“The recovery from the Great Recession has advanced sufficiently far, and domestic spending appears sufficiently robust, that an argument can be made for a rise in interest rates at this time...However, in light of the heightened uncertainties abroad and the slightly softer expected path for inflation, the committee judged it appropriate to wait…”
– Federal Reserve Chairwoman Janet Yellen, September 17th, 2015
Volatility increased significantly across multiple asset classes in the third quarter of this year. Disruption in China roiled markets around the globe while simultaneously spurring concerns about global economic growth prospects. Commodity markets also remained a front-and-center news item. The Federal Reserve’s much-anticipated September FOMC meeting created additional uncertainty as mixed messages from the US Central bank further rattled markets. Risk assets struggled during the quarter against this backdrop of higher market volatility.
After experiencing a somewhat-anticipated, seasonal first quarter slump, US GDP rebounded in the second quarter. According to the latest data (released in late September), second quarter GDP increased at an annual rate of 3.9%, a figure that represented a positive revision to earlier estimates.1 An increase in personal consumption expenditures represented a driving factor behind the second quarter GDP rebound with many sources attributing heightened consumer spending to savings from lower oil prices and continued improvement in the housing market.
The labor market offered mixed signals, adding further fuel to the debate regarding the health of the US economy. Positive revisions to the June and July nonfarm payroll reports showed that the economy added a healthy 245K and 223K jobs in each month, respectively.2 In contrast, August and September data revealed that only 136K and 142K new jobs were added in each month, respectively. Both figures represented disappointing misses relative to expectations and were also below the observed average of monthly job gains in 2015. Additionally, wage growth data remains mixed. Nevertheless, the August report also revealed that the overall domestic unemployment rate declined to 5.1%2, the lowest level for this metric in the past seven years.
The Federal Reserve was once again a significant factor as market participants anxiously awaited an answer to questions about the future of domestic interest rates. September brought with it another FOMC statement and the potential for policy action though the Fed ultimately decided to delay increasing the Federal Funds rate. While market expectations for a rate hike had been dwindling heading into the September meeting, Chairwoman Janet Yellen’s subsequent press conference engendered uncertainty as the Fed came across as more dovish than previously anticipated. Specifically, the Fed cited increasing concerns about “uncertainties abroad” and the risks said developments posed to the domestic economy. Additionally, the Fed appeared increasingly concerned about domestic inflation, leading to doubts about future policy action. The apparent change in tone from prior meetings, and seeming lack of confidence in the US economy had a clear negative impact on market sentiment and risk assets. One has to question how much the significant volatility in China (see International section below) impacted the Fed’s decision. While data points from the oft-cited “dot plot” still indicate one rate increase in 2015 and a glide path for higher rates in 2016, markets will likely continue to keep a close eye on the Fed.
On the micro front, second-quarter earnings mirrored the mixed bag from Q1. According to data from JP Morgan, approximately 75% of S&P 500 companies beat EPS; however, 51% of the same cohort missed sales estimates (data excludes the Energy sector). Persistent concerns about the impact of a stronger US dollar on revenues remained a theme among reporting companies throughout the quarter. After taking a breather in Q2, the dollar once again notched upwards against its peers to gain +0.9% in Q3.3 For the year, the dollar has advanced +6.7%.
Domestic merger and acquisition activity showed no signs of slowing down with more large-scale deals announced throughout the third quarter. Examples include Aetna’s proposed $37B merger with Humana, Berkshire Hathaway’s $32B acquisition of Precision Castparts, and Energy Transfer Equity’s $33B acquisition of the Williams Companies.
As noted in previous commentaries, we expect continued merger activity and bidding wars as larger companies take advantage of low rates and seek ways to augment growth. However, we also believe that the potential for increased regulatory action around proposed transactions is worth monitoring as government officials weigh the potential negative impact that reduced competition caused by industry consolidation can have on consumers. Furthermore, should weakness in the bond market (especially high yield) persist, it could impact financing conditions for future transactions.
European markets continued to grapple with uncertainty surrounding Greece’s future membership in the EU throughout the third quarter. Following some brinksmanship during negotiations with creditors, Greek Prime Minister Alex Tsipras resigned in August only to be re-elected in September. Markets appear to view this outcome as a sign of some stability within the beleaguered peripheral nation. For now, hope has re-emerged that Greece will meet the required bailout criteria.
