Despite a furious month-end rally, January was the worst month in the financial markets in a while. Certainly, markets had the worst start of a calendar year ever. The broad stock market performed even worse than the market averages. Volatility became the watchword with big swings seemingly happening on a daily basis.
We have been saying for the past year that we were expecting volatility to increase. The Fed’s unprecedented quantitative easing program kept volatility unnaturally low for a few years, so now that the Fed has signaled some tightening monetary policy, we are returning to more normal market volatility. Big drops in oil prices in the past (think 1986 and 1998) also contributed to increased volatility.
Much of January’s declines were attributed to concerns about economic growth in China and the continuing decline in energy and commodities prices. Many prognosticators have even suggested that a recession may be imminent in the US due to the China and energy issues. A recent report from Woody Brock of Strategic Economic Decisions suggests that this is unlikely (as I recently asserted in an article for Virginia Business). While China is the world’s second largest economy, the economy there is way, way smaller than the US economy. Indeed the Chinese economy is way, way smaller than the European Union’s (EU) aggregate economy. According to Brock, even if the Chinese economy grows at a rate that is 1.5% slower than the Chinese say it is growing, the slowdown in China would only subtract 0.95% from global economic growth this year. Additionally, Brock notes that China accounts for less than 1% of US exports. The US exports much more to our neighbors in Canada and Mexico. Therefore, a slowdown in China will likely have less impact on Main Street USA than some expect.
Declining energy prices may also have less impact on the US economy than many talking heads may think. Woody Brock notes that employment in energy extraction in the US makes up only 0.13% of non-farm payrolls. Moreover, capital spending in the energy sector in the US makes up only 5% of the nation’s total spending on equipment and structures. This is not far from its traditional average, although it is down from the peak of the fracking boom. I think that both of these data points are lower than nearly everyone would have expected. This indicates that many market participants may be overestimating the impact of lower energy prices on the US economy.
The rough start to the year in the financial markets is certainly troubling in the short-term. However, most of our clients have long-term investment time horizons and as we have noted in the past, those investors who were patient, stayed calm during market corrections and focused more on the long-term were eventually rewarded time and time again. We view this rough start to 2016 as a market correction and not the beginning of a bear market (although there is no doubt that some investments have been in bear market territory). We hope the correction is over but are not convinced that it is over. We would have expected the VIX index (the so-called “fear” index) to get into the 30-35 range to shake out investors who are fearful – but it has been in the 20-25 range recently. We also view the prospect of a recession in the near term to be unlikely.