During the third quarter of the year, investors experienced the largest percentage declines for US stock market indexes and the most volatility since 2011. We expect this roller coaster ride to continue because international and US corporate earnings will likely decline for the second quarter in a row, harkening back to the contracting corporate profitability last felt during the great financial crisis of 2007 – 2008. Despite continued low interest rates, companies are finding it harder to arrange for financing, especially firms in the lower credit quality arena. This portends rough times overall for investors who have been taking more risk over the last several years so as to earn a decent level of income.
So far in 2015, the Standard & Poor’s 500 index has fallen 6.9%, the Dow Jones Industrial Average of 30 stocks dropped 7.6%, and technology stocks declined 7.4%. The major market indexes are still historically overvalued with the S&P trading at 16.7 times earnings compared with its 10 year average of 15.7. Year to date, The Dow Jones transportation average is down 14.8% and the total US stock market has declined close to 7%. Smaller companies, which tend to generate the most jobs, contracted 8.6%. There has been a continued decline in precious metal prices, with mining stocks leading the way for a year to date decrease of 32.8%. Energy and related service companies are down 25% due to the 60% plus drop in the price of oil. Natural gas has declined less than oil, with a 37% drop over the last 12 months, while the actual price of gold has held fairly stable, down only 3% since the start of 2015. Energy, materials, and healthcare company sectors fell the most over the past three months, all posting double-digit losses during the third quarter.
Overseas, the global stock market index, excluding the US, is down 9.8%. Europe has been surprisingly resilient with an overall return of positive 1.5%. Italy’s stock market is up 12% year to date and the European central banks aggressive posturing of easy money policies is the main reason why European stock markets are not in deep negative territory. Stock markets in the Asia-Pacific region are down 9.1%, almost exactly the same as the US and overall world markets. We truly do live in an interconnected world.
The bond markets continue to be stable, with the overall market for US bonds producing a 1.1% total return from the start of 2015. Long-term bonds and lower rated bonds were in negative territory, down 3.7% and 1.1% respectively, while US government and agency bonds were up close to 2%. The reason for this benign performance is that there has been a continued flight to the safety of government bonds. In the absence of any gutsy move on the part of central banks, bond investors will continue to reap benefits of general malaise in other areas of the public markets. Further evidence of the intense coordination between the world’s central banks is that overseas government bonds returns were right in line with US government bond’s performance.
Many stock market professionals expect the Federal Reserve Bank officials to act in December to stabilize the markets expectations for higher interest rates by increasing interest rates. The US central bank vacillated in September and took the coward’s way out by not raising interest rates, and this erased almost $11 trillion from the value of stocks worldwide. We are now experiencing a reversal of the traditional relationship between the central bank and financial markets in that the markets used to follow the Fed’s lead and now the Fed acts in reaction to what the market does and in anticipation of what it might do, with the main goal now being not to upset the delicate calm that has prevailed since 2007 – 2008.
As I have often written, the stock and bond markets returns are very much influenced by the Federal Reserve Bank’s activity. At this point, the Fed talks about inflation but the markets are ignoring inflation and instead are focused on worries about sluggish global demand for goods. The deepening sell-off in commodities and the declining value of emerging-market currencies and equity prices are all at odds with the message coming out of the Federal Reserve. The US Institute for supply management’s factory index fell, showing the weakest manufacturing activity in 2 ½ years. Also, global electricity consumption, an indicator of overseas manufacturing activity, has declined 5.4% over the last 12 months. What started out as oil related weakness among energy companies is now evident in diminished activity in the computer, plastics and machinery industries. The outlook is for continued diminishment in economic activity over the next several months, except in consumer sales and the construction industry in major metropolitan areas.
Most people think that stock and bond market returns are directly related to corporate profitability. As noted above, profitability is expected to decline in most sectors other than for retailers, who are expected to post earnings growth of close to 12%. US consumers are showing surprising resilience by purchasing new cars, light trucks and single-family residences. Corporate earnings are actually weaker than they seem because companies have bought back a substantial number of their own shares, boosting earnings on paper but not in reality.
