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China and the Fed

By Advisor Perspectives
Capital Markets

The third quarter of 2015 was marked by significant losses in capital values and an increase in volatility. The S&P 500 lost 7.55% in the quarter and 6.71% year-to-date; NASDAQ dropped 7.77% quarterly and 2.26% for the year; Dow Jones Industrial average declined 8.15% in the quarter and 8.68% year-to-date. The VIX fear measure closed the quarter at 24.50, an increase of 42.6% since the beginning of the quarter and 37.7% since the beginning of the year. The Russell 2000 small cap index lost 11.82% for the quarter and 8.18% for the year. Short term treasury yields remain at near-zero levels while 10 year treasury yields declined 15.4% to its current value of 2.03%. NYMEX-traded oil declined by 21.31% while the U.S. dollar lost 1.92% to the euro and 2.81% to the Japanese yen.

Global markets, particularly Chinese, experienced serious declines in the third quarter. SSE Composite Index declined by 21.98% for the quarter, and is down 8.89% for the year. China also devalued the yuan with its base rate being cut by 1.9%. MSCI Emerging Markets Investable Market Index lost 17.88% in this quarter and is down 15.48% for the year. Japanese Nikkei 225 declined by 15.27% in the quarter but is flat for the year. EURO STOXX 50 lost 10.47% in the quarter but is up 2.56% for the year. Some bright spots for New Frontier investors included long treasuries (up 3.20%) and domestic REITs (up 3.03%). In spite of a very challenging quarter, our portfolios remain ahead of global benchmarks year-to-date.

The global economy was very close to collapse in late 2008. Nearly universal fear of default resulted in a near shutdown of commerce. Banks simply did not trust that borrowed funds would be paid back, and business activity stops when short-term lending stops. The Bush-Obama stimulus of 2008-2009 and the full support of the Federal Reserve resurrected lending confidence, and American banks began to return to profitability in March 2009. The Fed was in the forefront of applying modern monetary macroeconomic principles developed largely by a small number of Nobel Prize winning American economists with lessons learned from the Great Depression.

Since then the American economy has been the main driver of global economic growth. U.S. equity markets have outperformed all others with the S&P gaining nearly 200% since March 2009 and well exceeding prior 2007 highs. In contrast, EAFE has grown less than 100% and remains well below its prior highs. Markets reflected a recovering economy with 3.9% GDP growth in the last quarter and annual growth twice that of Europe and four times that of Japan. Consumer spending is up, household net worth is up, household debt ratio is down, and unemployment is at essentially a full employment rate of 5.1%. While the deficit is the lowest since 2007, China’s debt has ballooned dramatically. The dollar has strengthened relative to major currencies with enhanced purchasing power for U.S. consumers. Low interest rates are a positive driver of growth while the dollar remains the reserve currency safe haven of choice for global investors.

Serious uncertainties remain for U.S. investors. Economic policies and capital markets are often out of synch. The Fed’s decision this month not to raise interest rates was accompanied with the explanation: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” In other words, global economic and political risks raised concerns about whether American economic growth was sustainable without continuing Fed support. The Fed’s comments spooked the market.

The U.S. can’t be the only source of growth if growth is to be sustainable. While the Fed’s

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