Highlights:
- China's transitioning economy continues to be a driver of recent equity market volatility. However, in the long term, even reduced growth rates are likely to meet its goals and support global growth.
- Emerging market countries continue to be heavily impacted by the slowdown in China, tumbling commodity prices, as well as tightening U.S. monetary policy.
- The European Central Bank announced further stimulus measures that some have determined are not aggressive enough.
- The U.S. Federal Reserve, on the heels of strong labor market reports, raised interest rates for the first time in almost a decade, albeit slightly, as economic growth continues to be tepid and many larger corporations could see declining earnings for the first time since the recession.
Commentary:
Global equity markets were caught in the middle of a tug of war in 2015, with the U.S. Federal Reserve on one side determined to increase interest rates, and much of the rest of the world on the other side being pressured to lower interest rates. When it was all said and done, equity markets were generally stagnant, and the headwinds that held back equity markets in 2015 including concerns over slowing growth in China, stumbling commodity prices, lackluster global growth, declining corporate profits, and a stronger U.S. dollar could well persist into 2016.
Last quarter’s commentary went into considerable detail regarding the sustainability and trajectory of Chinese economic growth. We would suggest you refer to this commentary if you wish to refresh an idea of what is driving current volatility in China. While China may continue to drive equity market volatility in the short-term, we still believe it likely that this is more a function of China transitioning from its traditional engines of growth (manufacturing, real estate and government spending) to new engines of growth (the service and private sectors), rather than an indication of any pending collapse of the Chinese economy. As we have pointed out in the past, 6%+ growth would likely still allow China to meet its broader goals and support substantial global growth, making this a key statistic to monitor over the next several quarters.
The emerging market countries continued to be amongst the hardest hit by China’s economic retrenchment. The plunge in the commodity sector and tightening U.S. monetary policy further exacerbate pressure on many of these developing economies in 2015. Many of these developing countries now find themselves having to choose between the lesser of two evils – keeping interest rates low and risking further capital outflows, or increasing interest rates to staunch capital outflow, but with the risk of pushing their struggling economies into recession.
There was little doubt as to which direction the European Central Bank would take rates in the face of a struggling European economy and lingering deflation risk. However, many investors felt thatthe ECB did not act aggressively enough to stimulate bank lending and inflation when it lowered its already negative deposit rate to -0.3% from -0.2% and left its main lending rate unchanged at 0.05%. The ECB also extended its sixty billion euro per month bond buying program through March 2017 from its originally planned end date of September 2016. However, it did not increase the size of these monthly purchases, an outcome which was also contrary to market expectations.
The Fed took a divergent path from the ECB when they raised interest rates for the first time in nearly 10 years in December. Continued improvement in the labor market, buoyed by job creation and wage growth, set the stage for what is likely to be a gradual rate-hike environment over the next several years. The annual inflation rate continues to run below the Fed’s 2% target, but has been heavily influenced by low oil prices and a strong dollar, giving the Fed confidence that inflation will reach its 2% objective over the medium term. As was expected, investors reacted positively to the rate increase, even if somewhat limited, seeing it as validation of the ongoing resiliency of the U.S. economy.
Although rates are on the way up, they remain extremely low by historical standards and are likely to remain as such for the foreseeable future in the face of slow economic growth and amble economic capacity. Official GDP growth figures have not been published as of the writing of this commentary, but are likely to show another year of modest, but unspectacular growth. Consumer spending continues to make up for some of the slack left behind by sluggish business investment. The combination of a strong dollar, low global commodities prices and slowdowns in overseas economies have weighed on exports and caused many business to be reluctant to commit to capital projects. This same confluence of factors is likely to pressure profits and revenues for many large American companies, which could lead to declining earnings for the first time since the recession and further pressure U.S. equities that are already on the high end of historical valuation averages.
To conclude, equity markets have taken a step back over the last couple of months, but continuation of the overall recovery seen since the bottom of the recession remains likely. Currently, it is a slowing Chinese economy, low commodity prices, and rising interest rates that are driving market volatility. Next year, these factors may persist, but new concerns are likely to arise as well. However, companies around the world will continue to react and adapt. Investor perceptions of these reactions and adaptations will drive equity market results in the short-term, but fundamental earnings will drive them in the longer term. Thus the long-term investor who can live with the volatility in the short-term will be rewarded with a return premium over the longer term. The investment policy suggested for your portfolio anticipates these inevitable periods of volatility and general risk aversion, and is allocated and diversified accordingly to allow you to maintain your growth component exposure and participate in the equally as inevitable recoveries.
Urban Financial Advisory Corporation - January, 2016