Elsewhere around the EU, a broader review of economic data throughout Q3 paints a murky picture. While overall GDP growth has improved throughout 20154, concerns about stagnating inflation remain prominent. This lackluster inflation data, when paired with comments from ECB president Mario Draghi, has led to speculation that the central bank is prepared to increase the scope of its asset purchases in an effort to weaken the euro. He is not alone. Like Europe, Japan continues to represent another developed international nation facing growth and inflation woes.
China quickly superseded Greece as the dominant international source of concern for global markets. As alluded to in last quarter’s commentary, Chinese equity markets experienced a dramatic correction that persisted into Q3. The uncertainty created by the significant volatility in Chinese equities spilled into markets around the globe. Specifically, many view the volatility in Chinese financial assets as yet another crack in what appears to be an increasingly fragile growth story. A blow to Chinese GDP would meaningfully impact global economic growth.
Chinese policy makers intervened throughout the third quarter in an effort to promote stability. The most dramatic intervention occurred on August 10th when the PBOC engaged in a surprise devaluation of the renminbi that entailed a 1.9% cut to the currency’s reference rate. This largely unprecedented action sent ripples throughout markets as Chinese authorities sought to aggressively use the nation’s currency to combat growth fears. This action sparked renewed debates about global currency wars and has led investors to further question the supposed omnipotence of global central bankers as the sum total of the PBOC’s actions have done little to ease market angst to date.
Given China’s position as a major source of global demand for commodities, it was unsurprising to see this segment of the market struggle in Q3. For reference, the Bloomberg commodity index declined -14.5% in the third quarter. Oil prices failed to sustain their second quarter momentum with the price of WTI falling from its June 30th level of $60.44/barrel to close the third quarter at $45.09/barrel.
The myriad macroeconomic factors mentioned above had a tangible impact on risk asset volatility in the third quarter. Consider the following table, which shows the returns of various equity volatility indices in the third quarter (all data via Bloomberg):
Index / Region
Euro Stoxx 50
Nikkei 225 (Japan)
Against this backdrop of higher volatility, the S&P 500 shed -6.4%. This result marked the index’ worst quarter of performance since the European debt crisis in 2011.
Unlike the first two-quarters of 2015, where there was some dispersion of returns, most underlying sectors of the S&P 500 struggled in tandem amidst the broader market decline. The utilities sector, which is generally viewed as a bond proxy, was the only sector to finish in the green in Q3 (+5.4%) as investors likely sought “safer” assets amid the market volatility. In light of the commodity price declines referenced above, the energy (-17.4%) and materials (-16.9%) sectors expectedly struggled to a significant degree. It is also worth highlighting that the healthcare sector declined by over -10% in Q3. The sector had been a market leader for the first half of the year but has recently been buffeted by significant selling activity. Much of this selling was concentrated in the final weeks of September following some negative headlines pertaining to rising drug prices.
International markets were not immune to the negative investor sentiment and generally fared worse than their domestic counterparts. Despite progress in the Greek situation, the MSCI AC Europe index lost -8.9% in the third quarter. The AC Asia Index fared worse, posting a decline of -14.5%. And, as might be expected, the MSCI EM index yielded even poorer results for Q3 (-17.8%). Spillover effects from China (the MSCI China index was down over -22% in Q3) as well as the aforementioned growth/inflation concerns are both probable culprits in explaining the market moves in each international region. The following chart highlights second quarter performance for various equity markets5:
Bottom Line: While volatility is unpleasant, we still continue to view equities as a potentially attractive source of long-term growth in portfolios. We believe that volatility creates opportunities and are monitoring exposures closely. Given the uncertainty in emerging markets, we are favoring adding incremental exposure to developed regions at this time (when appropriate). Nevertheless, we continue to emphasize diversification and disciplined asset allocation.
Global bonds (as measured by the Barclays Global Aggregate Index) yielded gains in Q3 as investors likely fled to debt instruments to avoid the painful price action in equities. Additionally, a more dovish Federal Reserve facilitated some of the grind in tightening yields, particularly in the US. However, despite benefitting from this typical “flight to quality,” fixed income markets saw some sentiment volatility alongside their equity market counterparts. For example, Bloomberg reported that investors were all too willing to sell both bonds and equities during the period of extreme volatility in August. Additionally, streaks of alternating fund inflows and outflows from day to day and week to week revealed investors’ finicky mentality in the face of higher levels of uncertainty about the global economy and interest rates.
