Stock Market Downturn: Always Seems To Happen In October! by Ted Truscott, ColumbiaManagement
- Markets are now asking 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 U.K. growth?
- The stock market downturn is a reaction to changes in growth expectations and the volatility of that growth. Market assumptions for steady growth did not necessarily account for all the other risks.
- While we continue to see equities as an important pillar of longer term allocation strategies, investors need to be vigilant about the levels of risk that a high-equity allocation adds to a portfolio.
“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 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?
1) 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. Japan is in 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 recover. Even the much vaunted “Abenomics” has not done the trick. The lesson: once deflation becomes entrenched, it is hard to find a way out. As for the U.S., its competitive strengths are significant enough to outperform a modestly growing global economy, but its links to the broader world are too deep for it to completely decouple should global growth stall further.
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. The same cannot be said of deflation. So far those who have expected that inflation would come roaring back have been proven 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. To avoid a deflationary trap, raise asset prices and grow the economy, we have set short-term interest rates 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 U.K. 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 U.S. Meanwhile, governments around the world have been completely tone deaf to the concerns raised by their own central bankers for many years. Policymakers around the world need to wake up and adopt substantive reform measures to support longer term growth and give their central bankers a rest.
Exhibit 1 shows that Europe is showing dangerously low levels of inflation and growth is weakening rapidly. Just how the eurozone will avoid the fate of Japan is no small matter.
Exhibit 1: Euro area inflation
2) There is then the issue of equity market valuation and high levels of complacency. Valuation was becoming stretched, as measured by cyclically adjusted P/E ratios, 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 (Exhibit 2). Exhibit 3 shows that the VIX (a measure of volatility in the U.S. 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 chose to ignore. These include high levels of political risk around the world (Russia, China, ISIS), concerns about growth in Europe, a slowing Chinese economy and Ebola. In short, the stock markets in Europe and the U.S. were priced for a steady recovery with little margin for error. A correction was likely, although timing changes in markets is never easy. According to an adage in the investment world, “Everyone is wrong at the turn.”
Exhibit 2: U.S. stock market valuation
Exhibit 3: U.S. stock market volatility
I will never be able to explain adequately to clients 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, 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.
Long-term economic growth is now the problem, and the current downturn is a reaction to changes in growth expectations and the volatility of that growth. Market assumptions for steady growth did not necessarily account for all the other risks.
The road ahead
It is important in these times of market volatility (positive or negative) to keep a calm, long-term perspective. With market realization of risks inevitably comes overreaction and opportunity. Keeping one’s long-term goals and plans front and center is particularly crucial when things appear most turbulent. We continue to see equities as an important pillar of longer term allocation strategies, given low interest rates and poor returns on cash. However, investors need to be vigilant about the levels of 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. Investors should consider not only their asset allocation but also risk allocation. Investment solutions continue to evolve, and there are now strategies that focus on allocating risks rather than assets. The ability to adapt to changing market environments and adjust risk allocations accordingly may offer advantages for the long-term investor.
*“Weaker than it looks,” The Economist, 11 October, 2014, pp15-16