Global equities declined amid worries about China’s economic slowdown and the ripple effect on global growth. Emerging market equities turned in their worst quarterly retreat in four years. Waning Chinese economic data dampened emerging markets even as the government initiated multiple efforts to stimulate growth. International developed market equity indices turned in double-digit declines as concerns of a weaker China impacted investor sentiment negatively. The U.S. market fared better in response to these conditions though a 6.4% decline provides little comfort. The U.S. Federal Reserve deferred their “lift off” of interest rates after the September meeting in response to an uncertain economic climate globally.

The S&P 500 Index, a broad measure of the U.S. equity market, broke a streak of ten consecutive quarterly gains with a 6.4% retreat. Despite the pronounced weakness, the U.S. market was among the strongest performers during the period. Reported earnings exceeded analyst expectations for 74% of the companies in the Index. While the U.S. dollar waned slightly during the quarter, its relative strength still presents a formidable headwind for earnings. A stronger dollar dampens foreign earnings for U.S. companies and makes domestic goods potentially less competitive overseas. Large cap stocks outperformed small companies as investors sought the relative safety of larger companies. Growth oriented segments of the market bested their value brethren with the selloff in the Energy and Materials sectors showing no sign of softening. As interest rates declined, investors pushed into Utilities, which reported a 5.4% advance during the quarter, the only S&P 500 sector to produce positive results.

Non-U.S. developed market equities dropped 10.2%, as measured by the MSCI EAFE Index. Financial conditions and earnings momentum have improved in Europe as economies move from contraction to expansion, yet growth and inflation levels remain below expectations. The European Central Bank has reaffirmed its accommodative stance, which should continue to support equities. Valuations are attractive though slower growth with trading partner China, geopolitical uncertainty, and labor cost disadvantages have clearly tempered investor enthusiasm.

Emerging market returns, as measured by the MSCI Emerging Markets Index, moved into bear market territory with a 17.9% retreat during the quarter. Performance across countries and regions varied widely during the period. The continued deterioration of energy
and commodity markets provided noteworthy headwinds for Brazil and Russia while concerns of deteriorating growth in China sent their markets 22.7% lower during the quarter. While cheaper oil benefits consumers, it represents a pay cut for oil producers. The geopolitical
and economic consequences of persistently cheaper oil will likely be an ongoing source of volatility as markets gain a better understanding of the winners and losers.

Broadly speaking, the quarter produced positive results for traditional fixed income markets. The Barclays Aggregate Bond Index advanced for the sixth quarter in the last seven. This came as investors sought the relative safety of Treasuries, pushing the yield on the 10-year U.S. Treasury bond down from 2.4% to 2.1%. Despite a relatively healthy economic backdrop domestically, concerns of global instability and underwhelming inflationary pressure led the U.S. Federal Reserve to hold off on raising rates. All told, U.S. bond rates remain higher than several other developed countries, which helped maintain enough demand to suppress rates.

The global bond market, as measured by the Barclays Global Aggregate Index, advanced nearly 0.9% for the quarter as interest rates generally moved lower. The move can be largely attributed to diverging central bank policies globally and concerns of a more pronounced slowdown in emerging markets. Europe slipped back into deflationary levels as a result of low energy prices, which may leave room for the ECB to provide further support.

The high yield and bank loan markets performed poorly during the period as investors favored safe haven investments. In fact, the 4.9% drop for the high-yield benchmark showed its fifth worst quarterly result in decades. The yield on high yield bonds is a notch above 8.0%, the highest level in over four years. Investors have recalibrated their risk appetite across the fixed income landscape despite a solid economic backdrop. Concerns over future defaults among Energy and Materials companies weigh heavily on spreads.

