begin to normalize interest rates at its September meeting. However, it was an entirely different story in the quarter’s second half. Markets perceived China’s August 11 yuan devaluation as a sign that its economy needed more support than originally believed, and that the bursting of the Chinese stock bubble may eventually affect global markets. The S&P 500 Index finished the quarter with a loss of -6.44%, and is now down -5.29% on a year-to-date basis. It was the index’s first negative quarterly return since the fourth quarter of 2012, and marked the most severe quarterly decline in four years.
The ten primary economic sectors generated significant disparities in performance, putting sector selection at a premium for active managers. The interest rate-sensitive utilities sector, the only sector to generate positive returns, posted a gain of +5.40%. Consumer staples and consumer discretionary also fared well on a relative basis, with losses of -0.20% and -2.56%, respectively. The energy and materials sectors were by far the poorest performers during the quarter, declining -17.41% and -16.90%, respectively.
The Russell 1000 Index of large capitalization stocks generated a -6.83% total return. Within the large cap segment, growth stocks outperformed value stocks. Small capitalization stocks, as represented by the Russell 2000 Index, performed very poorly relative to large caps, ending with a total return of -11.92%. On an annualized basis, small caps now lag large caps by almost 3% (300 basis points) over the past five years. Unlike the situation in large caps, however, value significantly outperformed growth within the small cap universe. The Nasdaq Composite, dominated by information technology stocks, also slid during the third quarter, ending down -7.09%. The Dow Jones Industrial Average of 30 large industrial companies declined -6.98% during the quarter.
Real Estate Investment Trusts (REITs) bucked the general equity market trend, as interest rates dropped slightly. The DJ US Select REIT Index managed a gain of +3.09% . Commodities resumed their freefall, and the Bloomberg Commodity Index plunged -14.47% for the third quarter. The index is down approximately -26% over the past 12 months, and has declined at an annualized rate of more than -16% for the past three years.
International stocks suffered severely compared to U.S. equities, as investors continue to be nervous about the halting economic recovery in the Eurozone. The ECB began its asset-purchase program earlier in the year to provide stimulus to the flagging economy. However, deflation is a continuing concern: consumer prices in the region fell in September for the first time since the stimulus program was launched. Investors now are calling for the ECB to step up its asset purchases to stem any further slide. As a result, European stock indices were hit hard: the MSCI ACWI ex-USA Index, which measures performance of world markets outside the U.S., dropped -12.10% in the third quarter, again driven by both developed and emerging markets. The MSCI EAFE Index of developed markets stocks sank by -10.23% during the same period. Regional performance was very weak, and every region declined. Latin America and China were the poorest relative performers: the MSCI China and MSCI EM Eastern Europe indices suffered losses of -23.18% and -13.05%, respectively. Emerging markets performance also was extremely weak, keyed in part by the ongoing decline in commodity prices. The MSCI Emerging Markets Index posted a loss of -17.90%.
Although equity markets recently have given back some of the gains accumulated over the past few years, and the economies of China and Japan continue to struggle, economists generally remain optimistic about U.S. economic prospects. China’s slowing economy does not surprise economists, since the Chinese government has been lowering growth forecasts for some time, as it attempts to transition the economy to a more consumer-driven model from one driven by exports. Analysts also fault Chinese policymakers for mismanaging this transition by appearing to encourage the run-up in stock prices to bubble levels. Positives for the U.S. economy include gains in employment, one of the key criteria the FOMC considers in its decision about when to begin normalizing interest rates. Some economists estimate the economy will achieve full employment sometime in the third quarter of 2016. In addition, although the rise in the U.S. dollar has caused manufacturing to suffer, manufacturing employment remains robust. Inflation, one of the primary metrics the FOMC considers—along with employment—in its decision on when to raise rates, remains fairly low, and may be a key reason the committee didn’t move to raise them in September. But, wage growth is rising steadily, and current low inflation is a function of declining oil prices and the rising dollar, effects that many deem to be temporary. The continued positive trends in the housing segment also bode well for U.S. growth.
