Market Volatility: Goldilocks In Peril? by Robert McConnaughey, Columbia Threadneedle Investments
- We have been in a “Goldilocks” economy, where growth was persistent, but still modest enough to be supported by central bank easing at any sign of weakness.
- That backdrop is changing, with stresses emanating from the emerging markets and limits to incremental central bank actions.
- However, we do not see a structural crisis at hand and interesting opportunities are being revealed in the recent sell-off.
In the years since the financial crisis, we have been in what many observers have termed a “Goldilocks” economy where growth was persistent, but it was still modest enough to be supported by central bank easing at any sign of weakness. This backdrop allowed for healthy market returns for quite some time. However, this past week’s broad market decline raises questions as to whether there are cracks in the “not too hot, not too cold” economic storyline. I believe there are significant challenges to that backdrop persisting. However, such a shift does not mean that we need to run for the hills. We may need to be selective, but there are definitely interesting opportunities arising to find great entry points amidst the sell-off. Let’s examine the keys to what had been a “win-win” environment along with what has changed in order to determine a path to choose from this point forward.
Emerging market growth no longer lifting all boats
Even if modest, there has been enough overall growth to keep the engines of recovery humming. Emerging market growth well in excess of developed markets, led by Chinese strength, had been an important pillar of this backdrop. The difference now is that emerging market growth is faltering badly, with particular concerns regarding uncertainties in China. While official Chinese data is always controversial, it is increasingly clear from other specific and confirmable economic activity data that the official 7% GDP target is unlikely to be achieved in any sustainable manner.
More central bank largesse may not be the answer
Through the recovery, each setback in growth was met with forceful central bank action (at least credible threat of action). Good news was good for markets and modestly bad news was also, as it signaled more easing. U.S. Fed action was followed by European and Japanese easing and, more recently, the new big player on the scene, China, getting into the mix. But this raises two concerns. First, the incremental outlook for the central bank “cavalry” riding to the rescue is negative. The question for the U.S. Fed is not if, but when they will raise rates and uncertainties have increased regarding incremental policy actions in Japan, Europe and China filling that potential void. Further, this does not answer the question of whether further easing would actually fundamentally help if it did occur. Many strategists and economists rely on models based on the premise that lower rates/incremental liquidity always eventually leads to a growth response.
But this raises basic questions about the nature of the current global problem. Is it a lack of (cheap) credit? Not to my mind. I would focus on the challenge of massive amounts of global production capacity seeing returns eroded by forces of globalization and technological change intersecting with a normalization of unsustainable demand from China. It is increasingly apparent that virtually every capital-intensive business that operates versus a global set of competitors is struggling with pricing their products today. Perhaps the situation rhymes with the Japanese experience of the last 20 years where very low interest rates did little to fix a massive misallocation of capital, even probably delaying steps toward a real healing process by keeping “zombie” capacity in place.
Market faith in Chinese technocrats eroding
There has never been any shortage of skeptics regarding the sustainability of the Chinese growth model. The concerns regarding a low-cost export model and high levels of centrally planned, low ROE fixed-asset investment are well known. These concerns have always been well balanced by the faith of China bulls who would always respond that the central government had vast capital reserves, was well aware of the problems, and had both the will and skill to find solutions. Recent events have emboldened the skeptics and increased the discount rate on Chinese growth trajectory. Awkwardly handled interventions in the wildly volatile equity markets, the recent devaluation of the RMB, and the appearance of a significant ratcheting back of any longer term reform agenda have all raised concerns. Furthermore, these actions have been unfolded with a complete lack of policy transparency or clearly articulated agenda. Given the significance of China as a source of global demand as well as competitive supply, an increase in perceived risk there has a far-reaching impact on markets. We are very focused on analysis of incremental Chinese policy from here.
Further profit margin expansion not a sure thing
Through the recovery, incrementally more disciplined corporate management has been able to convert modest, but fairly stable top-line growth into healthy profit and cash flow growth. Beyond basic belt-tightening, “off-shoring” capital intensive/lower value added processes and technological innovation (automation, cloud computing) has delivered significant results. Again, the U.S. led the way in this regard, but there has been progress in the rest of the developed world as well. In turn, this has helped to heal government finances and the employment picture. Opportunities remain for greater corporate efficiencies around the world, but this is not a given. The U.S. has already reached historically high levels overall and the cultural changes necessary to deliver sustained gains in Europe, Japan and China are not a given.
Important that geopolitics remains at a manageable simmer
While there have been notable challenging events (Greece, Ukraine, the rise of ISIS), there have been no geopolitical crises acute enough in recent years to derail broader stability and recovery. A world already strained by efforts to recover from financial crisis and sustain economic momentum may be less resilient to major shocks. We will hope that we are not faced with such a challenge.
We are not in a structural crisis and opportunities are being uncovered by market declines
It is very difficult to point to a “rising tide” that is going to lift all boats and some real incremental risks have definitely arisen. However, I do not see us entering a widespread structural “crisis.” What I do see is an environment where neither overall global growth or central bank policy will rescue uneconomic, inefficient production capacity. There will eventually be a necessary wave of closures of uncompetitive businesses. It will be increasingly important to ensure that any investment we make is made with an intense focus on fundamental competitiveness. We do see interesting values emerging from this sell-off, but avoiding “value traps” will be crucial.
Against this backdrop, we see opportunities in:
- “Scarce growth” situations
- Businesses that are truly innovative and/or high barrier to entry (think software/ biotech or some monopoly structures).
- The U.S. has a disproportionate share of such businesses.
- This sell-off is presenting new buying opportunities where the long-term story has not changed but valuations have become far more forgiving.
- “Self-help” stories (where structural changes to capture more value from the revenue available is possible)
- Cost cutting
- Government or corporate reform stories (India and Japan are examples of markets with potential on both fronts)
- In sectors that are being broadly routed, we are beginning to see security selection opportunities where “babies are thrown out with the bathwater.”
- An example would be parts of the energy industry where economics are more driven by throughput volume than commodity price. These companies may not be fundamentally immune to sector pain, but they have been disproportionately punished.
- Also worth noting is the pain in investment-grade fixed income, where some examples of M&A or activist activity straining balance sheets has caused a “shoot first, ask questions later” widening of spreads across the sector.