What a ride!
By the beginning of October, the U.S. stock market rally had been going on for 66 months, since bottoming out in March 2009, enjoying a correction-free streak that had already been a year longer than average, despite corporate profit growth that was not only in the low single-digits, but was driven more by cost-cutting than revenue growth and EPS improvement driven often by share-repurchase programs rather than actual business improvements. During this time there was really only one significant correction from late April 2011 to early October 2011 when the Russell 2000 lost about 30% of its value and the S&P 500 lost nearly 20%.
Then last week things changed… and what a ride it is! On Tuesday October 7th, the S&P 500 fell 1.5%. The next day, October 8th was the strongest day in the markets so far this year. The markets experienced the biggest intraday swing, started down then shot massively up, with the S&P 500 to close up 1.8%.
What caused this rather dramatic upturn turn-around? The meeting minutes from the Federal Reserve’s Open Market Committee meeting, indicated that there was great concern over global economic weakness and the strength of the dollar. So a struggling global economy AND the dollar has strengthened significantly which could hurt U.S. exports, harming the domestic economy? Market participants knew that the day before… what was newsworthy is that THEY are concerned which gave the market comfort that the Fed isn’t going to raise interest rates in the near future. Yippeee! Oh, wait, but because things are still pretty rough out there…
So… the equity markets woke up the following day, on October 9th, and stocks once again dropped across the globe, with the S&P 500 reversing most of the prior day’s rally to close down 2.07% and small caps tumbled even more on continued concern about global economic strength with the Russell 2000 (small cap index) falling 2.66%.
At this point small-cap stocks, as measured by the Russell 2000, have fallen below the 200-day moving average for the first time since November 2012. Almost half of the stocks in the Nasdaq are down 20% from their one-year highs, which means they are already in a bear market. Doug Kass of Seabreeze Partners has been calling this “The Ali Blah Blah Top,” suggesting that the Chinese tech company’s monster initial public offering on September 19th was a signal that markets were too frothy.
The CNN Money Fear and Greed Index sums up today’s market sentiment fairly clearly.
We have seen some very interesting moves in the bond market this year as well. Over the past year longer-dated bond yields have fallen while the shorter-term (such as the 5-year) have actually risen, which is indicative of a flattening yield curve. The red line below shows the declining difference between the 30 year and 5 year rates.
In a normal environment the yield curve slopes upward, which makes intuitive sense. You’d charge someone more to borrow money from you for 10 years than 1 year.
When the yield curve inverts, that means you would charge more for a 1 year loan than a 10 year loan which is counter-intuitive to say the least. This happens when the market believes that long-term prospects are grim, thus the longer you go out, the lower the yield. A flattening or inverted yield curve is often interpreted as a sign that the economy is starting to cool and that the Fed may start to lower short-term rates. In contrast, a steepening yield curve usually points to a strong economy with increased inflation expectations.
Currently, the yield curve is considered steep due to the difference between long- and short-term interest rates. The bond market has been in this steep yield curve due to the Fed’s decision to keep rates near zero. However we are seeing the curve getting flatter as the prior chart illustrated, with the red arrow showing the difference between the 30-year rate and the 5-year rate declining. Looking ahead, the curve could flatten further, similar to what happened during the last increase in the federal funds rate, and may eventually invert.
On September 9th, Jeffrey Gundlach, CEO and CIO of DoubleLine Capital, (whose fund Meritas utilizes) gave his thoughts on the recent flattening of the yield curve. Gundlach thinks that this trend is remarkable. He suggests that strong economic data are driving the short end of the yield curve higher on expectations that the Fed will start tightening sooner. However, the economy might be more vulnerable to rate hikes than is widely appreciated. He concludes that “if you read the tea leaves of the bond market, it might be if the Fed raises rates even moderately like to 1% or 2%, maybe the economy can’t take it.”
The chart below shows how the price of longer-dated bonds have been falling, which is what happens when yields go up, while the shorter term bond prices have been rising, which is when yields go down.
Across the Atlantic, European equities have followed a similar pattern to the U.S., peaking in early June, with the Italian MIB up almost 20%. All are now down for the year, with the exception of the Italian MIB, but it sure looks to be following suit!
