switching gears

switching gears

3Q15 Market Overview

We experienced a heavy dose of volatility throughout the third quarter as global markets initially recovered from the Greece default headlines and then plunged on worries about a slowdown in China.

The most disturbing reports focused on China’s GDP growth slowing to less than 4% (from just under 7%). As China switches gears from a manufacturing to service based economy, we can expect added speculation about where China is actually headed. According to Vanguard’s Global Macro Matters research findings, a sharp economic fall for China seems unlikely unless they experience a painful U.S. style residential bubble collapse. Fortunately, this scenario is improbable since the ratio of mortgage debt to property assets is less than 7% and Chinese buyers are required to extend substantial down payments on their first and second mortgages.

Since quarter end, risk assets recovered strongly as investors realized that China might not lead us into global recession after all. As we close out the year, we are encouraged by a slowly improving U.S. economy and the direction the Federal Reserve is headed. So far, they have been successful in removing stimulus and will now carefully consider the obvious need to raise interest rates.

As we consider year-end tax planning trades, we will continue to take advantage of diverging market trends by rebalancing to target allocations while maintaining your desired risk level. This process typically involves harvesting gains or losses in the most tax-efficient manner possible and then re-allocating the proceeds to out of favor asset classes that offer more attractive long-term opportunities such as international equities and bonds.

U.S. Equity Markets

The U.S. equity markets were unsteady at best during the quarter; the Russell 3000 return was down 7.3% for the quarter and posted a year-to-date loss of 5.5%. Although equity markets marched higher in July, the gains quickly eroded in August as worries about a Chinese led economic slowdown took center stage. The global market selloff only accelerated when China’s government announced that it would devalue the yuan against the U.S. dollar. Even though corporate profit margins gave up modest ground during the quarter, the more damaging news revolved around tighter liquidity in the markets as China’s central bank sold U.S. treasuries to devalue their currency in an orderly fashion. This had the same effect of the Federal Reserve raising rates when in fact they decided to hold off a bit to avoid putting additional pressure on liquidity and inflation. Given the Federal Reserve concerns, they are likely to be extra cautious delivering their first interest rate hike in over a decade.

International Equity Markets

International developed equity markets posted a destructive quarterly loss of 10.2% and 5.3% year-to-date loss on the MSCI EAFE. Despite concerns over Greece and China, the eurozone economic recovery continued with the help of the European Central Bank’s bond buying stimulation program. Cheaper borrowing costs coupled with a weaker euro provided a much needed boost to support corporate earnings growth. The MSCI Europe equity index loss of 7.1% was less severe compared to Japan’s TOPIX which retreated 12.8%. Japan felt more pain from China’s bold currency devaluation move and their recovery was temporarily derailed. Most analysts believe that Japanese companies will recover by year-end and post high single digit earnings growth over the next twelve months. MSCI Emerging Markets posted a volatile 17.9% loss. Commodity export driven developing economies like Brazil were hit hardest as future expectations were quickly adjusted to factor in softening Chinese demand. After two consecutive years of underperformance relative to the U.S. markets, both developed and undeveloped international markets look much more attractive for long-term investors.

Fixed Income Markets

Safety-minded investors gained ground as the Barclays Aggregate increased 1.2% for the quarter and 1.1% year-to-date return. Against most predictions, the 10-year Treasury yield decreased from 2.35% on July 1 to 2.06% on the final trading day of the quarter. As yields decrease, bond prices with longer durations typically outperform since their existing yields become more valuable compared to newly issued lower yielding securities. This is exactly how the market priced in this new reality during the third quarter, by rewarding the Barclays U.S. Government Long with a 5.0% gain, Intermediate with a 1.2% gain and Short with a slight gain of 0.32%. In the international fixed-income arena, a similar reduction in interest rates across the board resulted in mostly positive returns. The JPM Non-US Unhedged posted a 2.1% gain. The Barclays Municipal also benefited from lower rates and ended up pleasing tax sensitive investors with a 1.7% quarterly gain.

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