On the job front, the US labor market slowed during the third quarter with 142,000 jobs added in September, well below the 200,000 per month level required to keep real employment growing in sync with the number of new entrants into the labor market. July and August employment numbers were revised downwards but that didn’t stop the government from reporting a 7 year low unemployment level of 5.1%. Government statistics do not take into account the number of people who have given up looking for work.
Industries that are shedding the most workers are energy and manufacturing areas, while service providers such as restaurants and hospitals continue to expand their job openings, mostly in fairly low paying positions.
The best new jobs are still in the high-tech and biotechnology industries. The good news is that job security is up, with firings hovering around the lowest levels in more than a decade. As reflected in employment numbers, economists estimate that overall economic growth in the US slowed to somewhere between 1% and 2% during the third quarter, down from last spring’s approximately 4% expansion rate. Companies across the US are increasingly concerned about the strong US dollar and economic slowdown overseas. All of this will be reflected in upcoming earnings announcements over the next several months.
The US energy sector has lost about one hundred thousand jobs since last December while the retail, restaurant and bar industries have added close to half of the new jobs created over the last 12 months. Wages are slightly down and have been relegated to around 2% over the last eight years. It is estimated that one out of every three workers has exited the workforce since the financial crisis and that there are about 6 million people involuntarily stuck working part-time because they can’t find full-time employment.
The precipitous drop in the price of oil and, to a lesser extent, natural gas has had a beneficial effect on merger and acquisition activity in that industry. This is a sign that smart people know that the current depression in the price of energy will not go on forever. The alternative energy industry’s performance has also been abysmal, in line with that experienced by carbon-based energy firms. Energy producers with ample financial resources and a long-term view have been buying up new properties and combining in ways that anticipate an eventual upturn in the price of energy. Several megamergers in the energy industry have occurred, with well-capitalized, best in class companies taking advantage of the opportunities afforded by marginal players dropping out.
The world’s economy is increasingly affected by what goes on in China, the world’s biggest importer of many raw materials. China tapped its substantial reserves to stem the decline of its currency in August. China has embarked on an aggressive economic revamping program in order to turn itself from relying on exports to becoming an internal, consumer driven economy. It is unclear whether they will be successful in recovering their current malaise, characterized as sniffling and sneezing, without causing the rest of the world to catch the flu.
The Bank for International Settlements, a global watchdog for world trade activities, warned of a looming banking crisis as a result of rapid credit growth in emerging markets. China has the highest ratio of debt to gross domestic product of any nation in the world, outdistancing by 50% the runner ups of Turkey and Brazil. China can continue to paper over many of its internal problems so that the outside world will continue to have no clue what is going on in that country. China is experiencing its first economic slowdown since the great financial crisis and tepid growth in both Japan and Europe have sapped demand for commodities, energy, and other finished goods. As a result, world trade looks to be undergoing a protracted contraction. If this is indeed the case, it will have a continued deleterious effect on US manufacturers who rely on exports.
Domestic US automobile manufacturers are showing solid gains in sales, despite the impact of faulty equipment and widespread recalls. Volkswagen and potentially other European firms are looking at stiff but not debilitating fines following the exposure of deceptive emissions testing practices. As is the case with energy companies, the steep decline in the price of European automakers presents long-term value investors with potential buying opportunities.
Because the financial markets are so dependent on political stability, we will devote some space in this quarter’s commentary to developments around the world which may impact future market performance. Japan’s ruling party is well into its third year of aggressive stimulation which has, by and large, failed to ignite domestic economic activity. The rosy flush of easy money has kept Japan’s securities markets in positive territory. The European economic experiment is facing serious internal challenges due to the immigration crisis now underway with refugees fleeing unrest in the Middle East, near East and the poor outlook for employment in parts of Africa. The cost of absorbing immigrants can only be borne by the wealthy countries in the northern part of Europe while many of the immigrants are stuck in the southernmost countries. This overlay of demographic tension, on top of the already disparate economies between these two parts of the European Union, will further strain the EU’s political ties. The upcoming British vote in 2017 on European Union membership may have surprising results.