As you’ve likely heard, Europe is now fighting to stay out of another recession, with the German economy, long the primary source of strength in the region, capitulating as well. This is material to the U.S. stock market as the U.S. stock market is not all about the U.S. economy. Foreign sales accounted for about 33% of aggregate revenue for the S&P500 in 2013 according to Goldman Sach’s analyst Amanda Sneider. In addition to weakening international sales, the U.S. also has to worry about the impact of a strengthening greenback, (we’ll have more on that later in this letter).
So just how tough is it in Europe? The French Prime Minister, Manuel Valls, enjoyed an approval rating of over 70% when President François Hollande gave him the position. Just six months later his approval rating has fallen to 22%, barely better than Hollande’s. Valls recently reportedly said of the French economy that, “in three to six months, if the situation isn’t reversed, we’ll be foutu,” a rather colorful way of saying the economy is in a very bad place, with unemployment still above 10% and GDP flat so far for the year.
Meanwhile France’s two largest car-makers are pressing Hollande to quicken the pace of economic reform, primarily with respect to the nation’s restrictive labor regime and high labor costs, in order to help them boost their competitiveness.
According to Carlos Ghosn, chief executive of Renault, “everything should be done to lower the cost of labor in France on conditions that are compatible with economic balance” Maxime Picat, chief executive of the Peugeot brand added: “The level of taxation and (social) charges are putting huge pressure on labor costs. This is really the key and where we’ve got the biggest gap with the countries very close to France,” he said. “With 1m cars (made in France) and such an exporting position, this is clearly key to us.”
This isn’t all that surprising if we look at the long-term trends in Eurozone productivity growth.
How’s that French austerity coming along? Errr, not so much which is getting the ire up over in Germany. Despite all the talk of cutting spending, Government debt has continued to grow almost unabated while its debt to GDP ratio only gets worse.
Recently Finance minister Michel Sapin admitted that France’s government will not be able to meet its EU deficit target until 2017, from these charts you can see no one ought to be surprised!
Meanwhile Italian Prime Minister Matteo Renzi claims that Italy will not follow in France’s footsteps, but will instead remain within the 3% deficit-to-gross GDP ratio mandated by the EU, despite his nation’s protracted recession. In August the youth (aged between 15 and 24) unemployment rate in Italy reached a new record high of 44.2% in August, while the overall unemployment rate was 12.3% v expectation of 12.6%, (see chart below).
Imagine that! Almost half of the youth in Italy cannot find a job. Think about how that affects the nation for decades to come. At a time when the young most need to be developing skills and using all that energy to be productive, they are wandering around aimless and increasingly frustrated that their aging nation is giving them the cold shoulder in the workforce.
On October 6th we learned that German factory orders plunged the most since 2009, underlining the risk of a slowdown in Europe’s largest economy. Orders, adjusted for seasonal swings and inflation, fell 5.7% in August versus expectations of a 2.5% decline, after climbing 4.9% in July, according to the Economy Ministry in Berlin. On October 9th Reuters reported that German exports plunged 5.8% in August, their largest amount since the height of the financial crisis, fueling debate on whether Berlin is doing enough to prop up the domestic and European economies. Hours after the trade data was released, a group of leading economic institutes joined the International Monetary Fund (IMF) in slashing forecasts for German growth. They are now expecting growth of 1.3% this year and 1.2% next, down from 1.9% and 2.0% previously.
With so many other Eurozone nations struggling, it isn’t surprising that while Germany had a strong start to the year, it shrank by 0.2% in the second quarter. Evidence is now mounting that it barely grew in the third quarter and some economists are forecasting another contraction in that period, which would amount to a technical recession.
Bottom Line:
The U.S. economy is on a stronger footing, but one of the core facets is still struggling – what families take home at the end of the day. Yes, the unemployment rate has fallen, but so has the labor participation rate, (the percentage of the population in the work force). Granted, some of that is because of the aging population, but not all and either way, it means a smaller portion of the country is working towards growing the economy. Yes, there are more job openings, the number of jobs waiting to be filled in the U.S. has climbed to the highest level in 13 years. But those jobs are not being filled because we have a significant skill gap. Employers can’t find the right people to fill the jobs. That hurts growth in two ways: (1) the person looking for work still isn’t able to get a paying job and (2) the business isn’t able to grow as effectively as it could if those positions were filled.
The U.S. is not an island. Countries all over the world that buy from the U.S. are struggling and a strengthening U.S. dollar isn’t helping them. This impacts what types of companies will do well in this new era.
Suppressed volatility always leads to increased volatility; an immutable fact.
