WILLIAM RIEGEL, CHIEF INVESTMENT OFFICER, TIAA ASSET MANAGEMENT
October 2, 2015
Global investors were eager to put the third quarter behind them, as equity indexes worldwide tumbled to multi-year lows for the three-month period ended September 30. The last two weeks of September are statistically the worst two weeks of the year and again lived up to that reputation.
Despite apprehension over China’s weakening economy, slowing U.S. manufacturing data, and ongoing Fed-related uncertainty, the S&P 500 Index was down only modestly for the week through October 1. The index retreated early on October 2 in the wake of September’s jobs report before reversing course to finish the week up about 1%.
Europe’s STOXX 600 Index also rebounded on October 2 to return 0.5% for the week in U.S. dollar terms (-0.4% in local currency terms). In China, stocks fell slightly in a holiday-shortened week, while the economy showed some signs of stabilizing. Manufacturing data topped expectations, housing prices are rising, and the services sector is still expanding.
Fixed-income markets have taken on a decidedly pessimistic tone as a confluence of events has pressured risk assets, benefiting U.S. Treasuries. These events include negative headlines surrounding corporate bonds, concerns over emerging-market weakness, and Fed rate timing. In this “risk-off” environment, the yield on the bellwether 10-year U.S. Treasury fell steadily throughout the week, touching 1.98% during afternoon trading on October 2. (Yield and price move in opposite directions.) In contrast, high-yield bonds once again realized sharp losses.
The U.S. economy added just 142,000 new jobs in September, well below forecasts. August’s payrolls, which have historically been revised upward, were trimmed by 37,000, while July’s totals were also revised downward, by 22,000. Looking beyond the headline number, we note that September’s weakness came from a drop in mining and manufacturing employment, sectors closely tied to the recent downshift in energy production and a stronger dollar. In contrast, service- and consumption-related sectors held up well, and retail employment increased.
Among the week’s other reports:
September’s employment and manufacturing data confirm that third-quarter GDP growth will end up slower than the second quarter’s 3.9% showing. Nonetheless, we continue to see evidence of stable consumer demand, steady wages, and an uptrend in broader measures of income and consumption, all pointing to an economy that remains on an annual growth path of 2%-2.5%.
In terms of the Fed, we think the odds still slightly favor a December rate hike. This could change if employment data continues to weaken prior to the Fed’s meeting on December 15-16, but the timing of the rate hike itself is less important to the economy than the ultimate pace of tightening.
In equity markets, Europe remains our favorite investment destination. Although U.S. equities are attractively valued on a relative basis given their very wide risk premiums, shares in Europe are even cheaper. Moreover, we believe Europe’s equity markets offer superior growth potential given below-normal corporate profit margins and below-trend revenues.
As for China, the primary source of concern worldwide, we are cautiously optimistic that its equity markets are poised for a short-term rally on the back of a rebound in sentiment. Contributing to this improved outlook is our expectation for better fourth-quarter growth, buoyed by fiscal stimulus that may be announced sooner than markets anticipate. Even though such stimulus may not correct all of China’s longer-term risks—including a potential housing bubble, a debt overhang, and overinvestments in infrastructure—it may boost investor sentiment and help spark a sharp rally in the emerging markets.
Fixed-income markets face headwinds from tighter liquidity and higher trading costs. However, if the Fed raises rates in December while adding a vote of confidence for the U.S. economy, we believe most fixed-income spreads can rally. Overall, fund flows will remain an important consideration, as outflows have forced institutional investors to sell positions they would normally have held.