Global markets hit a rough patch


The selloff in markets around the world appears to have a variety of catalysts. The two factors that many investors have fixated on are a slowdown in China and the timing of the US Federal Reserve’s rate-hiking cycle.

Policymakers in China have implemented extraordinary measures to try to put a floor under equity markets, while cushioning a slowdown in economic growth. China’s slowdown, an oversupply in crude oil and a strong US dollar have driven commodity prices to multiyear lows, challenging nations that are dependent on oil revenues. Meanwhile, as the Federal Reserve approaches its first rate increase, the markets have become increasingly concerned about the potential ripple effects — particularly in currency markets — with memories of 2013’s “taper tantrum” still fresh. Emerging markets broadly have been under pressure of late with weakness in export markets, recessions in Russia and Brazil and political uncertainty in Turkey.

Middling growth in the US and continental Europe, combined with the latest market turmoil and deflationary forces from China’s devaluation, suggest the US Federal Reserve and the Bank of England may not be able to begin their policy normalization processes as soon as had been expected. This would be yet another sign that the global economy has not completely healed following the global financial crisis and still relies on continuing central bank stimulus.

Currency devaluations

China’s devaluation of the renminbi earlier this month was small in size, roughly 4.5 percent, but large in symbolism. Many market participants took the move as a sign that conventional methods of supporting China’s export-dependent domestic economy (and financial markets) had run their course and that more-drastic measures were needed. This concern is likely overblown, as currency devaluation is just another means of stimulating growth. Nonetheless, with recent interventions in equity markets and the currency devaluation failing to stem the tide, Chinese policymakers are implementing more traditional measures. On 25 August, the Chinese central bank lowered the reserve requirement ratio by 0.50 percentage point and cut the one-year lending rate by 0.25 percentage point.

Despite the tendency of countries to seek weaker currencies to boost their export sectors and to stave off deflationary pressures, China’s move caught the market unprepared. China’s attempts to stabilize its markets through intervention and trading halts have proved largely ineffective. The real economy continues to be weak, with manufacturing surveys showing a contraction in that all-important sector. While China is seeking to rebalance its economic drivers from fixed investment to consumption — a process that could take years, if not a decade — it needs to maintain its export sector so as to create the conditions where jobs and consumer confidence support that transition. That’s a tall order in the best of times and very difficult amid intense market volatility.

Commodity prices

Commodities have performed poorly against this macro backdrop, heavily weighing on the energy, materials and industrial sectors as well as on commodity-exporting nations. Sluggish global growth and a strong US dollar are major contributing factors. We are now at an inflection point: Growth could get a boost from lower input costs or world growth could flatten out as profits begin to fall.

It’s worth noting that commodity prices have caused recessions in the past, but it has usually been a result of rising prices restraining growth. Low oil prices have historically led to higher global growth, so the recent drop could help cushion any slowdown. So could a delay in the Federal Reserve’s long-awaited first interest rate hike.

Emerging markets

Several important cyclical factors that lent support to emerging market debt in the years leading up to and through the global financial crisis have shifted more recently to become headwinds. Slower global growth (and a reduction in global trade), weaker commodity prices and a gradual shift toward a less accommodative Fed policy have been weighing on several emerging market economies. This dynamic accentuates the already notable degree of fundamental differentiation between emerging market issuers.

These cyclical factors have contributed to credit deterioration in some countries, while others are making relatively good progress in adjusting to new economic realities. We expect a discriminating market to reward issuers making progress toward reforms aimed at restoring macro balances, while ultimately punishing those that fail to capitalize on opportunities to implement improved policy. As always, careful selectivity, with an emphasis on bottom-up country allocation will be critical over the long term.

Investment implications

Turning to the equity perspective, the recent jump in market volatility is not without precedent. Since 1980, the S&P 500 Index has fallen in excess of 5% in a week 28 times. The index has recovered those losses within four weeks more than 70% of the time. That said, we’ve not had a 10% correction in the S&P 500 for nearly four years, so the volatility we’re seeing now looks far worse compared to the unusually low levels of equity market volatility we’ve experienced in recent years. We feel it’s important not to overreact to what might be a return to a normal environment. This sell-off has created more reasonable equity valuations. With lower commodity prices, minimal wage pressure and low inflation, many companies should be able to generate mid-single digit earnings per share growth, which may provide compelling buying opportunities.

