Economic Growth: Ghost Of Crises Past by Jay Leopold, ColumbiaManagement

  • The market’s extended period of low volatility was shattered in the past month.
  • While it is possible fear-driven selling could resume or accelerate, we do not believe this is the most likely outcome.
  • Given the U.S. economy’s reasonably good fundamentals, we believe that patient investors will get more treats than tricks in the future.

As a child I always loved Halloween, especially carving pumpkins, trading candy with my sister, and touring haunted houses. It has been a little less enjoyable to watch the ghosts of past crises resurface recently, creating fear in the hearts of some investors after an extended period of calm. But for investors with a longer-term horizon, there may be more treats than tricks in the future.

Economic growth and the capital markets experienced an extended period of low volatility in recent years. As a result, a sense of complacency had been building among investors. Historically, these periods of low volatility can last a number of years as seen by the VIX Index (a measure of expected volatility in the equity markets) between 1993-1997 and 2003-2007 (Exhibit 1). This environment was shattered suddenly in the past month.

Exhibit 1: CBOE Volatility Index, October 15, 2014

Economic Growth

Source: Columbia Management — U.S. Investment Risk, 10/14

Entering September, equity indices were at all-time records in the U.S. and six-year highs in Europe, while bond spreads were near generational lows. Valuation levels embedded some good news and were moderately rich compared to the past five years, but not compared to a longer historical time series, and certainly not in the context of the current low interest rate environment.

The genesis of the recent correction may have been an increasing consensus the Fed would begin to bump up rates in late 2015. Russia’s invasion of Crimea and intervention in Ukraine also may have played an important role. While there may be little direct economic impact, it shook the confidence of Europe that both depends on natural gas from Russia and would be on the front lines of a regional conflict if Russia exhibited Soviet-style aspirations. Already anemic growth in Europe has slowed further.

In addition, concerns regarding China’s growth have once again moved front and center. Finally, the unknowns regarding the spread of Ebola have contributed to the uncertainty and fear. Unforeseen events that have few precedents can affect investor psyche on the margin and lead to greater levels of risk aversion than might have been experienced otherwise. While the Ebola virus could have a real economic impact in some scenarios, in all likelihood the effect should be much more benign.

These increased worries, justified or not, broke the complacency in the capital markets, with equities plunging around the world as investors “de-risked.” From the September peak to mid-October low, S&P 500 fell roughly -8%, the smaller cap Russell 2000 -11%, and Europe indices even more. Treasuries benefitted, with the 10-yr plunging from 2.6% to 2.0% in less than a month. At the time of this writing, a portion of these significant moves have been retraced.

While scary memories of 2008 have faded somewhat, they still lurk in the far reaches of investor psychology. The recent plunge has forced many to confront emotions that had been crammed in a closet over the past several years, collecting cobwebs. The memories of 2008 likely have led to more emotional selling than might normally be expected. Market observers have often noted that October can be a scary month, especially when ghosts of past crises suddenly reappear.

Risk indicators in perspective

The U.S. Risk Dashboard measures risk appetites in the capital markets. For illustrative purposes in the VIX graph above, 84% of the daily VIX observations since 1990 were lower than the closing VIX on October 15, 2014. This score of 84 is displayed via a blue bar in Exhibit 2, indicating it is in “risk-off” territory. The bigger the blue bar, the more the risk indicator demonstrates risk aversion. Conversely, the bigger the yellow bar, the more the indicator demonstrates healthy investor risk appetites. The shorter-term VIX Index was firmly in “risk-off” territory while other indicators are collectively leaning in the same direction, but decidedly less so.

Exhibit 2: U.S. Risk Dashboard, October 15, 2014

Economic Growth

Source: Columbia Management — U.S. Investment Risk, 10/14

It is noteworthy that the fixed income “spread” risk indicators (top four on the dashboard) are more neutral, on balance. We find it comforting the fixed income market is showing relatively less sign of stress than the equity market. A more strained fixed income market can lead to a difficult lending environment, which can have a profound economic impact as we experienced in 2008.

It is also interesting to observe how the dashboard has changed in the past three months (Exhibit 3), when all indicators were exhibiting clear signs of healthy risk appetites. While these risk indicators are not meant to be buy/sell signals, it can provide investors context of the risk environment so that they can make better decisions based on their personal risk tolerances and investment style.

Exhibit 3: U.S. Risk Dashboard, July 13, 2014

Economic Growth

Source: Columbia Management — U.S. Investment Risk, 10/14

Outlook

The future is unknowable with certainty, but one can contemplate a range of outcomes. Panics can happen at any time, and it’s possible that fear-driven selling could resume or accelerate. However, we believe this is not the most likely outcome. The foundation of the U.S. economy is reasonably solid, and valuations aren’t as stretched as they were in 1987, as an example. The 1987 decline had little sustained impact on economic growth, and the market re-entered a steady bull market fairly quickly.

There appears to be only a modest risk of a multi-year, bank-driven recession and bear market developing. The health of the banking system is much stronger now than in 2007, just prior to the Great Financial Crisis. The more likely scenario is the current bout of selling reaches a climax in the next several weeks, if it hasn’t done so already. From there, the solid foundation of reasonably good fundamentals should take over. As fears of past ghosts subside, we believe patient investors are likely to receive more treats than tricks in the coming year.