Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital
Global growth concerns, specifically the impact of a slowdown in China, and the anticipation of Fed tightening beginning in the fall prompted a spike in volatility and a sell-off in risk assets in August. The decline occurred despite decent U.S. economic data. U.S. equity markets held up slightly better than the rest of the developed world while emerging markets fared worse. U.S. Treasury yields were unchanged on the month, but credit spreads widened in response to the risk-off environment. Crude oil prices hit another low in late August, also weighing on global equity and credit markets.
The S&P 500 Index ended the month down -6%, but experienced a peak to trough decline of -12%. Prior to that it had been more than 900 trading days since we last experienced a 10% correction. All sectors were negative on the month, with healthcare and consumer discretionary, which had been leading, experiencing the largest declines. Small caps experienced a -6% decline as well, while mid caps held up slightly better. Growth meaningfully lagged value in small caps, but style performance was less differentiated in the large cap space.
International developed equity markets lagged U.S. markets in August, despite a slightly weaker U.S. dollar. Japan edged out European markets. After leading through the first seven months of the year, international developed equity markets are now behind the S&P 500 U.S. equity markets year to date. Emerging market equities have experienced a steep decline, down more than -15% so far in the third quarter, amid the volatility in China and continued economic woes in Brazil and broad currency weakness.
August wasn’t a typical risk-off period as longer-term U.S. Treasury yields were unchanged on the month and yields on the short end of the curve rose slightly. The Barclays Aggregate Index declined -0.14% in August. Treasuries and mortgage-backed securities were flat for the month, but spread widening in both investment grade and high yield led to negative returns for corporate credit, with lower quality credits experiencing the largest declines. Municipal bonds were slightly ahead of taxable bonds in August and lead year to date.
Our outlook remains biased in favor of the positives, but recognizing risks remain. The global macro backdrop keeps us positive on risk assets over the intermediate-term, even as we move through the second half of the business cycle. A number of factors should support the economy and markets over the intermediate term.
- Global monetary policy accommodation: Despite the Federal Reserve heading toward monetary policy normalization, their approach will be cautious and data dependent. The ECB and the Bank of Japan have both executed bold easing measures in an attempt to support their economies.
- U.S. growth stable and inflation tame: U.S. GDP growth rebounded in the second quarter and consensus expectations are for 2.5% growth moving forward. Employment growth is solid, with an average monthly gain of 243,000 jobs during the past year. While wages are showing beginning signs of acceleration, reported inflation measures and inflation expectations remain below the Fed’s target.
- U.S. companies remain in solid shape: M&A activity has picked up and companies also are putting cash to work through capex and hiring. Earnings growth outside of the energy sector is positive, and margins have been resilient. However, weakness due to low commodity prices could begin to spread to sectors.
- Less uncertainty in Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year; however, Congress will still need to address the debt ceiling before the fall.
However, risks facing the economy and markets remain:
- Fed tightening: The Fed has set the stage to commence rate hikes in the coming months. Both the timing of the first rate increase, and the subsequent path of rates is uncertain, which could lead to increased market volatility.
- Slower global growth: Economic growth outside the U.S. is decidedly weaker. It remains to be seen whether central bank policies can spur sustainable growth in Europe and Japan. A significant slowdown in China is a concern, along with slower growth in other emerging economics like Brazil.
- Geopolitical risks could cause short-term volatility.
While the recent equity market drop is cause for concern, we view the move as more of a correction than the start of a bear market. The worst equity market declines are associated with recessions, which are preceded by substantial central bank tightening or accelerating inflation. As described above, we don’t see these conditions being met yet today. The trend of the macro data in the U.S. is still positive, and a significant slowdown in China, which will certainly weigh on global growth, is not likely enough to tip the U.S. economy into contraction. Even if the Fed begins tightening monetary policy in September, the pace will be measured as inflation is still below target. However, we would not be surprised if market volatility remains elevated and we re-tested the August 25 low as history provides many examples of that occurrence. Good retests of the bottom tend to occur with less emotion and less volume as the weak buyers have already been washed out.
As a result of this view that we’re still in a correction period and not a bear market, we are seeking out opportunities created by the increased volatility. We expect volatility to remain elevated as investors position for an environment without Fed liquidity. However, such an environment creates greater dislocations across and within asset classes that we can take advantage of as active managers.
Source: Brinker Capital. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting.