So much for a quiet summer.
Stock markets ran into turbulence at the end of August as worries over potential contagion from a slowing Chinese economy rippled across the globe.
The S&P 500 finished the month off 6.0%, its worst monthly performance since May of 2012. The MSCI Europe fell 9.6%, while Japan finished 11.4% and Australia 10.2%. Emerging Markets broadly were off 12.4%, with China down a volatile 14.3%. The swings in intra-day and intra-week volatility were especially profound with the VIX spiking over 50 on August 24th, to drop quickly into a 25-30 range over the next few days.1
Ultimately, this type of equity market action speaks to the period of transition we are in and investor unease over uncertain monetary policy, growth expectations and market leadership. How can investors determine if the August swoon was a one-time occurrence or the start of something bigger? Here are three points we think can help put the stock market correction in perspective:
- Shifting economic growth expectations: From a developed market perspective, new economic data was not the catalyst for the sell-off on August 24. Economic growth has been good but not great in the United States, Europe and Japan. However, in emerging markets, economic data called into question the growth of the Chinese economy and its government’s seemingly haphazard reaction—which included widening the float range of its currency—led to concerns that the situation was worse than official data indicated. This was the spark that changed investor risk sentiment, triggering days like August 26 when the Shanghai Composite fell as much as 19% before finishing the day down 7.8%.2 It’s ironic that both extremes—Chinese action and Federal Reserve inaction—are creating high levels of uncertainty.
- Lackluster rally in US Treasury yields: With the level of stock market selloff, it was interesting that there was less of a rally than typically expected in US Treasury yields. Historically, in the five instances where the S&P 500 was off 10% or more in four days, US Treasuries sustained a rally of at least 24 basis points. But in this case at the end of August, Treasuries finished around 5 basis points stronger.3 Why? First, investors are concerned about adding duration amid the on again/off again expectation of the Fed moving on interest rates in September. Second, the Fed is seeking to reduce its Treasury holdings rather than buying at the same time emerging market central banks are actively selling Treasuries to manage their foreign exchange interventions. Central banks have been the biggest buyers of Treasuries since 2008, but that is no longer the case.
- Equity valuations are still high: Despite the market rout, equity valuations have still not fallen to levels that would make the equity premium worth the risk required. In the case of US equities, the forward P/E ratio was above the historical median before the stock market selloff, and this pullback has only brought valuations back to average.4 In the past, such equity market corrections typically bring valuations to a discount. On top of these elevated valuations the earnings outlook is challenging. Profit growth in the United States has essentially been flat over the last three quarters, and the current 2016 outlook seems aggressive. Consensus earnings growth for 2015 (three quarters actual and one quarter still forecast) is 0.1%, while it is 11.3% for 2016.5 Against the weak economic backdrop, you have to question the ability for corporations to be able to deliver on that type of growth.
Given the unique market performance we’ve witnessed, is the August swoon a one-off occurrence or the start of something bigger? I think the reality is somewhere in the middle.
There are still plenty of issues for the markets to be concerned about given the weak economic and profit growth, lack of clarity on monetary policy and valuations that aren’t particularly compelling. This makes one and done seem a bit hopeful, and we should be cautious on buying into this dip.