Global Stock Prices Dropped on Headline Concerns.

But What Were the Underlying Causes?

And Where Are the Opportunities?

Following a long quiet period during which stock prices around the world mostly moved upward, the third quarter was characterized by wild swings and an overall decline in stock prices. In my last quarterly message, I described why we may have entered a new era for the global economy that could make stock prices prone to periodic “air pockets.” And, in fact, market behavior during the third quarter was consistent with the possibility of having entered this new economic era.

The setup for a possible new era has been fostered by the persistence of slow economic growth around the world since the end of the Global Financial Crisis. This slow growth has continued in the face of massive central-bank stimulus far beyond historical experience. But how could so much stimulus result in so little growth?

As I’ve suggested before, much of the answer lies in demographics. With the aging of the global population, people’s needs turn from investments in homes and cars toward savings to generate retirement income. As there’s less demand for investments and more supply of savings, interest rates inevitably drop. Central-bank stimulus has the effect of further adding to the supply of savings, leading to even lower rates.

A lengthy period of low interest rates promotes a lengthy period of high stock prices. The reason stock prices are bid up is that when interest rates are low, stocks are viewed as more attractive. So there’s a rush to buy. Prices will probably stop rising when investors view future stock returns as likely to be more in line with low interest rates.

An unfortunate side effect of high stock prices is increased volatility. The higher the multiple of earnings for which a stock sells, the more volatile the price may be. We experienced such volatility during the third quarter as investors feared that a slowdown in China would lead to lower earnings around the globe.

Above all else, air pockets in stock prices are disconcerting. We’d like to avoid them if we could. However, the only sure method of avoiding air pockets is to exit the market entirely — which is not an attractive alternative considering the paltry returns on cash these days.

If the new era has truly moved us beyond the interest-rate cycles that have characterized recorded economic history, there’s one big positive: The economy will be steadier without the booms and busts typical of powerful interest-rate movements.

So we may be in for more economic stability, but less stock-price stability. As I noted in my last quarterly message, while it’s still too early to declare that we’re definitely in a new era, the evidence for that scenario continues to mount.


Pundits tagged China’s troubles as the main culprit behind market volatility during the third quarter. And there’s no doubt that growth in the Chinese economy is now slowing. Several years ago, China’s inflation-adjusted gross domestic product (GDP) growth had been as high as 10%. But for 2015, China’s GDP growth is expected to be under 7%. In addition, China’s manufacturing activity recently slumped to a three-year low, and the service sector showed weakness too.

While growth anywhere near 7% is still attractive compared to most developed markets, many countries and companies around the world had been counting on much higher demand from China in order to meet their own growth projections. For example, South Korea’s exports dropped over 8% in September versus a year earlier following a 15% fall in August — due, in part, to the deceleration in the Chinese economy. Other victims of weaker-than-expected Chinese demand were commodity exporters like Brazil, which saw its currency decline to the lowest level against the dollar in two decades and its credit rating downgraded by Standard & Poor’s to “junk” status.

In the United States, the news was generally more positive — not because of particularly good economic data, but because expectations had been low. Inflation-adjusted GDP growth for the second quarter was revised to 3.9% from an earlier estimate of 2.3%. Nevertheless, full-year growth for 2015 is still expected to come in below 3%.

Other economic news in the U.S. mostly focused on the Federal Reserve’s (Fed’s) interest-rate policy going forward and on the employment situation. Because the economy has shown modest growth, there’s been some pressure on the Fed to raise interest rates. However, this pressure has been countered by those who fear that higher rates would further strengthen the dollar, which could hurt U.S. exports and make dollar-denominated debt more expensive for fragile emerging markets. At its September policy meeting, the Fed cited global economic challenges in its decision to leave short-term interest rates unchanged for the time being.

In September, the U.S. unemployment rate was 5.1%, the same as in August. But job creation for both months was disappointing. Only 142,000 jobs were created during September, compared to economists’ expectations for 203,000 new jobs. The shortfall resulted from losses in manufacturing and mining, which were impacted by the slowdown in China, falling commodity prices and the rising value of the dollar.

At the corporate level in the U.S., second-quarter earnings for companies in the S&P 500® Index fell -0.7%, the first year-over-year decline in quarterly earnings since 2012. And the S&P 500 posted a 3.4% slip in revenues for the second quarter.

