Market Update: October — it always seems to happen in October!
William F. (Ted) Truscott, CEO — Global Asset Management, Columbia Management and Threadneedle Investments — October 17, 2014
From “Weaker than it looks: Growth is healthy in America and Britain. But most of the world economy is in trouble”, The Economist, 11 October, 2014, pp 15–16.
“Virtually everywhere else, however, the news is grim. The euro zone, the world’s second-biggest economic area, seems to be falling from a feeble recovery back to outright recession as Germany hits the skids. … Japan, the world’s third biggest economy, may also be on the edge of a downturn. … Even in China, still growing at a suspiciously smooth 7.5% a year, there are worries about a property bust, a credit bubble and a fall in productivity. …
The prescription for the weaklings is simple: heal thyself. Rather than waiting for America to solve their problems, the laggards should treat the recent spate of bad news as a wake-up call. The ECB should start bond-buying forthwith. The Japanese government should delay a rise in the consumption tax until the economy recovers. Countries that can afford it, notably Germany, should invest in infrastructure. And even America and Britain should be wary, especially over tightening monetary policy too quickly.”
Welcome to October — a month that more often than not seems to bring out the worst in financial markets. After such a remarkable period of calm, low interest rates, and more than five years of rising markets; the last few weeks have certainly been nauseating. What’s behind all of this and why are markets reacting now?
As the quote above suggests, worldwide growth has surprised on the downside. However, there is an even darker side to this negative surprise — the fear that deflation has not been defeated. It is my view that we have been fighting deflation ever since the financial crisis erupted over six years ago. In fact, most of the world (especially Europe) looks more like Japan than we would care to admit.
As a reminder Japan is on its third decade of anemic economic growth, disinflation and, in some areas of the economy, outright deflation. Japan’s own financial bubble popped in 1989 unleashing a powerful period of deleveraging that has hindered growth and was further exacerbated by poor policy choices and belated responses from the Central Bank of Japan. This practically ensured that disinflation/deflation would take hold and Japan has not been able to dig itself out. Even the much vaunted “Abe-nomics” has not done the trick. The lesson — once deflation becomes entrenched, it is hard to find a way out.
Central banks around the world have preferred to run the risk of inflation to avoid deflation. The tools to battle inflation are well understood and have proven effective over time, but the same cannot be said of deflation. So far, those who have expected that inflation would come roaring back have been proven all too wrong except in the area of asset prices. The world’s central banks practically ensured a rise in the price of assets by setting interest rates at a low level.
Consider the United States. In order to avoid a deflationary trap, raise asset prices and grow the economy, we have had short-term interest rates set at close to 0% for five years, not to mention aggressive quantitative easing programs and a Federal Reserve balance sheet that has ballooned to over $4 trillion. What has all this easy money produced? After six long years, we finally have an unemployment rate below 6% and some reasonable economic growth. However, it has taken very unconventional approaches to achieve these results. This means that the deflationary forces unleashed by the financial crisis and subsequent reduction in indebtedness (“deleveraging”) were indeed powerful.
Markets are now asking themselves a very nasty question. What happens if growth slows again in the U.S. and/or weak and slowing growth in Europe, Russia and China drags down U.S. and UK growth? Who will ride to the rescue? Hard to believe central banks can do much more except bond buying in Europe to mimic steps taken in the United States. Meanwhile governments around the world have been completely tone deaf to the concerns raised by their own central bankers for years. Policy makers in the government need to wake up and adopt pro-growth measures to help give their central bankers a rest.
The chart below shows that Europe is showing dangerously low levels of inflation and growth is weakening rapidly. Just how the Eurozone avoids the fate of Japan is no small matter.
There is also the matter of equity market valuation and high levels of complacency. The first set of charts below show that valuation was becoming stretched as measured by P/E, price to sales, and price to book ratios (note that the spike in the valuation charts below is the height of the dot.com bubble — a level of valuation we will hopefully never see again).
The final chart shows that the VIX (a measure of volatility in the US equity market) has been remarkably calm for the last several years despite a series of mounting risks. It was only a matter of time before complacency caught up with reality. That reality is a series of risks that markets had chosen to ignore. These include high levels of political risk around the world (Russia, China, and ISIS), concerns about growth in Europe, a slowing Chinese economy and the Ebola virus just to name a few.
In short, the stock markets in Europe and the U.S. were priced for perfection with little margin for error. A correction was likely although attempting to time changes in markets is never easy. There’s an old adage in the investment world which notes that “everyone is wrong at the turn.”
I will never be able to adequately explain to investors why markets can turn so suddenly and violently, but it is somewhat reassuring to note that the spike in the VIX is nowhere near levels reached in 2008. There are plenty of worries still out there but a return to the panic driven days of 2008 is highly unlikely. Much of the risk has been taken out of the financial system while U.S. and British banks have been recapitalized. Europe is now working on its banks.
Now, long term economic growth is the problem and the current downturn is a reaction to changes in growth expectations. This is a result of the markets getting ahead of growth expectations and ignoring all the other risks.
The road ahead
Equities continue to be the asset of choice given low levels of interest rates and poor returns on cash. However, clients need to be vigilant about the additional risk that a high equity allocation adds to a portfolio. Investment grade, municipal, and high yield bonds offer opportunity as spreads have widened and the tax advantages offered by municipal bonds are quite real.
Clients are encouraged to talk to their personal financial advisor and review not only their asset allocation but also their risk allocation. Investment products continue to evolve and there are now funds and vehicles that focus on allocating risks rather than assets. The ability to change risk allocation and adapt to changing economic and market environments may offer advantages to certain clients.
As investors continue to deal with increased volatility and unpredictable markets, now may be a good time for them to review their plans with their advisors and make adjustments to their portfolios to help ensure they are meeting their near- and long-term needs.
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