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The United States continues to make progress.  Yes, manufacturing slowed during the summer, but the rest of the economy is doing well.  Demand for goods and services is holding up.  More Americans are becoming employed and very few are filing for unemployment insurance.  For the first time in years, the percentage of the population with jobs is rising.  Income and spending are rising, too.

With the unemployment rate at 5.1%, the Fed is nearing its first rate increase in a decade.  The Fed believes that the best way to forecast inflation is by looking at labor market slack.  To measure that, they rely on a variety of indicators with the unemployment rate at the top of the list.  Now that the unemployment rate (5.1%) is near the low end of the Fed’s long-run estimated range (5.0 – 5.8%), a rate increase seems appropriate.

Leading up to this point, the Fed has been clear about its intentions.  For several months, markets have been anticipating the first rate increase in a decade.  The foreign exchange value of the dollar rose.  Inflation expectations are falling and real short-term rates are on the rise.  The yield curve has flattened somewhat.  Credit spreads and other measures of financial system risk aversion have increased.  The number of advancing versus declining issues on the stock market has turned down.   Foreign and commodity sensitive markets are bearing the brunt of these shifts.

Emerging Markets Struggle

Emerging market fundamentals are under stress (Exhibit A, below).  Recent volatility reflects worry over emerging market debt, currencies, and growth.  The emerging market purchasing managers index for August fell into contraction territory, for example.  The falloff in manufacturing is closely tied to China’s slowdown.  Weakening local demand is also hurting some emerging economies.  Sliding currencies are complicating matters.  Brazil’s real is down 40% versus the dollar in the last year.  Russia’s ruble is down 50%.   Malaysia’s ringgit is down 27%.  Weak currencies add to inflation and make foreign denominated debts harder to pay.  Higher inflation and concerns about creditworthiness also leads governments to become more restrictive.  The net result is slower growth and increased risk.

We’ve heard this tune before.  After rapid growth in borrowing, emerging markets are struggling to maintain a rapid pace of debt-fueled growth.  Emerging market private debt grew near 17% per year from 2009-2011.  This heavy borrowing and spending helped lift the globe out of recession.  China’s output grew from $3.5 trillion in 2007 to over $10 trillion today — an astonishing 16% per year.  Looking at emerging market economies in total, borrowings increased to 130% of Gross Domestic Product (GDP) today from 100% back in 2009, according to data from the Bank of International Settlements.  In contrast, developing countries cut total debt from 100% of GDP to 80%.  Again, rapid credit expansion helped fuel emerging market growth for a time, but the pace is proving unsustainable.  Today’s troubles in foreign markets reflect the exhaustion and overhang from the credit cycle.

Priced In?

Emerging market valuations do not appear excessive, however.  At 60% of GDP, the value of emerging market companies is far less than they were at the end of 2007.  Back then, investors were eager and willing to pay over 130% of GDP to own an average emerging market stock.  In past cycles, emerging market capitalization to GDP ratios bottomed closer to 40-50% of GDP.  While emerging market valuations are improved, growth in the United States is more consistent.  Hence, we are maintaining our domestic focus.

Portfolio Posture 

We continue to focus on fundamentals such as balance sheet quality, consistency of cash flow, and valuations.  Stock / bond allocations remain near neutral levels.  Duration remains relatively short and we remain underweight in credit.  Portfolios remain tilted toward U.S. dollar investments over foreign currency denominated investments.  Favored sectors include consumer discretionary, healthcare, and financials.

Emerging Markets Key Statistics
September 8, 2015
External Debt (Bil$)Gross Domestic Product (Bil$)Foreign Exchange Reserves (Bil$)Foreign Exchange Reserves (% Chg. 1-Year)Currency vs. U.S. Dollar (% Chg. 1-Year)Debt % Gross Domestic ProductDebt % Foreign Exchange ReservesMarket Cap (Bil$)Mkt Cap to GDP (Bil$)Weight in MSCI EM Index
China$863$10,360$3,558-10.4%-3.6%8%24%$5,0350.4918%
South Korea$421$1,410$3680.1%-14.7%30%114%$1,1010.7815%
Taiwan$181$355$4250.4%-8.8%51%43%$3510.9912%
India$476$2,067$32812.7%-9.4%23%145%$1,3830.678%
South Africa$144$350$39-7.4%-21.6%41%372%$4151.198%
Brazil$699$2,346$370-2.3%-40.3%30%189%$2,1410.917%
Mexico$283$1,283$186-3.0%-21.9%22%153%$3960.315%
Russia$556$1,861$313-27.5%-46.0%30%177%$3910.214%
Malaysia$794$327$93-27.2%-26.9%243%857%$3411.043%
Indonesia$304$889$105-5.3%-17.9%34%289%$3090.352%
Thailand$137$374$150-7.0%-11.2%37%91%$3510.942%
Philippines$75$285$80-0.8%-7.1%26%94%$2310.811%
Source: Bloomberg

Asset Allocation Portfolio Posture

LONG-RUN STRATEGIC POSTURE:  Strategic allocations are set to reflect our long-run forecasts for key asset classes.  We expect policy rates to remain low as central banks continue to push lower-for-longer rate strategies.  Eventually, rates should rise back to more normal levels, but this is expected to happen gradually and unevenly.  Fixed income returns are expected to lag current yields as rates rise.  Equity returns will track moderate growth in global GDP with little to no further lift from margin expansion (margins are already elevated).  Equity valuations appear reasonable and in line with historic multiples, so no additional return is being attributed to margin expansion.

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.
Kevin Caron, Portfolio Manager
Chad Morganlander, Portfolio Manager
Matthew Battipaglia, Analyst
Suzanne Ashley, Analyst


Disclosure

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small company stocks are typically more volatile and carry additional risks, since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.

There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events.  Investing in emerging markets may involve greater risk and volatility than investing in more developed countries.