In a nutshell
- Stocks pulled back
- China weakness
- Bond bull market may finally be over
- Higher inflation = Commodities doing well. Except for Gold?!?
U.S. Stocks – Taking a breather
The long awaited 5% pullback in the U.S. market finally happened as the market drop in September essentially wiped out July and August’s gains. The damage wasn’t limited to large company stocks. Smaller companies also experienced their own corrections.
Before this latest correction, the market had gone almost a year without a 5% slide. Looking at just the broad market averages, however, has covered up what has essentially been a rolling correction in stocks over the past several months. I talked about this in more detail a couple of months ago.
The good news is that the 4th quarter has historically been the best performing of the year, averaging 4% over the past 70 years. In fact, as this is being published (10/27), the major averages are already up at least that much so far.
International Stocks – China weighs on emerging markets
While developed markets struggled along with the U.S., the real story for international stocks this quarter was China. By far the largest emerging market country, China’s stock market fell 18% in the third quarter. This dragged the broad emerging markets index down 9% over the quarter and flipped it negative for the year.
There are a few reasons for the steep drop. First and foremost, the Chinese government has been cracking down on some of the most profitable companies and industries. This year it has implemented new regulations on large technology companies such as Alibaba and Tencent. Needless to say, it caused concern among institutional investors around the world.
Just as importantly, it has pressured real estate companies to clean up their balance sheets. The result is financial stress for even very large companies such as Evergrande, the 2nd largest real estate developer in China. Real estate values have also come under pressure, with prices in a number of cities dropping. And since the chinese population has an estimated 60% to 80% of their wealth tied to housing, the concern is that they will slow their spending.
China is also continuing to use large scale lockdowns to try and prevent the spread of Covid-19. While we don’t hear much about this in our news cycle, these shutdowns continue to have severe negative effects on the economy.
As the U.S. is the world’s largest economy, it’s said that when it catches a cold, the rest of the world gets the flu. In other words, an economic slowdown in the U.S. can trigger more severe downturns in other countries. Since China is the world’s 2nd largest economy, the same could now be said about them. China’s economic troubles could definitely spread, even to the U.S.
Bonds – Interest rates bottoming?
High quality bonds were flat for the quarter and are down this year as well as the past 12 months. High yield (lower quality) bonds did better, eking out a 0.51% return for the quarter. These types of bonds tend to follow the stock market more so than their higher quality brethren so it’s no surprise they are outperforming.
While bond prices move up and down on a daily basis, over longer time frames their performance is driven by interest rates. Bonds are inversely correlated, which means that when interest rates are going up, bond prices usually go down. When interest rates go down, bond prices go up.
While it hasn’t been a smooth ride, interest rates have been falling since 1981. This has acted as a tailwind for bonds as they have both earned interest and gone up in value. For the past decade, however, investors have been wondering how much lower interest rates could go. With every new low over the past several years, there’s been no shortage of bond market experts that have said rates couldn’t go any lower.
Taking a closer look at the last 5 years, it looks like interest rates may have finally made a long term bottom in 2020. If true, we could be at the beginning of a multi-year upward trend in rates. In that case, the tailwind that’s helped propel bond returns for decades may have turned into a headwind. That could mean much lower returns for bonds.
Alternative Investments – Commodities continue their leadership, except for gold
The best performing asset class during the quarter and year to date has been commodities. Unfortunately we are reminded of this every time we go to the gas station to fill up. Products such as oil, industrial metals, livestock and agricultural crops are primarily driven by economic changes in supply and demand; much more so than other investment assets such as stocks and bonds.
One of the effects of last year’s global lockdown was an increase in savings and a very steep but short drop in demand for anything except hand sanitizer, groceries and toilet paper. Once everyone realized the world wasn’t coming to an end, we started buying other stuff as well. Since we couldn’t go on vacation or out to eat, we had more money to purchase stuff like computers, TV’s, cars and houses instead. The surge in buying caused a supply shortage which has left producers still trying to catch up. This in turn has caused a spike in demand for raw materials, driving those prices higher.
Interestingly, one area of the commodities market that hasn’t participated in this boom is gold. After a strong run-up during the first 6 months of 2020, it’s been in a downward trend. This seems odd. I’ve always been told that gold performs well during times of unanticipated high inflation. Seeing as our current inflation rate is higher than it’s been most anytime since the late 1980’s, one would think gold would be one of the year’s strongest performers.
Maybe gold is telling us that this bout of inflation really is transitory. Maybe it’s telling us that investors would rather be in better performing alternatives such as real estate or other commodities. And maybe some gold investors are switching to Bitcoin, described by some as digital gold. Whatever the reason or reasons, it;s definitely worth watching.