September felt much like a milder version of August for stocks, with another weak month adding to August's poor performance, leaving Q3 as the weakest for US stocks since 2011. China's slowing economy is still weighing on investors and, with a Federal Reserve that seems in no rush to raise interest rates, many have begun second-guessing this multi-year bull market in stocks. International stocks fared no better in September, with both developed and emerging market stocks back-tracking more than US equities. Commodities and gold also resumed their downswings, with only US bonds showing slightly positive returns for the month:
The general perception among many investors has been that the place to find growth is in emerging markets, which presumably are expanding more rapidly than their developed-world counterparts. Sometimes, this is a correct perception - such as during the Bull Market running from 2003 to 2007. However, it has most definitely not been true for the last couple of years. In fact, growth has turned to contraction in many Emerging Market countries. Their Purchasing Managers Index (PMI) readings, which measure the health of the manufacturing sector, have fallen sharply into contraction territory. Stock prices, too, have reflected this unhappy state, with most emerging markets indexes lower than their levels of 5 years ago. Emerging market stocks have significantly lagged US stocks (S&P 500) and international developed market stocks (MSCI EAFE) over the last one, three and five year periods. This is an extended period of underperformance, which will eventually start to swing the other way. Although not imminent, this is something that we are watching closely:
The first half of September saw all eyes on the US Federal Reserve's interest rate decision on September 19. Bond yields rose gradually from the panic-induced lows of August 24th, as most investors assumed a quarter point rise was coming. The FOMC decided, however, to keep short rates at 0% (unchanged). The key statement in their press release was this: "The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad." This was an acknowledgement that weak markets and economies in China and the Eurozone forced the Fed's hand into playing the global accommodation game further.
Their decision also came after the IMF warned of the danger that raising rates could place on emerging market economies, whose borrowings have quadrupled from $4 trillion to $18 trillion over the last decade. Ultra-low U.S. Dollar interest rates incented much of the borrowing to be done in U.S. Dollar (non-local) currency. When U.S. interest rates rise, that will put downward pressure on their local currencies, making interest and principal payments much more expensive to repay.
Market sentiment shifted clearly in September to a view that the global economy is slowing, and the Fed's delay in raising rates may be seen as warranted if the US economy also begins to decelerate. It is very likely that the Fed took into account weak US unemployment figures in its September 17th decision. The October 2nd release of those employment figures revealed much weaker conditions than market participants expected. Most analysts focused on the lack of growth in wages, declining workweek, and increasing number of job seekers who have now opted out of the labor force. The release changed the tone of the markets, with stocks wilting and bonds strengthening. Investors now question whether the Fed can raise rates at all in 2015.
September proved to be a tumultuous month for US politics. Speaker of the House John Boehner resigned seemingly on the spur of the moment at month end, a day after a visit and address to the US Congress by Pope Francis. Most observers have pointed to the acrimonious relationship between the "tea party" faction of his party (which has been trying to oust Boehner since the last election), and the speaker's more traditional wing. The debt ceiling extension vote on September 30th brought things to a head, and Boehner resigned, rather than face continued attempts by his "rebellious" members to remove him from his office. He can count, and he knew he did not have the votes to continue. The rebels won.
This represents a signal shift in political direction, and we should expect an increase in political brinksmanship between the left and right. We are likely to see an early test of the mettle of the new Speaker, as the US runs out of money in mid-November, and a budget will have to be agreed on. The coming budget battle will serve to underscore the intractability of the US debt, and raise the threat of default on sovereign debt again. As a reminder, total U.S. debt has been growing at an alarming rate:
Source: St. Louis Federal Reserve
Washington insiders who caused this mess are going to be seen as increasingly unworthy of re-election, which is already manifesting itself in both parties as candidates jockey to claim the mantle of "outsider". A real sea-change is developing, and the 2016 election is setting up to be a doozy.
The issue of sovereign debt defaults is also lurking in the background. At mid-month, Moody's downgraded "Aa1" credit France to "Aa2". Japan was also downgraded by S&P in September from "AA-" to "A+". Both of these countries, and the U.S., were formerly rated "AAA". In the emerging markets, Brazil was cut to "junk" status this month, falling from "BBB-" to "BB+". Both Italy and Turkey, at "BBB-", are teetering on the edge of "investment grade". The downward pressure on credit ratings for sovereign debt is another signal shift that, for now, is getting little attention from investors. It is, in our view, among the most important of all developments in the financial markets, and we will be tracking this closely.
Of most concern is the startling move by Russia at month end to begin a bombing campaign in Syria to aid their long time ally President Assad. We were very surprised that markets did not sell off more on this news. It is the nightmare scenario that is now pulling all of the world's major actors into an unpredictable chess game of deadly proportions. As we publish this, it has been reported that Iran is actively moving troops into staging areas to join Russia. The U.S. and its allies Saudi Arabia and Israel are being directly challenged by this move, and any response now has few good outcomes.
The historical significance of this event is more than a signal shift, it is a game changer. The entire Mideast power balance has been thrown into turmoil. Czar Putin is making good on his word to restore Russia to its "past glory" by inserting Russia squarely into the Mideast (after "taking back" the Ukraine), and a newly resurgent Iran, having deceived the West and extracted a new nuclear weapons "treaty", has immediately taken to the battlefield. It is hard to describe all the repercussions and implications for markets that might arise as a result. Suffice it to say that it is a very concerning situation which, unfortunately, looks set to be with us for a very long time.
As we head into October, markets are trying to figure out the state of the global economy. If the upcoming data releases confirm a slowing US economy, investors will likely allocate more money to high quality bonds, supporting prices (even though yields are low). U.S. stocks prices have now broken long term trend lines (support), and are in downtrends globally, joining international stocks, commodities and emerging markets. It will take three to six months to see if if this trend accelerates to the downside, or if it stabilizes and resumes an uptrend. These are very important times for investors, who are being challenged with difficult markets everywhere. Our defenses are up and we are prepared for a variety of scenarios that await. Thank you for reading our Journal, and we'll report back next in early November.
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