Economic Commentary October 2015

Posted on Monday, October 12, 2015

Volatility Rules in the Third Quarter

Mel Miller, CFA | Chief Economist

What a challenging time for investors! The third quarter of 2015 was dominated by volatility. Traders were the beneficiaries of market volatility-not investors. While some volatility is "normal," this quarter was exceptional. There was no escape.

Stock market volatility as measured by the Chicago Board Options Exchange SPX Volatility Index (VIX), nearly uadrupled at the peak and ended the quarter more than double the previous quarter. High volatility can, on occasion, result in rising stock prices; but not this time.

Chicago _Board

The S&P 500 Index declined over 7% during the quarter. In fact, a " correction" occurred as the index declined by 12% between July 20th and August 25th. Emerging market investors experienced even greater volatility and loss as the MSCI Emerging Market Index dropped 21% from peak to trough during the third quarter.

Fixed income securities were the only "winners" for the quarter. As a proxy, the yield on the 10-year Treasury declined approximately 30 basis points (-0.30%), even though speculation around the timing of the Federal Reserve's highly anticipated interest rate rise dominated the financial news.

Driving Force: Chinese Yuan

The volatile relationship between the U.S. dollar and the Chinese Yuan was the driving force behind the increase in market volatility. The graph highlights the decline of the U.S. Dollar relative to the Yuan for the past five years.

US_Dollar _Yuan _Relationship

In fact, the dollar peaked in 1994 and either held stable or edged lower until January 2014. Since then, the Chinese government, worried about their slowing economy, has allowed its currency to weaken (the Chinese Yuan does not float freely, but is controlled by government officials).

In an even bolder move, China announced an official 2% devaluation on August 10, 2015. The People's Bank of China called the change a "one-time adjustment." This was totally unexpected and world markets reacted negatively. Investors as well as presidential candidates in the United States questioned the truthfulness of the official statement.

Why was the devaluation of the Yuan so disturbing for the markets? In summary, a lower Yuan reduces the price of Chinese exports while at the same time increasing the price of foreign imports. U.S. exporters, having been the beneficiaries of a declining dollar since 1994, are now being faced with a situation where the value of the dollar is increasing in value relative to other currencies around the world.

It's now a world in which U.S. exports are getting more expensive. It's also a world where commodity prices, which are denominated in U.S. dollars, are under pressure. Commodity prices declined dramatically during the quarter, impacting producers and exporting commodity countries. Equity investors were suddenly reminded of the impact exports have on company earnings.

Feeling the Burn

The carryover to the manufacturing economy was immediate. The ISM Purchasing Managers Index declined from 58 at the beginning of the year to 50.2 for September. After growing near a post-recession high at the beginning of the year, it is now nearing the contraction level of 50.

Durable goods new orders moved from positive territory to negative, an ominous future indicator. Exporting manufacturers and commodity based firms are bearing the brunt of the Chinese currency devaluation.

Manufacturing _Sector

The contrast with the Non-Manufacturing ISM Purchasing Managers Index is startling as it continued to move up toward a level not seen since 1997, only to be followed by a dramatic decline in September. The number of service sector jobs, which are traditionally lower paying than manufacturing jobs, grew while manufacturing jobs declined. In addition, the labor participation rate continued to edge lower to a level not seen since 1977. The average hourly earnings of all employees year-over-year saw no improvement.

Retail sales on an annual basis have slowed to the 2% range, down from the 4% pace of last year. The slowdown has occurred in spite of the boost consumers have receive from the declining price of oil which broke $40 a barrel in the third quarter. In fact, U.S. consumers are currently paying $2.31 on average for regular gas, with some states reporting sub $2.00 a gallon. Excluding the volatile gas and food sectors, core inflation is still only up 1.8% over the last twelve months.

Expectations for Interest Rates

Volatility in the international markets and slowing inflation has created a major problem for the Federal Reserve­. Fed Chairperson, Janet Yellen, has been signaling a rate hike for months and had to delay action on interest rates in September because of declining inflation pressure and volatility in the international markets resulting from the devaluation of the Yuan. Raising short-term rates would only put upward pressure on the U.S. dollar exaggerating the export decline.

Service _Sector

Where do these unusual levels of volatility leave the U.S. economy? The economy "grew" only 0.6% in the first quarter and rebounded to 3.9% in the second quarter.In keeping with the volatility theme, my forecast for the third quarter is 2% GDP growth.

Look for continued volatility in the fourth quarter. And expect the Fed not to raise interest rates until 2016.