On the heels of another sluggish first quarter, the U.S. economy grew by 3.9% in the second quarter due to higher consumer and construction spending. The unemployment rate held steady at 5.1%, a 7-year low, while labor force participation continued to push lower. Wage inflation appears to be picking up in a sign that labor markets may be approaching full employment. Consumer confidence reached the lowest level in nearly a year due to volatile financial markets and fears of a global slowdown. Amid concerns that recent global economic uncertainty may place downward pressure on economic and inflation data, the Federal Reserve left its target rate unchanged. The CPI came in at a 1.8% annualized rate, just a tick below the 2.0% level the Fed is targeting. Meanwhile, the IMF recently cut its global growth forecast to 3.1% from a 3.3% pace seen at the beginning of the quarter to better reflect a continued slowdown in emerging markets and a weaker recovery in advanced economies.

The Eurozone grew at a 0.4% rate in the second quarter. The Bloc’s recovery has been led by its largest member, Germany, which has benefited from both reduced financing costs and the lower euro. Among member states, Germany has the lowest unemployment rate of 4.5%. The Eurozone trade surplus (exports minus imports) reached a record high during the period, boosted by increased exports generated from a weaker euro. High unemployment and debt levels remain challenging for the region, but targeted monetary policies have begun to move the needle in the right direction.

Seeking to divert the economy from a hard landing, policy makers in China devalued the country’s currency and cut interest rates in response to deteriorating manufacturing activity and a sharp decline in the local stock market. While the devaluation itself was small (3%), it represented a notable deviation from expected policy. Much of the weakness appears to be a natural evolution as the country transitions to a more consumer-led economy. However, the prospect of meeting the government’s goal of 7% growth is increasingly uncertain.

The recent correction has led equities to trade much closer to their long-term averages in the U.S., below average in developed markets, and well below average in most emerging markets. The global economy is growing modestly, primarily driven by below average interest rates rather than strong global consumption. The U.S. is further along in its recovery relative to the other developed countries and is likely the first to begin increasing rates. As a result, the U.S. dollar has strengthened given the prospect of higher interest rates. While a strong U.S. dollar has depressed corporate earnings expectations, it makes imports cheaper and should provide a boost to consumer spending, which represents about 70% of the U.S. economy. The U.S. economy is still the most stable developed market and continues to grow at a measured pace. Resilient consumers, low unemployment, modest inflation, and low interest rates offer support for current valuation levels. The S&P 500 Index earnings outlook calls for flat to negative earnings growth in the coming quarters. However, with the exception of the Energy and Materials sectors, earnings are projected to increase.

International developed equity markets have yet to fully recover from the recession. The MSCI EAFE Index is still trading more than 20% below its prior peak. A weak euro, cheap oil prices, low interest rates, and a historic expansionary monetary policy from the ECB has the European markets pointing in the right direction after years spent in the long shadow of the U.S. Both Europe and Japan face hurdles, and their governments appear committed to supporting their economies at almost any cost. The Eurozone has repositioned itself for growth, and investors are beginning to move funds into the region on expectations of an economic recovery.

Rate cuts in India and China support growth, and more cuts could follow if growth falters or inflation drops. Chinese officials acted quickly when export growth slowed and the property market lost steam. China cut rates four times in 2015 and took other measures to spur economic growth and support the stock market. The story in emerging markets continues to center around low commodity prices, weakening currencies, and slowing earnings growth. China and India are positioned for relatively attractive growth as they stand to benefit from a growing consumer base and lower commodity prices.

The Fed believes the slowdown in the first half of the year was transitory and that growth will rebound in the coming quarters. Low global interest rates will likely keep them from moving too quickly due to U.S. dollar strength and the risk that a wider spread will push the U.S. dollar even higher. The Fed held rates steady at the September meeting and identified slower global growth and low inflation as the primary reasons. The probability of a rate hike in 2015 is fading, and the market expects the first move to occur in the first quarter of 2016. U.S. bonds are not providing their traditional level of downside protection during periods of increased volatility as their correlation to stocks has risen well above normal levels. Bond returns should be muted and could dip into negative territory in 2015 if global economic growth proves unexpectedly strong. When the Fed does raise rates, they will likely do so slowly and carefully. A rate hike should serve as an acknowledgement that the economy has strengthened enough to withstand it.

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