In contrast to the broader bond universe, generally riskier high-yield bonds struggled in tandem with their equity market counterparts. While this performance by riskier bonds might be expected in a volatile market, it is worth noting that the Barclays Global High Yield Index reported negative results for five consecutive months (May 2015 to September 2015), a phenomenon that was not observed in any such five month period for the entirety of the 1990s and the 2000s to date. As seen below, high yield spreads have widened meaningfully relative to the start of 20146:
As noted in previous commentaries, the high yield market demonstrates meaningful exposure to the energy markets and the recent reset in commodity prices contributed to negative performance in Q3.
The following chart documents performance of various credit markets in the third quarter:7
Bottom Line: We continue to approach credit markets with caution. While we favor credit risk over duration risk across the board, we realize that even shorter duration assets could experience principal volatility as the near end of the yield curve responds to Federal Reserve policy actions. We remain concerned about continued yield and spread movements in a lower liquidity world and continue to be cognizant of the risks posed by the inherent asset-liability mismatches found within daily liquidity products. Bonds are often considered a leading indicator for equities and potential cracks in the market for credit instruments are worth monitoring closely.
Hedge funds yielded generally negative results during a volatile third quarter; the HFN Hedge Fund Aggregate Index declined -2.5% and the HFN Equity Hedge Index lost nearly -4%. While these results were better than broader equity markets, many market participants were perhaps surprised by the downside participation that hedge funds demonstrated in Q3.
Some of the negative performance can be attributed to the poor performance of several “crowded” hedge fund positions. As hedge funds sought to reduce risk amidst the market volatility, the selling down of commonly held positions likely created a cascading effect that exacerbated price declines. For example, SunEdison and Valeant Pharmaceuticals featured prominently in discussions regarding the sources of hedge fund pain in Q3. As usual, we remain highly attuned to the degree to which hedge fund crowding can add risk to client portfolios.
Fixed income strategies and distressed strategies were also generally laggards with exposure to energy and media names the most likely sources of negative attribution for many managers. In contrast, macro strategies yielded absolute results according to relevant HFN index. It appears that divergent monetary policies and broader market volatility have continued to afford these managers with a relatively fruitful hunting ground.
The following chart summarizes quarterly performance for select hedge fund strategies:8
Bottom Line: After a volatile third quarter, the broader hedge fund universe is yielding a mixed bag of results with some strategies still in the black for 2015 and others posting negative returns on a year to date basis. Following a multi-year, significant bull market rally, volatility has certainly returned to markets. We continue to believe that these strategies represent an important risk-managed portion of client portfolios.
Conclusion and Outlook
Our focus remains grounded in a dedicated, disciplined asset allocation framework for each client portfolio. We continue to believe that portfolio diversification across asset classes facilitates a broad opportunity set for delivering returns in an environment of increasing uncertainty.
1 Source: Bureau of Economic Analysis
2 Source: Bureau of Labor Statistics
5 Sources: S&P, Bloomberg, Russell, MSCI
6 Source: St. Louis Federal Reserve
7 Source: Barclays
8 Source: HFN
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Massey, Quick & Co., LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Massey, Quick & Co., LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Massey, Quick & Co., LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a Massey, Quick & Co., LLC client, please remember to contact Massey, Quick & Co., LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the Massey, Quick & Co., LLC’s current written disclosure statement discussing our advisory services and fees is available upon request.
This presentation and the accompanying discussion include forward-looking statements. All statements that are not historical facts are forward-looking statements, including any statements that relate to future market conditions, results, operations, strategies or other future conditions or developments and any statements regarding objectives, opportunities, positioning or prospects. Forward-looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties and contingencies. Forward-looking statements are not a promise or guaranty about future events.
Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices
Indices included in this report are for purposes of comparing your returns to the returns on a broad-based index of securities most comparable to the types of securities held in your account(s). Although your account(s) invest in securities that are generally similar in type to the related indices, the particular issuers, industry segments, geographic regions, and weighting of investments in your account do not necessarily track the index. The indices assume reinvestment of dividends and do not reflect deduction of any fees or expenses.
Please Note: (1) performance results do not reflect the impact of taxes; (2) It should not be assumed that account holdings will correspond directly to any comparative benchmark index; and, (3) comparative indices may be more or less volatile than your account holdings.
Please note: Indices are frequently updated and the returns on any given day may differ from those presented in this document.
Index data is supplied from various sources and is believed to be accurate but Massey Quick has not independently verified the accuracy of this information.