Global financial markets endured their worst week of the year this past week amid concerns over slowing economic growth and currency woes in China and other emerging markets, among other reasons. At times like these it is easy to start thinking short term, but keep in mind that the foundations of investing success are well established (have a plan, keep a close eye on expenses, stay diversified, and make sure your portfolio composition is lined up with your tolerance for risk and the timetable for when you’ll need to start drawing down the portfolio).

After weeks like we just experienced, though, it can be hard to stay on track. At Schwab we’re here to help you do just that. If you have any questions about your portfolio or your specific situation, call your Schwab Financial Consultant directly or call 1-800-435-4000.

As for this past week and the market environment in general, here are answers to some key questions about the market volatility.

Q: What factors contributed to the selloff in U.S. stocks this past week?

A: The culprits are numerous, but related. Commodity prices have been plunging along with economic weakness in China and its recent currency devaluation. Global deflation concerns are elevated again, leading to heightened uncertainty regarding the timing of the Federal Reserve’s initial interest rate increase. In addition, high yield and corporate credit spreads have widened significantly—typically a negative signal for the stock market.

Friday was also an unusual day in that because of investors’/traders’ desire to lighten up in advance of the weekend—especially relevant this time given the uncertainty about China’s start to the trading week, which comes on Sunday New York time and it was also an options expiration day on Friday, which added to the volatility, volume and downside momentum.

Q: How does the U.S. market normally react to a week like this?

A: It’s always a good idea to be cautious about historical statistics, but here’s some food for thought (featuring data from Bespoke Investment Group).

The S&P was down 5.7% this week. In only four other times in this bull market has the index been down this much (or more) for a week, and 28 other times going back to 1980. Looking at all 5%+ weekly drops for the S&P 500 since 1980, the median return the next week was 1.1% (61% positive), the next 4 weeks was 1.8% (61% positive), and the next 12 weeks was 5.5% (71% positive). This compares to an average return for all periods of 0.2%, 0.7% and 2.2%, respectively. In other words, after weekly pullbacks like this, the out-weeks tend to be much better than normal in terms of performance. The historical stats for the NASDAQ (since the bull market began) are even better, with median returns of 0.8% (80% positive), 4.8% (90% positive) and 7.5% (90% positive), respectively.

What’s more important than reacting to short-term movements and trends, however, is to make sure you have an investment plan in place that reflects your goals and that you’re keeping that plan up to date as your circumstances change.

Q: Is the Federal Reserve still expected to raise rates soon?

A: Yes. We believe the Federal Reserve will likely raise rates at its next meeting in September. The Fed committee takes market conditions into account when setting policy, but the Fed’s dual mandate is full employment and price stability. The labor market is improving and the Fed expects inflation to rise in the intermediate term.

Q: What is driving the currency turmoil in emerging markets?

A: Emerging market currencies have fallen significantly over the past year, and the trend has accelerated in recent months. It’s been a perfect storm for many of these countries, especially those that produce and export commodities. Slowing demand from China for basic materials and accumulated oversupply has led to a collapse in commodity prices. While the trend has been steep, prices will level off at some point

Q: What does the selloff in emerging market currencies mean for the bond markets?

A: We’ve been concerned about the build-up in corporate debt denominated in U.S. dollars in emerging markets. Some companies took advantage of low rates and strong demand for yield by issuing debt in U.S. dollars over the past few years. But with their home country currencies down substantially versus the dollar, repaying that debt could be very difficult unless there is revenue in dollars coming in. We believe an increase in defaults over the next year or so is likely.

Q: What are the key takeaways from China’s recent currency adjustment?

A: It should not have a major impact on U.S. economic growth because China is not a major purchaser of U.S. exported goods or services. Lower demand for commodities from China, meanwhile, is likely to result in lower prices and slower inflation, keeping bond yields low. China’s actions also may have a negative impact on emerging market currencies and bonds. The devaluation of the yuan sparked worries that China’s economic growth is deteriorating at a faster pace. It also set off worries about whether other countries would also devalue their currencies, possibly raising the risk of global deflation.

Q: Will China’s actions affect the Federal Reserve’s decisions on interest rates?

A: Unless there is a rapid decline in China’s currency or more turmoil in the global currency markets, we believe the Federal Reserve is not likely to alter its plans to raise the federal funds rate this year. (The federal funds rate is a key benchmark that affects the markets and many consumer rates.) That said, China’s currency devaluation is probably is another reason the Federal Reserve will move slowly in raising rates.

Q: Why are interest rates falling if the market is still anticipating a Fed rate hike?

A: Long-term bond yields are tied to growth and inflation expectations. Inflation remains low. While short-term bond yields have risen in anticipation of the first Fed rate increase, Treasury yields for bonds with maturities of ten years of more have been falling since June. Inflation remains below the Fed’s 2% target, as falling commodity prices and the strong dollar are holding down prices. Demand for U.S. Treasuries remains high as well since they offer higher yields than most other developed market government bonds. We believe these factors can keep long-term yields low, resulting in a flatter yield curve.

Q: What’s going on with global commodity prices?

A: All types of commodities have fallen sharply this year. In some cases, it is for a specific reason such as an increase in oil supply. Overall, concerns over global growth have caused worries about demand for many commodities, leading investors to pare back positions. Also, many commodities are traded in dollars, which has been strengthening. This is pushing commodity prices lower.

Q: Is there anything investors should consider amid the drop in commodity prices?

A: Our advice to investors is to stick with their long-term asset allocation plans. We do not believe the drop in commodities is forecasting a global or U.S. recession, but it does reduce the growth rate of countries that are major exporters.

Q: Is a strong dollar a positive or negative for the U.S. economy and markets?

A: A rise in the dollar affects the economy and markets in several different ways. A strong dollar holds down import prices, especially for commodities, which are traded in dollars. This keeps a lid on inflation. It also makes U.S. exports less competitive, which tends to slow down the economy, especially the manufacturing sector. Also, when the dollar rises, foreign investors often find it attractive to direct investment funds to the U.S. bond market, which hold down interest rates. For the stock market, there is no consistent correlation between movements in the U.S. trade-weighted dollar and S&P 500 earnings. Overall, a strong dollar has a neutral impact on corporate earnings.

Q: Are bonds a bad investment now because they will go down when rates start rising?

A: All else being equal, when interest rates rise, bond prices fall. Bonds with longer durations are more affected by a change in interest rates than bonds with shorter durations. However, interest rates don’t necessarily move uniformly across the yield curve, even when the Fed is tightening monetary policy. The Fed controls short-term interest rates, but long-term interest rates are set in a global market and are predominantly driven by inflation expectations. Recently, short-term interest rates have been rising while long-term interest rates have been falling – resulting in a flatter yield curve. We continue to believe that Treasuries and investment grade bonds with intermediate term maturities offer the best risk/reward in the fixed income markets. We are more cautious about high yield or sub-investment grade bonds.

Q: What can investors do to prepare for the stock market’s ups and downs?

A: Rebalancing portfolios is a classic strategy designed to lower risk and potentially enhance returns. It involves trimming those asset classes that have risen in value and are taking up an outsize portion of the portfolio while adding to those asset classes that have declined in value and have a smaller portion of the portfolio. Diversification can also reduce volatility over time. A portfolio with a mix of stocks, bonds, and cash would suffer less significant drop during a market crisis and preserve wealth for greater growth potential over time.

 

(c) Charles Schwab

www.schwab.com

 

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