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Summer Swoon?

Market Thoughts 08.24.2015

Global stock markets sold off last week and opened lower again today led by weakness in Asia overnight. The Dow Jones Industrial average was down over 1,000 points at one point on Monday morning. Concerns over global growth and a lack of confidence in Chinese markets are leading stocks lower. China’s stock market fell 8.5 percent today, its largest drop since 2007. China has been an engine for growth since the financial crisis, helping economies around the world recover, but it appears the Chinese economy is hitting a growth wall. China issues aside, investors should expect corrections such as this periodically. On average, we have seen a market decline of at least 10 percent once every 20 months. We’ve gone more than twice that time, almost 4 years, since our last 10 percent pullback. Given current market conditions, we know investors have questions. This Market Thoughts discusses the reasons behind the recent sell-off and provides context for today's market environment.

What is behind the recent sell-off?

While it is impossible to pinpoint a single variable driving markets for any short period of time, the main issue appears to be concern about slowing global economic growth, driven by a slowdown in China. Fears over a slowdown in China are not new, but several actions taken by the Chinese government over the past month have shaken investor confidence and signaled that the Chinese slowdown may be worse than expected.

Why is the market reacting so negatively to news out of China?

Asia’s largest economy is slowing, investors expect the Federal Reserve to raise interest rates in the next year, and China surprised the markets by devaluing its currency. A similar sequence of events in the 1990s led to the Asian financial crisis, which temporarily dragged down stock markets, including those in the U.S.

When China devalued its currency, it forced other Asian and emerging market countries to devalue their currencies to remain competitive. This may cause problems for those countries because some of their debts are denominated in foreign currency (such as dollars), which just became tougher to pay back. Investors worry that China’s move may put other economies and emerging markets at risk.

Are we headed for another Asian financial crisis, which was not a U.S. problem but did affect our stock market?

At this point, we do not think so. While parallels exist, there are also important differences. Today, Asian economies are much stronger than during the Asian financial crisis in the 1990s. Their economies are more developed and diversified, they have more cash reserves, and they have less debt. Most importantly, a lot of these countries have dropped their currency linkage to the U.S. dollar, allowing their currencies to float, which means that devaluing their currencies does not hurt them as much. These economies are in a much better position to weather a slowdown in China and slower global growth.

Could an Asian-like financial crisis put the U.S. economy at risk?

These events put the U.S. stock market under temporary pressure, but economic fundamentals in the U.S. remain strong. The slowing Chinese economy has already hurt the stock prices of multinational corporations that sell to China. However, we believe the U.S. economic outlook remains positive. Exports remain a small part of the U.S. economy and consumer spending, which makes up close to 70 percent of GDP, is doing well. Low interest rates, cheap energy, and an improving housing market provide an economic tailwind. While financial contagion is a concern we will track, we do not see the Chinese slowdown changing our view of U.S. fundamentals at this time.

What investment portfolio actions are necessary?

The natural reaction to sudden market drops is to seek safety and protection. While investment recommendations will differ by client, we can make a few broad statements. First, while we don’t know when the market decline will end, we do know that raising cash or moving to the sidelines is typically not a sound long-term strategy. Second, most investors have diversified portfolios that are not comprised entirely of stocks. Market declines remind investors of the benefits of portfolio diversification—a tenet sometimes forgotten during extended periods of rising stock prices. Third, we remain constructive on fundamentals across most of the developed world. While emerging markets have struggled to deal with commodity price declines, a slowing China, and the possibility of a Fed interest rate hike, most of the world is stable. The U.S. economy has several positive catalysts, Europe is showing signs of growth, and Japan remains committed to supporting its economy with pro-growth monetary policy.

While we will be watching events over the coming days for signs of contagion, we are also exploring opportunities as markets potentially overshoot. For investors who have been on the sidelines, this correction may present the opportunity to rebalance portfolios. We are also presented with many opportunities to take advantage of recent volatility in developed markets, especially in the U.S., as some areas with little to no direct exposure to Asia sell-off in sympathy. We are long-term investors, so short-term market fluctuations can present more opportunities than concerns. We will be watching the current situation for any sign it is causing a breakdown in fundamentals. We expect near-term volatility as investors sell or panic in the face of uncertainty, not knowing or understanding the reasons for the sell-off.

Should you have any questions about what this means for you or your constituents, please do not hesitate to let us know. As always, CAPTRUST is here to discuss your particular situation.

Onward,

CAPTRUST Investment Committee