China Ripple Effect

We mentioned in our recent Q1 investment commentary that we believed, moving into early 2014, the risk of a market pull-back or correction had increased for a number of reasons: 1) the market’s extraordinary gain in 2013, 2) concerns over initiation of Federal Reserve taper, 3) concerns over slower growth in China, 4) divergences in certain technical market indicators, 5) having gone over two years without a correction of 10% or more, which is about twice the statistical norm.

Over the past seven trading sessions, the market measured by the S&P500 has declined about 3.5%. The reason? China. Investors have become more concerned that growth in China may be slower than previously expected. This has a potential “ripple effect” particularly to emerging market economies which are more heavily dependent economically on China. We believe these issues will prove transitory, or an “adjustment”, in the overall global growth outlook, and should not have too great an impact on U.S. companies. If the Chinese economy does slow to a degree much greater than expected, it could have some impact on U.S. corporate earnings to a greater degree than we now expect.

With respect to our investment strategy, we continue to remain more heavily weighted in U.S. stocks. In international stocks, we do have exposure to EAFE, a broad international index, but we are underweighted in emerging markets equities. We believe fundamentals for U.S. stocks remain generally positive: earnings growth is expected to accelerate in 2014; U.S. corporations continue to hold record levels of cash; M&A activity should remain strong in 2014; inflation remains subdued. Positive investor sentiment has become somewhat more of a concern but at 14.8x 2014 earnings, valuation is not excessive.

As we always do, we are keeping a close eye on developments in China and emerging markets.  We  have not changed our view that the risk of a 10% or greater pullback in the U.S. stock market has increased. However, we would view such a correction as a normal “adjustment” within a longer term bull market, and as of now, we are taking no specific actions to change investment allocations or strategy. As a reminder, an important way in which we aim to buffer client portfolios from market volatility is through our strategy of asset class diversification. This diversification helps to reduce sensitivity to changes in equity prices and, thereby, reduce portfolio volatility with the ultimate long-term goal of improved risk adjusted return.