Third Quarter Comments

Each quarter since we became a fully independent Investment Advisor registered with the State of Indiana in 2007, we have supplied our clients on a quarterly basis with brief comments about the economy, the markets and our thinking about both. We assemble these comments after we have had an opportunity to review the last quarter’s events, and consider their ramifications going forward. As they are a snapshot in time, these comments can become dated quickly, and so should not be considered investment guidance, nor should they be considered comprehensive of all of our thinking.

Below is that which we have advised our clients after the end of the third quarter in 2015.

THIRD QUARTER 2015

The third quarter of 2015 was significantly negative for most asset classes as the potential for a global slowdown became more widely appreciated and the US Fed decided to delay a rate increase. Other than investment grade bonds, there were no major asset classes with positive returns.

The S&P 500 fell 6.4%, the Russell Mid Cap Index lost 8.0% and US small cap stocks were down 11.9%. Foreign stocks fared no better with the foreign developed market index losing 10.2% and the emerging market index falling 17.8%. Investment grade bonds gained 1.2%.
COMMENTS

In our last quarterly letter, we noted that the stock market appeared “fully valued, able to advance cautiously in line with earnings, but not much more than that, and susceptible to disappointment.” In the third quarter, that disappointment came in the form of sobering news from China, which since the financial crisis has been the world’s leading engine of growth.

China’s difficulties have arisen from an economy in which too much investment has taken place, encouraged by a vigorous Chinese government able to drive economic activity in ways unthinkable to markets more free than theirs. Highways to nowhere, empty airports, empty cities, and manufacturing facilities turned ghostly were all constructed with a “build it and they will come” philosophy that, with a still slow global economy, could not any longer be sustained. Exports fell 8.3% year over year in July, and construction fell 16.8%. The Chinese government hoped to encourage a pivot to domestic consumption; however, an anti-corruption campaign discouraged displays of consumer luxury and the weakest car sales in over a decade suggest that the Chinese consumer may not be ready yet to pick up the load. A survey of manufacturers revealed the worst sentiment in 6 years. In spite of government intervention, China’s stock market fell over 40% peak to trough. That, along with a giant explosion in the city of Tianjin, an ineffectual attempt at cover-up, and questionable economic growth statistics amidst it all has shaken the world’s confidence in China’s ability to navigate its travails.

China’s overcapacity unfortunately translates into global overcapacity, which in turn (and in combination with instability in Europe flowing from a crisis of immigration from the Middle East) threatens to subvert the U.S. economy. Though slow, the U.S. has remained one of the strongest economies in the world. With a Federal Reserve flirting with raising interest rates, the U.S. dollar has enjoyed a climb, which has made our own exports more expensive and imports less so. Consequently, our exports have dropped to their lowest levels in years, inventories have climbed to unusually high levels, U.S. manufacturing has slowed, and prices paid have dropped. The whiff of deflation at home and abroad has produced renewed central bank action in both Europe and China, and given pause to the U.S. Fed.
LOOKING AHEAD

U.S. and world markets in the early fourth quarter have already enjoyed a substantial rebound owing to a reduced prospect of interest rate hikes. However, recession and deflation threaten to intrude, neither of which would be welcomed with herald trumpets. Instead, they would creep in and take their seats unannounced, with government, financial, and commercial institutions doing their best to encourage the rest of us to ignore them as long as possible, perhaps until they have already left. Why? Were Americans to become aware of recession or deflation, we might adjust to their presence by saving more and spending less, and so by reducing demand, encourage them to extend their stay and perhaps even worsen.

There’s evidence that both of these unwelcome guests may already be at the table. First, as Wharton’s Jeremy Siegel observed, earnings estimates for 2015 have dropped below those of 2014, a slide unprecedented outside of a recession. Corporations ranging from Deutsche Bank to Caterpillar to Cummins Engine to Procter and Gamble to Whole Foods to Walmart have been cutting jobs. Consumer prices in both the U.S. and in Europe have declined year over year, largely due to declines in the price of energy (which, it is continually hoped, will fuel other purchases), and wages and salaries have dropped, especially in American manufacturing, which is already in recession.

At the same time, even as the labor market has tightened and retailers announce wage increases to attract seasonal employees for the holidays, the very stagnation of wages amidst increasing income and wealth inequality has created popular and political pushback. In the United Kingdom, the House of Lords turned back legislation from the Commons, demanding that the effect of budget cuts on the poor be examined. In Canada, the Liberal Party surprised observers with its return to power. And in the United States, Senator Bernie Sanders, once styled the Mayor of the People’s Republic of Burlington, has declared himself a Democratic Socialist with a focus on income inequality, and has drawn enthusiastic campaign crowds.

Whether the pressure is public, political, or market, can wages rise without eroding profits, and to what effect on stock prices? Walmart offers a cautionary tale, for having announced future significant wage increases in prospect, they issued a profit warning earlier this month blaming higher wages, and suffered their worst one day stock drop since 1988. More optimistically, it may be that Walmart’s problems are unique to them, but that higher wages economy-wide do emerge and translate into the increased consumer demand, rising prices, and improved revenue sufficient to maintain or even grow profits.
IN SUMMARY

Under the circumstances of slow global growth, potential recession, and potential wage-driven profit pressures, investor caution is warranted, but not necessarily pessimism. We must remain mindful of the power of central banks to move markets, and indeed China and Europe have both announced easing programs which have done precisely that. Should conditions weaken, the U.S. Federal Reserve retains tools, including even negative interest rates, to respond. While not banking on the Fed, it remains unwise also to bet against it, as any number of investors have learned to their sorrow. We advise remaining invested appropriate to risk, diversified, and prepared in the short term to weather volatility should more of it appear, for over the long term only that will produce return.