United States: Island of Relative Prosperity

Posted on October 8th, 2015 by David Laidlaw 

During the 3rd Quarter, volatility increased significantly as the S&P 500 lost 6.4% of its value. This loss represents the worst quarterly return since 2011. The market has declined over 5% year-to-date and is on track to post the first negative return since the financial crisis seven years ago.

These market losses reflect lower corporate earnings over the period. In aggregate, the companies within the S&P 500 earned 1.1% less than 2014 through the first nine months of the year. Earnings are weaker than last year because a stronger US Dollar makes our goods sold abroad more expensive and thus depresses exports, which declined 4.3% through the end of July. A stronger US dollar also hurts foreign sales as those sales are translated back into dollars in the accounting process. Finally, earnings within the energy sector have collapsed due to much lower oil prices (even though lower energy prices are a net positive for most industrial companies).

Stock markets around the world are also trying to gauge the impact of two developments. The first is the economic slowdown in China. As we noted in our piece in August, while still a “developing economy,” China is the second largest economy in the world and weakness there has wide ranging effects throughout an interconnected global economy.

The second long-developing issue is the Federal Reserve’s (Fed’s) plan to raise interest rates. The Fed has produced mixed messages. After failing to raise rates in June, the Fed again hinted that rates would be increased in September only to backtrack and keep rates at 0% given turbulence in the securities’ markets.

However, the day after their most recent meeting, officials from the Fed insisted that rates would be increased before the end of the year. Higher interest rates typically entail lower prices for stocks and bonds so uncertainties concerning the path of interest rates has added to the price swings.

On the positive side of the ledger, the Fed is debating raising rates since our economy is performing fairly well. The US has created almost 200,000 per month this year and the most widely tracked rate of unemployment has dropped to 5.1% from over 10% six years ago. Americans will buy approximately 18 million new cars this year which represents the highest rate of purchases since the recession. Economic strength in the US contrasts with pronounced weakness throughout the rest of the world. Japan’s industrial production declined for the second month in a row due to slumping exports to China. During the second quarter of this year, the Japanese economy shrank at an annual rate of 1.2%. Estimates for the 3rd quarter indicate this economy is projected to decrease again. Europe has only grown its economy at an anemic 1.5% over the past year and still has an unemployment rate of 9.5%. The social disruption caused by its migrant crisis also threatens to disrupt Europe’s fragile stasis. Finally, all of the commodity-based economies have been decimated. For instance, Brazil and Russia are shrinking at rates of 1.3% and 2.7% respectively according to the World Bank.

The previous graph shows the difference between annual economic rates of growth in the US and the rest of the G-20 over the past twenty five-years. The US should grow much slower than an unweighted average of the other 19 largest economies since ours is a more mature and much larger economy than others. The graph reflects this reality with two notable exceptions. During the mid to late 1990s and over the past year, the US has grown  faster than the rest of the world.

The period of faster growth in the US during the 1990s lasted for four years. This period was remarkable due to the rapid technological change happening as a result of the development of the Internet. Massive capital investment occurred as companies raced to build out their computing and telecommunications infrastructure. Also notable during this period was the decrease in large-scale military conflicts which provided a significant “peace dividend.” 

The US has grown faster than other economies coming out of the financial crisis since many foreign banks never cleared their bad loans. Advances in technology will drive productivity both here and abroad; however, the US will not benefit from the “first mover” advantage that it enjoyed in the 1990s. The level of global instability also suggests that military spending and engagement will increase. The US may continue to grow faster than the rest of the world over the near term, but this condition will not persist.

Most of our moves within client portfolios have been to position portfolios more conservatively. We have further reduced holdings within the energy sector and sold foreign Exchange Traded Funds (ETFs) due to concerns that a strong dollar will further erode the
buying power of currencies in the emerging markets.

Market dislocations create opportunities since fantastic businesses are sold in a panic along with the stocks of poorly run companies that deserve to sell for lower prices. Indiscriminate selling during the financial crisis afforded numerous opportunities for the patient investor. While we do not expect to see valuations drop to levels seen during the depths of financial crisis, many companies are already looking much more attractive from a valuation standpoint.