A good example of the adage “the best defense is a strong offense” is exemplified by Russia and Iran in their aggressive moves in the Syrian conflict. Russia’s economy is on the ropes because both the embargo imposed by the US and Western Europe over the Ukrainian crisis and the 60% decline in the price of oil have pummeled its economy. This has and will not stop them from expertly playing on the Western world’s reluctance to engage in conflict so Russia is aggressively expanding its military reach in both the Mideast as well as the Arctic Circle region where it is securing future energy extraction sites. Iran is emboldened by its upcoming reentry into the world’s oil markets and the end of the international embargo due to its “compromise” and apparently successful completion of negotiations with the rest of the world over its nuclear program. Iran’s economy has been crippled by the embargo and they, like the Russians, see opportunities to expand their political and economic influence in spite of their current weakness.
Back in the USA, the ramp-up of the presidential election cycle is showing some surprising developments. Donald Trump’s continued presence in the top tier of Republican candidates is an indicator that no clear front-runner will emerge until after the primaries next spring. The triumph of form over substance is not surprising, given widespread and deep discontent with the efficacy of our political process. It is unlikely that a clear agenda will emerge from either political party, driven by a strong and bold leader, due to the trepidation on the part of politicians to publically take a firm and potentially unpopular stand on any of the major structural problems facing our country. On the Democratic side, Hillary Clinton’s continued lack of gaining traction has allowed several challengers to emerge: Joe Biden and Bernie Sanders, both of whom are well into their 70s. Given the extreme high personal toll that the Office of the Presidency seems to extract, evidenced by both George W. Bush and Barack Obama’s accelerated greying during their time in the office, it is hard to imagine turning the reins of the country over to someone who is well past retirement age.
Upcoming events and Personnel news
Rob: We hosted our first of three client events on October 2nd at the Montezuma Arts Gallery (333 Montezuma Avenue), with upcoming events scheduled for November 10 and December 3 at the same location in Santa Fe. For those of you not able to attend, we will be posting some video clips on our website in the upcoming weeks. On a personal level, my older daughter, Robyn has returned from living abroad and she is here locally, exploring job and dramatic arts/education opportunities in New Mexico.
Jeff: I am continuing to make slow progress from my rotator cuff surgery and am diligently going to my physical therapy appointments and doing all my assigned exercises. While I am making my best efforts to be patient, it’s really hard as I would like for all of this to be over and done with. I am regularly singing with a jazz trio and hope to start playing the guitar again in a few more months.
Lauren: This summer, I moved out of my little house on Canyon Road in town to a property in Tesuque complete with chickens and alpaca. I am now enjoying being out of town as there is plenty to do and explore. Though we are about to set in on winter, I am already planning my spring garden and hope to have some raised beds built by then which are necessary to keep out the many Tesuque rabbits!
Kyle: This summer, I bought a new barbecue smoker which helped take up some of my free time as I enjoy working on my cooking techniques. I will be a little sad and probably a little hungrier when the weather gets colder as I will have to put the smoker away for the season. At the end of August, my sons started kindergarten and after some adjustment, it appears they are really settling into the environment. While summertime is great, I am looking forward to the colder weather and am keeping my fingers crossed for a good ski season.
Dana: I recently returned from Santa Cruz, CA where I celebrated my 60th birthday with friends and family, including my two children who live in Southern California. We enjoyed a trail ride and picnic at Garrod Farms in Saratoga. In addition to stables, they have a vineyard and wine tasting room. We timed the event just right as there was live music that day and the songs just happened to be from my era. It was a delightful occasion in which to usher in a new decade.
Local tea and Conference call-in dates
Along with our special scheduled events, the next Rikoon Group quarterly live presentation and review of the markets, the economy and worldwide political events will take place on November 10 at 3:30pm at 333 Montezuma Ave. It will be followed by a special Artist Talk, starting at 5:30pm, in conjunction with the other happenings there. The quarterly phone conference call will take place on Thursday, November 12th, at 3:30pm MST, according to the revised call-in information as follows: 1-605-475-6333, access code: 425993.