Stocks tumbled in August, as investors grew more concerned about the Chinese economy and the nation’s related financial market volatility. In the U.S. however, the economy showed marked signs of strength. While we have positioned our strategies more cautiously, and are closely watching news out of China, we believe that the recent pull back in stocks is most likely a correction rather than the start of a bear market.
Economic data coming out of China continued to disappoint in recent weeks. Exports fell by 8.3% in July, much worse than consensus expectations for a 1.5% decline. Auto sales during the month reached the lowest level since February of last year, and the government’s manufacturing purchasing managers index fell into contractionary territory, its worst reading since late 2012. Perhaps as a result of the disappointing economic performance, China’s central bank allowed the yuan to depreciate by 1.86%, the largest single day decline since 2005. In our view, this was a key catalyst which led to China’s headwinds impacting other global financial markets. Countries which compete with China for exports are disadvantaged by a weaker yuan, as are resource rich nations which have become dependent on Chinese demand in recent years. For these reasons, it is not surprising to us that in the aftermath of China’s weak data and currency devaluation, many emerging market nations have seen their stock markets and currencies decline to multi-year lows.
Readings of the domestic economy, however, were quite strong in our view. Second quarter GDP was revised up significantly from an earlier reading of 2.3% to 3.7%, we believe in part driven by consumer spending which rose by a solid 3.1%. Auto sales hit an annual rate of 17.6 million in July, marking a 10-year high. Also reaching a 10-year best for July was the Institute for Supply Management’s non-manufacturing PMI, which came in at 60.3 for the month. There was also considerable strength out of the housing market, where single-family starts recently reached their best level since December 2007 and existing home sales came in at the strongest pace since February 2007. We are encouraged by these readings and continue to believe that we are positioned well to capitalize on this trend.
In recent weeks, we became increasingly concerned about the potential for turbulence in China to negatively impact financial markets globally. As noted above, we felt the currency devaluation in particular opened the door for greater disruption with its direct impact on other economies. Moreover, we believe that markets were caught off guard by this action and it caused many investors to question whether the magnitude of China’s economic slowdown might be greater than had previously been thought. We also question the effectiveness of the Chinese government’s heavy-handed attempts to prop up its stock market through various measures including large scale stock purchases and selling restrictions. Collectively we believe that these actions have caused many investors to question China’s leadership just as the country embarks on a challenging period in which it is trying to make significant structural changes to decrease its reliance on exports while still maintaining a robust growth profile. Meanwhile in the U.S., a lackluster second quarter earnings season and flagging technical indicators led us to conclude that stocks were becoming increasingly vulnerable to external shocks. We therefore took certain steps during the month to reposition our client portfolios in a more defensive posture to better reflect our view of increased risk in the market.
As the U.S. is predominantly a consumer driven economy and is not meaningfully reliant on exports, we see little chance that the headwinds emanating from China will deal a major blow to our economic growth. We continue to believe that improving domestic economic conditions, including solid employment growth and an accelerating housing market, can support business activity going forward. We anticipate this, along with the potential boost to consumption from materially lower commodity prices, will likely support corporate earnings during the back half of the year. In addition, the recent decline in stock prices has taken market valuations back down to levels more in line with historical averages. Furthermore, we think China’s weakness may have a mitigating consequence in that it could influence the Federal Reserve to further delay its plan to hike interest rates, which could be another mild positive for equities. For these reasons we see the recent stock action as merely a correction, and not the start of a pronounced bear market.
We do however, remain concerned about the potential for further near-term stock market gyrations, and note that measures of equity volatility remain quite elevated. Until volatility returns to more normal levels, our expectation is that we will continue to position client portfolios in a somewhat defensive posture, so as to preserve capital to the best of our ability.
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