January 8, 2016 – Global stock markets are selling off to start 2016, and if this trend continues, it may be one of the worst starting weeks to a new trading year since 1928 according to The Wall Street Journal.
The S&P 500 suffered a correction (decline of over 10%) in August of 2015 and then recovered by early November 2015. Since that recent high in November, the S&P 500 Index is down about 7.5% again – threatening another correction.
The drivers behind this recent sell-off and the one in August of 2015 are similar – it is largely related to China, more specifically the Chinese yuan, which has weakened considerably since the IMF announced that it would include the currency in the Special Drawing Rights (SDR) basket. The sell-off in the currency, in our view, is largely related to the shift in monetary policy in the US and the Chinese desire to meet the multiple demands to be included in the IMF currency basket. Now that the Fed is moving toward a higher interest rate environment (although only marginally), the US dollar is strengthening and so too is the Chinese currency (yuan) which has been effectively pegged to the US dollar. Going forward the yuan may begin to track this currency basket rather than the US dollar exclusively. A weaker yuan would be a good thing for China’s economy at this point since it is slowing down and shifting some of its emphasis to the domestic sector. During this transition, China would benefit from increased export revenue which could offset some of the slowdown they are currently experiencing. As a reminder, Chinese monetary authorities have tried to loosen credit conditions by reducing reserve requirements for banks and by lowering interest rates over the last 13 months, but a stronger currency has somewhat offset these benefits. Now that the currency value is adjusting, these accommodative monetary policies may be more effective. We continue to believe that the People’s Bank of China (PBOC) can and will influence the markets in an effort to bring stability.
Just as in August 2015, we do not see this recent market sell-off as a harbinger to a recession in the US economy. In fact, there is good evidence that the service sector is improving. Labor and housing markets are stabilizing and consumer spending is improving as evidenced by the recent retail sales figures. Monetary conditions are still quite accommodative in the US and the Fed will not blindly increase rates further if economic conditions, both domestically and abroad, do not warrant it. In addition, inflation remains low and typically recessions occur during an inflation spike rather than a decline in prices. While earnings have declined in 2015 on the back of lower oil prices and higher wage costs, these are generally good omens for future consumer spending.
Clearly, market participants are becoming more concerned and the sentiment indicators produced by the American Association of Individual Investors for the week ended January 6, 2016 show that the bearish indicator is up 14.6% to 38.3%. This is often a contrarian indicator since investors tend to react to the most recent events and project them forward. When one looks back to 2015, the significant drop in oil prices and other commodities, the spike in high yield bond yields (which typically indicate stress in markets), and the significant underperformance in economically sensitive sectors like energy and materials can be unnerving. However, it is our view that a patient, strategic, thoughtful, and diversified strategy will be rewarded. Timing markets is a difficult endeavor and 2015 was another good example of this. If one were to have sold in September amidst the last China growth scare, the losses would have been realized and one would have missed the sharp subsequent recovery.
As we mentioned in our last quarterly investment review, there are risks in this environment. We have just completed the seventh year of positive returns in the US equity market, as measured by the S&P 500 Index, and while we do not consider markets overvalued, they are no longer undervalued. In addition, as the market powers higher, the leadership continues to narrow. Combine this dynamic with the start of interest rate increases and there is potential for more uncertainty which may lead to increased volatility. However, balancing these risks are the strength we see in consumption in the US economy and continued accommodative monetary policy globally.
Please feel free to contact the Pitcairn team with any questions.