The yield on the 10-year Treasury note hit a recent high of 2.5 percent on June 10. Since then, the yield has drifted down to 2.2 percent on Aug. 18 when U.S. stock market declines began to accelerate. Between Aug. 18 and Aug. 24, the 10-year Treasury yield fell sharply, falling as low as 2.01 percent, a level not seen since April. Like the late August rebound in equity markets, yields reversed some of the worst declines, reaching 2.19 percent on Aug. 28.
The safety sought in Treasury securities by many investors during this latest bout of risk aversion is just one reason why China is a major buyer of U.S. government debt. China’s enormous trade surpluses with the U.S. create substantial dollar reserves. China looks for safe, liquid assets where those reserves can be invested.
Over the years China has accumulated $1.3 trillion worth of Treasury securities, about 20 percent of all foreign holdings of Treasurys. Over the past 12 months alone, China has purchased about $137 billion worth of government-related debt securities (Chart 5) including about $90 billion of Treasurys.
If our analysis of the trade patterns between the U.S. and China is correct, the net trade deficit for the U.S. is likely to widen over the coming months and quarters, leaving China with more reserves to invest. If China continues to put much of those reserves into Treasurys and other government debt, the marginal buying is likely to help restrain yield increases, especially as the Fed eventually begins to raise short-term interest rates.
The one caveat is that China may need to use dollars to defend its currency against downward pressure from sellers of the yuan. This could potentially divert U.S. dollars from being invested in Treasurys.
August brought more of the same for commodities. Following a major bull market run for most raw materials between 1999 and 2008, where price indexes soared nearly 600 percent, commodity prices have been losing ground overall since 2011. In many cases, prices moved sharply lower last month as fears of slowing global growth spread (Chart 6).
Among the major commodity groups, energy continues to be hardest hit. In addition to fears of lower demand as growth slows, primarily in China, massive supply gluts have arisen. New technologies have enabled increased crude oil and natural gas production in some traditionally high-cost areas, including some regions in the U.S. As U.S. production increased, imports of crude into the U.S. fell, leaving global markets oversupplied. At the same time, global producers, especially Saudi Arabia, have maintained output and allowed prices to fall in order to protect their own market share. At some point, lower- priced oil may force some high-cost producers out of business. But until then, energy, and particularly oil, is likely to suffer from oversupply as well as soft demand.
At the other end of the spectrum, precious metals have benefited, to some degree, by being somewhat of a haven in times of uncertainty. Gold in particular is a popular asset for hedging risk. While commodity prices in general are under pressure, the status of gold as a safe store of value has likely held the metal to relatively modest recent declines as commodity indexes plunged and rebounded. Going forward, perception of the precious metal as a haven may work against gold investors as the Fed begins to raise interest rates, reducing the risk of inflation.
Industrial metals such as copper are traditionally the most cyclically sensitive and may show better relative performance if fears of a slowdown in China ease and if signs of faster U.S. and European growth emerge.
Broadly, commodity indexes sank to 10-year lows in the last week of August, below even the levels reached during the Great Recession. The downside from here should be somewhat limited, especially if global growth and the dollar stabilize.
The Standard & Poor’s 500 Index of U.S. shares fell sharply late last month as waves of uncertainty rolled over global capital markets. By Aug. 28, the S&P had dropped to 1,988.87, down 6.7 percent from its all-time high of 2,130.82 set on May 21. By our calculation, the price-to-earnings ratio stands at 18.5, at the high end of the central range of P/E values.
We firmly believe that fundamentals drive equity prices over the medium and long term. Since the 1930s, both U.S. corporate profits and equity prices have grown at about a 7 percent annual rate. In the short term, however, deviations from trend for both profits and share prices can be significant. Over the past few years, U.S. corporate profits from the rest of the world have grown at a significantly slower pace than profits of U.S. companies earned domestically (Chart 7). Slowing global growth and a rising dollar likely have contributed to the relatively poor performance of profits earned by U.S. companies from the rest of the world.
Domestic profit growth has been accelerating in recent quarters, despite the downtick in the second quarter (largely due to declines in the energy sector). As U.S. economic growth continues to slowly accelerate, we expect domestic profits to be supported by top-line sales gains. The downside risk is that a tightening labor supply and rising interest rates could squeeze profit margins by pushing both unit labor and non-labor costs higher in coming quarters. The wild card in the outlook for domestic profits continues to be productivity. Slow productivity growth hampers efforts to maintain profit margins in the face of rising costs. If productivity growth were to accelerate and the gains were passed along in the form of higher wages and salaries, then markets could benefit from a world of rising sales and stable margins and could support future demand by allowing faster wage growth.
Current estimates from Standard & Poor’s analysts project the growth rate for operating earnings for companies represented in the S&P 500 index will average 13.7 percent for the second half of 2015 and all of 2016, on a per-share basis. Thomson Reuters estimates that growth at 11.2 percent for next year on the same basis. Profit growth in the low double-digit range or even high single-digit range would be above the long-term average and should support future share price gains.
The declines in equity markets around the world were substantial in August. The Dow Jones Global Index for world equity markets excluding the U.S. fell more than 10 percent in the waning days of last month. Numerous stories chronicled the plight of Chinese investors, many of whom had never owned stocks before, as the bubble in equity prices burst. Theories began to surface about how the selloff might affect an already fragile economy if consumers suddenly retreated after suffering investment losses. Only time will tell how the new generation of Chinese investors reacts to volatility, but for American investors, we have some unfolding evidence.
Net new share issuance in exchange traded funds (ETFs) that invest in global markets began to fall off even before the major selling began (Chart 8). The flow of cash into ETFs remained positive for the month of July (the latest data available) but only slightly so.
Yet the net new cash flowing into mutual funds that invest in global markets remained remarkably strong in early August. Still, the latest fund-flows data do not cover the time period of the worst of the selloff.
It will be interesting to see if U.S. investors sold first and asked questions later as the month ended or whether enough opportunists came along to “buy the dip.” Cash flows of significant size can be an important factor in the depth and duration of any selloff.
By Aug. 31, the worst of the selling seemed to have subsided as many markets stabilized or recouped some losses, but September began with another 3 percent drop in the S&P. Next on the horizon is the Fed’s expected liftoff for short-term rates and the impact that may have on global markets, particularly emerging markets. For many investors, the best advice is to stay the course but be forewarned that more volatility may mark the weeks and months ahead.