Markets drop around the world
January was a terrible month for markets around the world. U.S. markets had their worst January since 2009, with all three major indices posting declines. The Dow Jones Industrial Average was down 5.39 percent; the S&P 500 Index did only slightly better, declining 4.96 percent; and the Nasdaq Composite Index did worst, dropping 7.82 percent.
A loss of confidence was the primary reason for the downturn. Market turbulence in China rattled investors, as the Federal Reserve's (Fed's) rate increase started to remove their security blanket. Fundamentals also weighed in. A further substantial drop in oil prices eroded that industry's revenue and profit prospects. Moreover, for the S&P 500 as a whole, earnings for the fourth quarter of 2015 were expected to decline 5.8 percent—the third decline in a row, which is something else that has not happened since 2009. Declining earnings made it difficult to justify the relatively high stock valuations that had prevailed at the start of 2016.
Technically, the markets remained in weak territory. All three indices were well below their 200-day moving averages, often a signal of future weakness. The Dow and the Nasdaq also failed to break technical resistance levels at month's end. The S&P 500, however, did break these levels, suggesting that the technical picture may stabilize.
International markets had an even worse January than U.S. markets. The MSCI EAFE Index, representing developed markets, dropped 7.23 percent, while the MSCI Emerging Markets Index declined slightly less, by 6.48 percent. Technically, both indices are now well below their 200-day moving averages. With China still attempting an economic transition, and the strong U.S. dollar threatening the financial stability of many countries, continued weakness looks quite possible.
Fixed income, a traditional beneficiary of market turbulence, did well in January. The Barclays Capital Aggregate Bond Index gained 1.38 percent for the month. Bond prices rose on a decline in U.S. rates, with the 10-year Treasury yield down from 2.24 percent at the start of January to 1.94 percent at month-end. With equity markets on the decline, bonds looked like the safer option, driving prices up and yields down—and U.S. assets down even more so.
U.S. economy grows, though more slowly
U.S. gross domestic product (GDP) growth for the fourth quarter of 2015, reported in January, was 0.7 percent, down from 2 percent in the previous quarter. The decline was due largely to continued weakness in U.S. manufacturing and exports, held in check by the strong U.S. dollar. A further sharp downturn in oil prices drove additional declines in U.S. energy investment and employment, which was also a substantial drag on GDP.
Consumer spending growth also declined in the fourth quarter, although there was some recovery in the last two months of the year. Consumer confidence, however, remained strong, and savings rates increased as workers opted to save rather than spend their rising wage income. These trends continued into January.
Positive signs for the economy included a strong jobs picture, with growth in the fourth quarter accelerating from a weak third quarter, and rising wage growth, something that had been missing in previous quarters. The housing market also continued to grow strongly, with December new home sales surprising to the upside and prices increasing at healthy rates. This factor appears to offer the prospect of further growth, as new home sales remain below historical levels and therefore could have room to improve (see Figure 1).
Figure 1. New Home Sales, 2000–2015
International problems multiply
Much of the slowdown in U.S. GDP appeared to stem from problems in the rest of the world. Headlines highlighting the slowing Chinese economy, the European refugee crisis, and other issues clearly raised the perception of risk. The direct negative effect of these worries on the industrial and manufacturing sectors of the U.S. economy received extensive coverage, and this also kept consumers from spending freely.
Substantial declines in China's stock markets through most of January forced concerns about China's economy and financial system to the forefront of world attention. The declines also rattled emerging markets in general, shaking the confidence of many investors in the ability of China's government officials to manage that nation's economy. In addition, concern about China's growth helped push oil prices down even further. Although the People's Bank of China continues to drive stimulus, there are signs that the bank's ability to affect the economy is waning.
Europe has continued to struggle. With the ongoing refugee crisis dividing governments, and economic growth still at low levels despite the European Central Bank's (ECB) stimulus policies, signs of new problems are on the horizon. The Italian banking system, in particular, has become an area of concern and is driving new political conflict around deposit guarantee programs.
Finally, at the end of January, Japan announced a new step in monetary stimulus—negative interest rates. This is widely considered a radical move and one that Japan's central bank only took because all other measures had not succeeded.
In summary, the increasing monetary stimulus by central banks around the world reflects the failure of their economies to resume healthy levels of growth. China's attempt to transition away from export-led growth has slowed growth rates substantially, which has led to capital flight and market turbulence. Europe is growing but very slowly, and structural problems remain. Moreover, political turmoil has made dealing with economic problems even harder, increasing the role of the ECB. Japan has attempted to jump-start its economy for more than 20 years, without success. So the possibility that economies around the world simply will not grow in the future at the rates at which they have grown in the past is becoming increasingly likely.
The Fed starts to raise interest rates
Despite the problems around the globe, the U.S. economy remains solid. With employment growing strongly, the housing market substantially recovered, and both consumers and businesses paying down debt, the Fed finally felt confident enough to raise rates.
By raising rates, however, the Fed has exacerbated other concerns, notably about the future strength of the U.S. dollar. After moving to multiyear highs in 2015, the strong dollar has made U.S. manufacturers less competitive in international markets and has been a significant headwind for the U.S. economy as a whole. With other central banks stimulating their economies by easing monetary policy and the Fed conversely starting to tighten U.S. monetary policy, the divergence could drive the dollar even higher, which would further damage U.S. exports and manufacturing. Moreover, much of the concern in emerging markets lies around debt taken on in dollar terms. A stronger dollar would mean that those debts would be even more difficult to repay.
Historically, the dollar has actually started to decline as interest rates have begun to increase, but the policy divergence in January suggests that this time things might be different. If so, the headwinds for the U.S. economy could actually strengthen, even as other systemic risks increase. With all of these factors in play, it appears likely that the Fed may raise rates more slowly than it now projects.
Rising risks mean nervous markets
The substantial declines in stock markets around the world in January reflect this increasingly risky economic environment, as investors move away from their more optimistic perceptions of the past several years. Nevertheless, although risks abound, there are opportunities. U.S. growth continues, and more forward-looking indicators suggest that it may accelerate. In addition, the current perceptions of risk seem excessive. China, for example, has enormous resources and can very probably negotiate its challenges successfully. Should some of the negative perceptions abate, the possibility of a positive outcome and reaction is very real.
Given the negative perceptions but still solid U.S. economic foundation, things are not nearly as bad as they seem. Even the recent turbulence reflects this. By historical standards, turbulence is normal and even overdue. Although further volatility is very likely, the factors that have led to sustained downturns in the past—such as a recession, rapidly rising interest rates, or higher commodity prices—simply are not there.
Consequently, even though it has been a difficult month and there is a great deal to pay attention to, investors should remain calm. January's events underscore the need for maintaining a diversified portfolio and a long-term perspective aligned with investor goals. The ongoing growth of the U.S. economy, which appears to be on track, should provide a cushion for any market adjustments in the short term, and proper diversification should further limit their effects on investor portfolios. Longer term, cautious optimism remains the appropriate stance, as history has shown us that markets and economies consistently return to a growth path.
Authored by Brad McMillan, senior vice president, chief investment officer at Commonwealth Financial Network.
All information according to Bloomberg, unless stated otherwise.
Disclosure:Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.