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The Dow or DJIA (Dow Jones Industrial Average) is an unmanaged index of 30 common stocks comprised of 30 actively traded blue chip stocks, primarily industrials and assumes reinvestment of dividends. The Nasdaq Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market. The S&P 500 Index is an unmanaged index comprised of 500 widely held securities considered to be representative of the stock market in general. The DJ U.S. Select REIT Index is a subset of the Dow Jones Americas Select RESI and includes only REITs and REIT-like securities (The Dow Jones U.S. Select Real Estate Securities Index (RESI) represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S.). The Bloomberg Commodity Index is a broadly diversified commodity price index that tracks prices of futures contracts on physical commodities on the commodity market and is designed to minimize concentration in any one commodity or sector. The MSCI EAFE Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises the MSCI country indices that represent developed markets outside of North America: Europe, Australasia and the Far East. The 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 MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes. The MSCI Emerging Markets (EM) Eastern Europe Index captures large- and mid-cap representation across 4 Emerging Markets (the Czech Republic, Hungary, Poland and Russia) countries in Eastern Europe. With 52 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI ACWI Ex-U.S. Index is a market-capitalization-weighted index maintained and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI China Index captures large and mid-cap representation across China H shares, B shares, Red chips and P chips covering about 85% of this China equity universe. The Barclays Municipal Bond Index is an unmanaged index comprised of investment-grade, fixed-rate municipal securities representative of the tax-exempt bond market in general. The Barclays Global Aggregate ex-U.S. Index is a market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most U.S. traded investment grade bonds are represented. Municipal bonds, and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury securities, Government agency bonds, Mortgage-backed bonds, Corporate bonds, and a small amount of foreign bonds traded in U.S. The Barclays U.S. 5-10 Year Corporate Bond Index measures the investment return of U.S. dollar denominated, investment-grade, fixed rate, taxable securities issued by industrial, utility, and financial companies with maturities between 5 and 10 years. Treasury securities, mortgage-backed securities (MBS) foreign bonds, government agency bonds and corporate bonds are some of the categories included in the index. The Barclays Capital US 5-7 Year Treasury Bond Index is a market capitalization weighted index and includes treasury bonds issued by the US with a time to maturity of at least 5 years, but no more than 7 years. The Russell 1000 Index is a market capitalization-weighted benchmark index made up of the 1000 largest U.S. companies in the Russell 3000 Index (which comprises the 3000 largest U.S. companies). The Russell 2000 Index is an unmanaged index considered representative of small-cap stocks. The Russell 3000 Index is an unmanaged index considered representative of the US stock market and measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market. The Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse of the single-family housing market. The survey asks respondents to rate market conditions for the sale of new homes at the present time and in the next six months as well as the traffic of prospective buyers of new homes. The JPMorgan Emerging Market Bond Index (EMBI Global) tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the JPMorgan EMBI+. As with the EMBI+, the EMBI Global includes U.S.dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million.
The Federal Open Market Committee (FOMC) is the monetary policymaking body of the Federal Reserve System. Fed Funds Rate, the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. The European Central Bank (ECB) is the central bank for Europe's single currency, the euro. The ECB’s main task is to maintain the euro's purchasing power and thus price stability in the euro area. The euro area comprises the 19 European Union countries that have introduced the euro since 1999. The Gross Domestic Product (GDP) rate is a measurement of the output of goods and services produced by labor and property located in the United States. The Bureau of Labor Statistics (BLS) is a unit of the United States Department of Labor. It is the principal fact-finding agency for the U.S. government in the broad field of labor economics and statistics and serves as a principal agency of the U.S. Federal Statistical System. The Bureau of Economic Analysis (BEA) is an agency in the US Department of Commerce that provides important economic statistics including the gross domestic product of the US; a governmental statistical agency that collects, processes, analyzes, and disseminates essential statistical data to the American public, the U.S. Congress, other Federal agencies, State and local governments, business, and labor representatives. The PCE (Personal Consumption Expenditure) Index of Prices is a US-wide indicator of the average increase in prices for all domestic personal consumption. Using a variety of data including U.S. Consumer Price Index and Producer Price Index prices, it is derived from personal consumption expenditures; essentially a measure of goods and services targeted towards individuals and consumed by individuals.