Markets Update: Third Quarter 2015

Simply stated, the third quarter was quite volatile, especially for global equity markets. Equity indices were driven down significantly by concern about China and other emerging market economies while bonds and REITs managed to provide flat to slightly positive returns. As regular readers of this report know, it was only a matter of time before stocks experienced some form of a pullback given the run up in US markets and the various headwinds around the world.

The US Federal Reserve still has yet to increase the Fed Funds rate. The uncertainty created by this inaction contributed to heightened volatility and hurt risky areas of the bond market. However, their decision, or lack thereof, supported prices of high quality bonds as did the so called “flight to safety” trades made by investors moving from equity markets to the stability of fixed income. Yields on the benchmark 10 year US treasury contracted from 2.34% on June 30th to 2.06% on September 30th, thus driving prices higher. Inflation remained solidly in check, which also supported prices. Short-term US bonds earned 0.59% and the more diversified Barclays US Aggregate Bond index grew 1.23%. Globally, fixed income instruments saw a similar fate. High quality government and corporate bonds were in favor and managed to produce a slightly positive quarter with a return of 1.32%.

Significant selling pressure took hold the last week of August and markets were not able to recover through the end of the period. The bulk of the declines were in emerging markets but developed markets did not escape the pain. Weakness in the Chinese economy and issues with their stock market rose to the surface and served as the catalyst for the Q3 slump. US stocks lost 7.25%, international developed stocks lost 10.51% and emerging market equities ended the quarter down 17.78%. Here in the US, small and value companies underperformed the market. In both international developed and emerging markets, small companies faired better than the broad benchmark while value companies underperformed. After such a challenging quarter, global equity markets are now in the red for the year through September 30th.

The global economy can largely be characterized by two trends – a relatively robust US economy and a slowing world outside our borders, particularly in emerging markets. The main issues facing the world have not changed much since last quarter but the focus has shifted. Greece has taken a back seat and China and the emerging markets are now the primary concern. Here in the US, a strong consumer continues to play a very important role in the domestic economy, investment is strong and the jobs picture continued to improve. At the same time, wages have not increased at a rate commensurate with a strong economy and growth overall has been very weak when compared to other post-recessionary periods. Various Federal Reserve Board members have telegraphed that they will increase interest rates this year yet they sighted the unclear economic picture at their most recent session as a reason to hold tight. There are two meetings left in 2015 for them to make a move. Abroad, growth in the European Union continued to move in the right direction and monetary policy remained favorable. Japan saw inflation slip for the first time in 2 years, which increased pressure on the Bank of Japan to ease monetary policy further. Emerging market economies faced a number of challenges, including a slowing China, capital flight, a strong US dollar and weak commodity prices. As we’ve highlighted in our recent quarterly reports, China, the world’s second largest economy, continues to transition to a more consumer oriented market and attempts to rout out corruption. This process has made for a bumpy ride, which can continue for some time, but should benefit the country and the global economy over the long run if carried out well.

The Patience Principle

As the focus turns to China’s economic outlook, global markets have provided investors with a rough ride. But while falling markets can be worrisome, maintaining a longer‑term perspective makes the volatility easier to handle.

A typical response to unsettling markets is an emotional one. We sell risky assets when prices are down and wait for more “certainty.”

These timing strategies can take a few forms. One is to use forecasting to get out when the market is judged as “overbought” and then to buy back in when the signals tell you it is “oversold.”

There is very little evidence that such forecast-based timing decisions work with any consistency. And even if people manage to luck their way out of the market at the right time, they still have to decide when to get back in.

A more sound, logical strategy is to reflect on how markets price risk. Over the long term, we know there is a return on capital. But those returns are rarely delivered in an even pattern. There are periods when markets fall precipitously and others when they rise inexorably.

Now, there may be nothing wrong with that sort of volatility if the individual can stomach it. But others can feel uncomfortable. And that’s OK too. The important point is being prepared about possible outcomes from your investment choices.

Markets rarely move in one direction for long. If they did, there would be little risk in investing and in the absence of risk, there would be no return. One element of risk, although not the whole story, is the volatility of an investment.

Look at a world stock market benchmark such as the MSCI World Index. In the 45 years from 1970 to 2014, the index has registered annual gains of as high as 41.9% (in 1986) and losses of as much as 40.7% (2008). Over that full period, the index delivered an annualized rate of return of 8.9%. To earn that return, you had to remain fully invested, taking the unsettling down periods with the heartening up markets, but also rebalancing each year to return your desired asset allocation back to where you want it to be.

Look at 2008, the year of the global financial crisis and the worst single year in our sample. In the following year the MSCI World index registered one of its best ever gains.

Second-guessing markets means second-guessing news. What has happened is already priced in. What happens next is what we don’t know, so we diversify and spread our risk to match our own appetite and that uncertainty.

Markets are constantly adjusting to new information. A fall in prices means investors are collectively demanding an additional return for the risk of owning equities. If your horizon is 5, 10, 15, or 20 years, the uncertainty will soon fade and the markets will worry about something else. Ultimately, what drives your return is how you allocate your capital across different assets, how much you invest over time, and the power of compounding.

In the short term, the greatest contribution you can make to your long-term wealth is exercising patience.