Taken together, the recent economic data has been entirely consistent with what I’ve postulated as a “lower for longer” interest-rate scenario.


During the third quarter, the globally oriented MSCI World Ex-U.S.A. Index fell -10.57%. The S&P 500 did somewhat better, declining -6.44%. And small caps, as measured by the Russell 2000® Index, dropped -11.92%. Bonds, on the other hand, held up well. The intermediate-term Barclays Capital U.S. Aggregate Bond Index increased 1.23%, while the long-term Barclays U.S. 20+ Year Treasury Bond Index partially reversed its loss from the previous quarter and gained 5.32%.

As we ponder what’s in store for the financial markets, let’s first summarize current conditions: The U.S. is doing reasonably well compared to its developed-market peers, but stock valuations are generally high. The outlook for both Europe and Japan is mixed — with some relatively attractive company fundamentals and more-reasonable stock valuations, but with economies still at risk of slipping back into recession.

Among emerging markets, China’s economic growth is slowing and the Chinese government seems to be mishandling conditions related to investor confidence by directly manipulating stock prices and currency exchange rates. Moreover, China’s slowdown is having real effects on other economies, particularly those in the emerging universe.

As we search for attractive investments in the current environment, it’s possible that we’ll be more successful by taking advantage of opportunities from periodic air pockets in stock prices than by waiting for a crash to create the elusive bargains that may never arrive. The recent air pockets triggered by headline concerns regarding China may have offered some of the best buying opportunities we’ll see this year — not necessarily for Chinese shares, but for stocks around the world.

Paradoxically, the slowdown in China could actually improve investment prospects in some other areas, as production costs decline with less competition for commodities like steel, copper and oil. Moreover, still-abundant Chinese capital may also flow to these areas as investment opportunities diminish within China itself.

While our crystal ball is especially cloudy due to the uncertainty of a possible new era, the silver lining is that mixed markets generally have provided a good environment for bottom-up stock pickers like the portfolio managers and analysts at Wasatch Advisors. So far this year, we’ve continued our efforts at tire-kicking around the globe — visiting companies in Canada, Mexico, the United Kingdom, France, Germany, Italy, Spain, Sweden, Switzerland, Egypt, Ethiopia, Israel, Kenya, South Africa, Tanzania, Tunisia, the United Arab Emirates, China, Hong Kong, Malaysia, Pakistan, the Philippines, South Korea, Taiwan, Thailand, Vietnam, Australia, Japan and New Zealand.


Almost 20 years ago, we — at small, Salt Lake City-based Wasatch Advisors — became global investors. One of the reasons, even back then, was we were beginning to see that, despite their size, our U.S. small-cap companies were being affected by international competitors. Fortunately, our stepped-up global research efforts gave us a ringside seat to witness the massive progress made by emerging economies over the last two decades.

I recall my first trip to Beijing. There were few paved roads, and bicycles were the primary means of transportation. Current visitors to Beijing find little remaining evidence of that era, even though it was less than 20 years ago.

One result of being global investors has been that our broad perspective has helped us more readily anticipate trouble spots. For example, our emerging-market portfolios have been underweight in China as we’ve worried about excessive stock valuations in the face of an economy in transition from export-led growth to consumer-led growth. Having seen the Shanghai Composite Index decline almost 30% during the third quarter, it’s clear that being underweight in China helped us this time.

Our bottom-up analyses of companies around the world also helped us identify Japan as having a potentially rewarding investment environment. And despite stock-market volatility similar to most countries, Japan’s Nikkei 225 was one of the few stock-market indices that were still positive (on a total-return basis) for the year to date through September 30, 2015.

As for our outlook, we believe opportunities in emerging markets have narrowed — with the best opportunities being in places like India, Mexico and Taiwan, where the political environments are fairly good and the economies are not overly dependent on commodity exports. Naturally, our outlook is being reflected in our emerging-market-focused portfolios and in our other international portfolios that include some emerging-market exposure. This means we’re increasing our country concentrations among emerging markets — but we’re still maintaining broad diversification across companies.

With sincere thanks for your continued investment and for your trust,

Sam Stewart


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