Thrills and Spills! Just another August joy ride.

“Please keep your arms and hands inside the ride at all times.  On this ride you will experience sudden drops and sharp climbs.  If you have a weak stomach, this ride may not be for you.”  We may get excited when we see this kind of sign before getting on a roller coaster ride, but few enjoy a stock market ride where such warnings apply.  During the month of August the Dow Jones Index moved in total (both up and down) more than 10,000 points—that’s 56% of the index’s starting value.  The volatility index known as the “VIX” (remember the “Worry Wall” we wrote about last summer?) moved from a low of 12 to a high of over 40 (reflecting rising concern) and is at 28 at the time of this writing.  You may be asking what in the world is going on.

Historically the months of August and September are two of the most volatile months of the year.  This year, however, we got a little extra help from the Federal Reserve and our Chinese neighbors.  The Federal Reserve had previously put the markets on notice that it was very close to raising interest rates for the first time in six years.  At the beginning of the month it was widely expected that the rate increase would happen in September.  Now, the belief is that October may be more likely.  China’s currency and the country’s slowing economy are among the culprits for the change in expectations.

Early in the month China surprised markets with a devaluation of its currency (the Yuan or Renminbi).  This was interpreted as a sign that the Chinese economy was in worse shape than expected and that the government was desperate, and possibly losing control.  Here’s why.  The Chinese Yuan is a managed currency tied to the US dollar.  As the dollar has strengthened against most other currencies over the past year, so has the Yuan.  And just as US exports suffer from a stronger dollar, so do Chinese exports from a stronger Yuan.  The initial devaluation signals the central bank’s intent to address the situation and is likely only the first of several moves that may occur over the next few years.  Questions are being raised as to whether the Chinese are doing too little too late, whether the central bank can keep from losing control of the process, whether this is a step toward currency wars, etc., all with negative implications for global growth.

But there is another reason for China to want to loosen the bond between the Yuan and the dollar.  China wants the Yuan to become a global reserve currency, like the US dollar.  For this to happen, the Yuan needs to trade freely.  Reserve currency status requires more than this, but it is another reason why China is happy to allow the Yuan to adjust (in a controlled way) to market levels.

A rate increase by the Fed is expected to result in the dollar strengthening further.  Such a development may force the Chinese into another controlled devaluation sooner than it had intended.  Given that the August devaluation sparked an outbreak of market declines and the renewal of bleak forecasts, the Fed may decide to postpone its first rate hike.

While it is evident that China’s growth is slowing, it is also important to recognize that US exports to China make up less than 1% of US GDP.  Additionally, economic data from the US continues to show strength—including employment numbers, durable goods orders, consumer confidence, and GDP.  While this supports our longer-term positive market outlook, our volatility model did lead us to reduce stock market exposure as a risk management step for many of our clients.  In addition, a couple of our hedged managers also provided a dampening effect to the overall volatility of our model portfolios during the month.

With our positive outlook, we are looking to put cash to work for our clients.  With that said, we are respecting September and the current market conditions as well as its historical volatility.  So, while buying opportunities are present, we are being careful and slow with our buys and allocations.  Now remember to keep your seat belts fastened and your arms and hands inside the vehicle—September is shaping up to be as wild a ride as August.