For the first time since 2011 US stock markets experienced a market correction when the S&P 500 dropped 12.5% from its May high to its most recent low on August 25. The S&P 500 ended the quarter down 6.44% and down 5.29% for the year through the end of September. Most other major indices were down as well, with many suffering quarterly losses in excess of10%. Equities in emerging markets experienced the worst performance losing 17.90% for the quarter and 15.47% for the year to date.
Investors’ anxiety, expressed through heightened third quarter market volatility, was primarily the result of three factors: a slowing Chinese economy, deteriorating commodity prices and continued uncertainty about when and how the Federal Reserve will act.
Increased equity market volatility in the third quarter was spurred primarily by worries over the slowing Chinese economy. In August Chinese policymakers announced a surprise devaluation of the yuan, revealing worries in the Chinese government over the competitiveness of the struggling Chinese industrial sector. In addition, the Chinese government went to great lengths to prop up their stock market – halting trading at several brokerage firms and in some cases engaging in the direct purchase of stocks. Despite these extreme measures the Shanghai Composite Index fell more than 25% during the quarter. The dramatic market sell-off, combined with the extreme actions the Chinese government, sent ripples of fear throughout global equity markets.
The events in China also wreaked havoc on commodity markets. Commodity markets were stricken by a fundamental problem – too much supply and too little demand. Demand for commodities has been deteriorating for some time due to the slowdown in China and the tepid recovery from the global financial crisis in the rest of the developed world. Commodity producers, engaged in a struggle for survival, have continued to soak the market with supply. The combination of these two factors has led to a collapse in prices. At some point the market will correct this supply/demand imbalance and commodity prices will stabilize, but it is difficult to pinpoint when that might occur.
In September the Federal Reserve once again declined to raise rates. To put this decision in perspective, the Fed last began a cycle of tighter monetary policy in June 2004. The last time the Fed raised the federal funds rate was in June 2006. Domestic economic data continues to slowly improve, as evidenced by increased housing starts, rising auto sales, and declining unemployment. Despite the improved economic data the Fed appeared to be influenced by the seeming fragile nature of the global economy. A combination of the continued lack of action by the Fed and the strengthening US dollar helped push interest rates down with the yield on the 10-Year Treasury bond falling to 2.05% from 2.43% at the beginning of the third quarter. With rates falling, high quality bonds were up for the quarter, pushing bond returns for the year into positive territory and helping to offset some of the losses incurred in stocks.