U.S. markets weak
September was a weak month for U.S. markets, with the Dow Jones Industrial Average posting a loss of 1.35 percent; the S&P 500 Index declining further, down 2.47 percent; and the Nasdaq dropping 3.27 percent. All three indices bounced around breakeven levels throughout most of the month before finally declining in the last week.
All three indices were also down for the quarter, with September extending the losses from August, after first seeming to show a recovery. For the quarter, the Dow was down 6.98 percent, the S&P 500 down 6.44 percent, and the Nasdaq down 7.35 percent. This was the weakest quarter since 2011.
Monthly weakness was driven by both fundamental and technical factors. Per FactSet, at September's end, the estimated earnings decline rate for the third quarter was 4.5 percent—well below the expected 1-percent decline forecast as of June 30. Nine of ten sectors, led by materials, now have lower expected earnings growth due to downward revisions. If earnings decline as expected, it will be the first back-to-back quarterly earnings decline since 2009.
Technical factors that led to weakness include the S&P 500's strong decline through the 2,000 level in August and consequent inability to recover in September. Historically, the stock market has either moved strongly through major breakpoints or hesitated and dropped, and the S&P 500 has had a difficult time rising back above 2,000.
Another sign of technical weakness is that, in recent weeks, growth companies and smaller stocks have underperformed, with investors shifting focus to larger, safer companies rather than betting on continued growth. Growth companies in all size ranges have underperformed and smaller companies have underperformed their larger counterparts, suggesting that investors have become increasingly risk-averse, which is a poor foundation for a sustained advance.
International markets suffered much more than U.S. markets. The MSCI EAFE Index continued its weak performance from August, declining 5.08 percent in September on growing political stress regarding Europe's refugee crisis. Although the European Union (EU) is requiring its member nations to accept refugees, the mass movements have threatened a breakdown of the EU's open borders policy and led to political confrontations over where refugees will be placed. The political conflicts have been mitigated, however, by continued slow economic recovery. For the quarter, the EAFE was down a steep 10.23 percent.
Emerging markets performed worst of all, with the MSCI Emerging Markets Index down 3.26 percent for the month and down a significant 18.53 percent for the quarter. In addition to troubles in Europe, China's growth continued to slow, causing damage not only to China's markets but also to the economies of other emerging markets dependent on China's growth. Just as with the U.S. indices, the drop in September continued losses from August; in this arena, however, July also was a losing month.
Unlike equities, core fixed income showed a small uptick for the month, with the Barclays Capital Aggregate Bond Index up 0.68 percent, taking the quarter as a whole to a small 1.23-percent gain. The increase was driven by a decline in interest rates in September, with the yield on the 10-year U.S. Treasury bond dropping from 2.17 percent to 2.06 percent.
Despite the drop in rates, other sectors of the bond market declined. The Barclays Capital U.S. Corporate High Yield Index, in particular, lost 2.60 percent for the month and 4.86 percent for the quarter on weakening credit conditions in the energy and materials spaces.
U.S. economy shows signs of slowing
Good news for the U.S. economy continued in September, but signs of slowing growth were apparent. Positive data points included rising auto sales—at 10-year highs—and very strong results from the service sector, which constitutes seven-eighths of the economy and where the primary business surveys remain at close to 10-year highs. The impressive auto sales figures are illustrated in Figure 1. Personal income and spending also showed reasonable gains, with strong underlying details.
Figure 1. Light-Weight Vehicle Sales, 2006–2015
Source: U.S. Bureau of Economic Analysis
Other news, however, was mixed. New home sales continued to grow at a strong rate, and confidence in the homebuilding industry set a new high, but existing home sales were down. The pattern of mixed data continued in retail sales, which grew less than expected, although that was largely due to declines in gasoline prices.
The weakest part of the month was employment. Job gains were well below expectations, at 142,000, far less than the 200,000-plus levels of recent months. At the same time, other employment metrics were strong, with a record number of job openings posted and initial jobless claims remaining low. In addition, the NFIB Small Business Optimism Index rose, which is important, as small companies are a major driver of hiring. All in all, this suggests that employment continues to grow, but it does inject a note of caution.
Consumer confidence also showed mixed results for September. The University of Michigan Consumer Sentiment Survey dropped significantly, from 91.9 to 85.7, the largest decline since the government shutdown of December 2012. On the other hand, the Conference Board's Consumer Confidence Survey, which was released later in the month, showed a surprise increase from already strong levels. Even given this discrepancy between the two measures of confidence, growth appears likely to continue, as the Michigan survey indicated continued spending growth.
Despite economic gains, given the signs of a U.S. slowdown and risks elsewhere in the world, the Federal Reserve (Fed) decided to postpone raising rates, a somewhat surprising decision that rattled markets. The Fed did indicate that it would likely raise rates this year, but the continued uncertainty about timing, along with fears regarding what the Fed is seeing that prevented it from raising rates, likely contributed to September's market turmoil.
Geopolitical turbulence hits markets
As previously mentioned, a big international story for September was the growing tide of refugees fleeing the Middle East and heading for Europe, creating new confrontations between Germany and other EU members, even as the continent still faces economic concerns. Beyond Europe, the story of slowing growth in China continued to have an impact well beyond China's borders, with the slowdown extending to emerging economies.
Commodity prices continue to decline
A big part of the economic impact from China's slowing growth has been commodity price declines. Many emerging markets, in particular, have built their economies around a constant growth in demand for commodities. But with China's economy slowing and its leaders moving away from their focus on infrastructure and exports, there has been a double hit to demand, with the consequent damage wreaked on commodity-selling countries and companies.
In addition, the fallout from China's slowdown has been particularly bad because the current recovery marks the first time that China's economy—not that of the U.S.—has provided the majority of global growth. With China slowing, there is no replacement for the lost demand from its spending. For oil, especially, prices have remained low both because of a drop in demand—as China's and Europe's growth has slowed—and an increase in supply from the U.S. and other countries.
Low prices have also led to negative consequences both for countries, as employment and revenue from commodities have declined, and for companies, which have experienced losses to their profits and balance sheets. In the short term, this trend has forced countries to struggle to adjust to the new reality and companies to try to match production with demand. In the longer-term, lower commodity and energy prices typically lead to faster growth, which suggests a potential positive impact that may in the future offset the current carnage.
Investors pull back as risks rise
September is historically a difficult month, and that has been the case this year, particularly in international markets. Although the U.S. has suffered less damage so far, we have experienced market declines and are still exposed to growing geopolitical and economic turbulence. As China adjusts to lower growth rates and Europe struggles with the refugee crisis, the U.S. recovery will likely continue but at a slower pace. Markets can be expected to adjust to lower growth rates, and companies can be expected to adjust their expectations based on conditions in the rest of the world.
Although market price adjustments are never pleasant, they are an inevitable result of investors adjusting risk exposures and in the long run are usually not significant. Investors with properly diversified portfolios have enjoyed the market run-up in the past several years and should be prepared to take an inevitable downturn in stride.
On balance, more turbulence looks quite possible; however, the U.S. remains well positioned for the future, and U.S. investors should continue to participate in the growth.
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. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below.