The third quarter marked the long-awaited return of stock market volatility. Issues ranging from slowing Chinese growth to U.S. Federal Reserve (“Fed”) policy to falling commodity prices created sufficient investor uncertainty and risk aversion to cause a 6.44% decline in the S&P 500® Index. This volatility was not confined to just the U.S., as foreign markets also suffered. Importantly, we do not believe this correction signals the start of a bear market or recession, but is simply an overdue, healthy consolidation in the equity market which is supported by an economy that remains on solid ground.
The key catalyst for the sell-off was the August 11 decision by the Chinese government to allow its currency, the Yuan, to decline in value against the U.S. dollar in an effort to ignite greater trade activity. This move was seen by many as a sign that the Chinese economy, which has been reported as growing at 7% by the government, is actually growing at a much slower rate than believed. In addition, China had been in the headlines following the dramatic collapse of its primary stock market in early July, so global investors were already on edge. The situation was exacerbated by currency devaluations in other Emerging Market countries, as well as by data subsequently released that demonstrated a significant slowdown in China’s manufacturing sector. Continued declines in the prices of oil, copper, iron ore and gold (the Bloomberg Commodity Index fell 14.47% in the quarter) put further pressure on Emerging Markets' growth, led to additional speculation about how weak China may actually be and kept investors in a generally foul mood.
The Fed contributed to the uncertainty plaguing investors by postponing an expected increase in the Fed Funds rate during its September meeting. One of the key reasons for failing to raise the rate, which has been at near zero for almost seven years, was concerns about "recent global economic and financial developments.” This led investors to deduce that the Fed was delaying the inevitable due to its own concerns about China, which created further angst for the markets. While it seems very possible that the Fed will begin the rate hike cycle before year end, especially since 13 of 17 Fed members have indicated a desire to do so, the uncertainty surrounding Fed policy will likely keep volatility elevated in the meantime.
Despite the weakness in stocks, U.S. economic data remained in a general uptrend. The unemployment rate fell to a healthy 5.1%, while new job openings hit an all-time high. The strength of the consumer was evident in the rise in auto sales, retail sales and consumer confidence, while the housing sector was boosted by strong new home sales and rising home builder confidence. Low gasoline prices are benefitting U.S. growth, while banks are as healthy as they have been in decades. Weakness was found in the manufacturing segment, which has been negatively impacted by the strong U.S. dollar and paltry foreign demand, but the U.S. still appears on pace to deliver solid growth for the remainder of the year.
Non-U.S. stocks performed even worse than U.S. stocks during the third quarter, as foreign economies tend to have a greater reliance on trade with China and the Emerging Markets. Developed market stocks, as measured by the MSCI EAFE Index, fell 10.23%, while the MSCI Emerging Markets Index plummeted 17.90%. A vicious cycle of falling commodity prices, declining currencies and foreign capital outflows has created a major headwind for the broad emerging market universe.
Long-term interest rates fell globally during the quarter as investors sought the safety of government bonds, while U.S. investment grade corporate bonds rallied given the positive economic data reported in the U.S. As a result, the Barclays U.S. Aggregate Index, which is comprised of both U.S. Treasuries and investment grade debt, produced a positive return of 1.23%, while the Barclays Global Aggregate Bond Index rose 0.85%. High yield bonds, however, tend to trade more in line with equities and thus fell in value during the quarter as investor risk appetites declined. Global REITs rallied as interest rates fell and investors sought out higher yields, while the U.S. dollar rose slightly as investors pursued the relative safety of U.S. financial assets.
For the remainder of the year, we expect continued levels of higher volatility, particularly as concerns about China and the Fed persist. The Fed has the option to begin raising the Fed Funds rate at either its October or December meeting, and we would expect investors to cheer such a move as it removes much of the uncertainty surrounding U.S. monetary policy. U.S. economic growth appears stable, while stock market corrections of the magnitude we witnessed in the third quarter generally last on average only seven months. At Guidestone, we believe patient, long-term investors will continue to be rewarded by practicing prudent global diversification, employing experienced active fund managers and by tuning out the daily market “noise” that causes so many to make poor decisions.
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