Market Commentary: Volatility Is the Toll We Pay

Volatility Is the Toll We Pay

After rising for five consecutive months, stocks have hit some weakness. This is to be expected. Investors have been rather spoiled this year, with stocks having one of their best starts. Yet, while stocks usually go up, they can also go down. Even in some of the best years, stocks tend to see double-digit corrections at some point.

  • Volatility continued last week, and that is perfectly normal for this time of year.
  • Even bull markets see periods of volatility, a point that may help put this year in perspective.
  • Credit markets continue to show very few signs of economic stress.
  • Recent economic data from China show that the world’s second largest economy is in trouble.
  • Much of China’s economic growth is driven by real estate investment, which has pulled back significantly.
  • Any adverse impact on the U.S. economy is likely to be minimal.

The S&P 500 pulled back nearly 8% in March during the regional banking crisis and recently fell nearly 5% from the late July peak. However, it’s important to remember that volatility is normal, even in bull markets, and it is the toll we pay to invest. Or as Jack Bogle, the founder of Vanguard, put it, “The stock market is a giant distraction to the business of investing.” In other words, stock market volatility can make you take your eyes off the prize of longer-term investing.

With help from our friends at Ned Davis Research, here is a helpful chart that shows just how often volatility occurs.

A few takeaways:

  • The S&P experiences more than three mild 5% corrections per year.
  • There tends to be one 10% correction per year, while a bear market happens close to every three years on average.
  • Interestingly, each year sees an average of seven separate 3% dips. While not very significant drops, they can cause quite a bit of worry.

The stock market had a great start to 2023, and it was simply time for a well-deserved break. This isn’t abnormal and is in fact quite healthy. We continue to expect stocks to reach new highs before this year is over, primarily due to action in the credit markets.

Credit spreads tell us how much extra interest over Treasury rates investors are demanding from companies that want to borrow money — if investors believe a recession is imminent, they may expect lending to companies to be more risky and hence demand higher interest rates. In other words, if there was a monster under the bed the credit markets would likely show it.

The chart below shows that during past recessions spreads have soared, but they remain quite tight currently. We think credit markets comprise the smartest investors in the room, and if they aren’t worried, the weakness in the market likely won’t get much worse and may offer an opportunity to add to equities.

What’s Happening in China?

We’ve received several questions on China recently, including how the economic turmoil there may impact the U.S. and financial markets. In short, China’s economy is in trouble. Retail sales are up just 2.5% year over year, well off the pre-pandemic average pace of 7-10%. Usually, the industrial side of the economy makes up for slow consumer spending, but not this time. Industrial production is up just 3.7% since last year, which is well below the average 6% pace before the pandemic.

Exports have also fallen almost 15% over the past year as the rest of the world shifted spending from goods to services in the post-pandemic environment. Perhaps even more concerning is that imports also fell 12% over the past year, which is a sign that internal demand in China is slowing down.

As a result, economic growth in the world’s second largest economy is set to slow meaningfully. In inflation-adjusted terms, the Chinese economy grew an average of 7.7% per year between 2010 and 2019. That’s slowed to 4.4% over the last three years (2020-2021) and may slow even further, perhaps to 3-4%.

In the U.S., just under 70% of the economy is made up of consumer spending. However, in China, consumer spending makes up less than 40%. It’s the supply side that matters more, and that is driven by investment spending, which accounts for 44% of GDP, versus about 20% in the U.S.

Problematically, much of this investment spending was in the real estate sector on the back of rising debt. Overall debt to the non-financial sector soared over the past decade, from about 140% of GDP at the end of 2008 to almost 300% at the end of 2022. Contrast that to the U.S., where it has stayed relatively steady at around 250% of GDP. This was how China grew after the global financial crisis. Much of the debt bolstered real estate activity, which by some estimates accounts for just under 30% of GDP, versus about 17% in the U.S.

However, authorities were aware that the debt drove some unproductive “investments,” including infrastructure, such as airports, bridges, and highways. Overbuilding is present on the residential side as well. The WSJ reports that about one-fifth of apartments in urban China (about 130 million units) were estimated to be unoccupied in 2018, when the latest data was available.

Authorities started clamping down a couple of years ago, and the results are evident. Investment in the real estate sector was running around 10% annually before the pandemic. As of July, real estate investment is down almost 8% year over year. So, it shouldn’t be a surprise that real estate activity has crashed. Here are some key year-over-year stats:

  • Property sales are down 15% in volume terms.
  • Floor space under construction is down 7%.
  • New home starts growth is down 26%.

This is not good news for Chinese households. The absence of safety net programs, such as Social Security and Medicare, mean Chinese households save a lot, and they typically invest income and savings in their homes or other real estate. Crashing prices means they’re less likely to spend their savings on real estate. But that also means there’s less money going into the sector.

Will China’s Troubles Impact the U.S. Economy?

From an economic perspective, there’s probably not going to be a significant adverse impact on the U.S. economy. U.S. imports from China have fallen significantly over the past year. U.S. consumers need fewer pandemic-related materials and other goods as they continue to spend more on services. There is also some decoupling occurring, with goods imports from China falling as a percentage of GDP. Currently, it is below 2% of GDP, which is the lowest it has been since 2006. Instead, imports from other countries have picked up.

Trade with China is not going to zero, but it’s likely to shrink. Note that part of what’s happening is increased trade with Asian nations such as Vietnam, Philippines, and India, as imported goods get re-routed from China to the U.S. via these countries.

The reality is that China needs the U.S. more than the other way around. The U.S. economy is reliant on consumption, which is generated internally. China, on the other hand, is dependent on investment and exports, and for that it needs external demand to be strong.

If there is any impact, it will be in the financial markets via headline risk, similar to 2015-2016 when China devalued its currency. The difference is that the U.S. economy is now on firmer footing.

If the Chinese are selling down their reserves of MBS and Treasuries, that could put more upward pressure on U.S. Treasury yields, though only at the margin since this is the most liquid market in the world. Most of what happens with yields will still be driven by U.S. growth prospects and Fed policy expectations. U.S. economic growth, in sharp contrast to China, has been resilient — rising 2.6% over the past year, which is faster than the pre-pandemic pace. And it may be accelerating in the third quarter, based on a slew of solid economic data received recently.

China’s problems didn’t start this year. We would argue they started a decade ago as growth became increasingly reliant on debt. It’s quite amazing to think that the U.S. economy is probably growing faster than the Chinese economy at this point. That’s something we haven’t seen in decades, and right now the U.S. economy’s relative strength looks set to continue.


This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.

S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly-traded companies from most sectors in the global economy, the major exception being financial services.

A diversified portfolio does not assure a profit or protect against loss in a declining market.

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