We feel the persistence of a global environment of slow growth, low inflation and easy monetary policy will continue to be reasonably supportive for risk assets, although bouts of volatility are to be expected. Overall, near-term volatility does not impact the way we invest. Thus we are approaching the current market environment in the context of our discipline as long-term investors, taking advantage of price volatility to buy attractively valued companies and making investment decisions based on our confidence in the long-term prospects of the individual securities in our portfolios.

Bond Investors Struggle With Recent Losses

As U.S. stocks continue their recent rally, the bond markets gave up ground in May and so far in June.  U.S. bond funds suffered their second-worst withdrawals last week in more than two decades after speculation about an eventual end to the Federal Reserve’s bond purchases sent fixed-income markets lower.

Investors pulled $9.1 billion from fixed-income mutual funds and exchange-traded funds in the week ended June 5, Denver-based Lipper said yesterday in an e-mailed statement. That’s the second-biggest redemptions for a week since the company started tracking the data in 1992. Corporate high-yield funds saw redemptions of $3.2 billion, Lipper said, the largest weekly withdrawal on record.

While retail investors have favored the perceived safety of bond funds over equity funds since the financial crisis, money managers and analysts have been predicting a reversal as interest rates near zero would eventually rise and send bond prices lower. Global bond markets posted their biggest monthly losses in nine years in May, as the more than $40 trillion of bonds in the Bank of America Merrill Lynch Global Broad Market Index fell 1.5 percent on average.

Market ‘Disarray’

Federal Reserve Chairman Ben S. Bernanke told Congress on May 22 that the central bank’s policy-setting board could start scaling back its bond purchases in its “next few meetings,” if the U.S. employment outlook shows sustained improvement.

Economists polled by Bloomberg this week predicted the Fed will trim its so-called quantitative easing program to $65 billion a month at the Oct. 29-30 meeting of the Federal Open Market Committee, from the current level of $85 billion.

‘Keeps Going’

“Every year for the past four years, people have said the bond trade is over and yet it keeps going,” Lee Spelman, head of U.S. equity client portfolio managers at New York-based JP Morgan Asset Management, said in an interview last month.

Economists surveyed by Bloomberg expect U.S. rates to rise over the next four quarters.

Jeffrey Gundlach disagrees. The manager of the $41 billion DoubleLine Total Return Fund, said this week that while rates may move higher in the near-term, he expects the yield on the 10-year U.S. Treasury note to drop to 1.7 percent by the end of the year. It closed yesterday at 2.08 percent, according to data compiled by Bloomberg.  “It’s a horrible time to be exiting bonds,” Gundlach said.

Meanwhile, Loomis Sayles & Co. is buying 30-year Treasury bonds on a bet that the Federal Reserve will continue printing money, according to money manager, Matt Eagan.  The Fed’s bond-buying plan “will be around longer than the market thought,” Eagan, who is co-portfolio manager of the Loomis Sayles Strategic Alpha Fund and Strategic Income Fund, told reporters in London today. “The economy is not strong enough despite the recovery. The market is getting ahead of itself. Even if the Fed starts to taper, they will still be injecting liquidity into the market.”

Source: Bloomberg News


From Here to QEternity

It’s been just over four years since the Federal Reserve announced the first of several rounds of Quantitative Easing (“QE”) programs launching the most aggressive monetary intervention program in U.S. history.  Every time one of the QE programs has ended the economy and markets have pulled back.  So this last time the Fed stepped back in, it decided to leave the program open-ended.

In case you are wondering how long this round will last?  In short, we do not know, however, it may be longer than you can imagine – if history is a guide.

In 1935, at the urging of the US Treasury, the Federal Reserve announced a standing bid for US Treasuries at 2.5% (the price depended on the maturity and coupon rate of the bonds). This standing bid essentially put a floor underneath the price of US Treasury bonds so that any buyer of bonds had limited risk. This was the point. The US government needed bond buyers to be confident of their purchases.  This standing bid lasted for 17 years, until 1951.

During this time, inflation fluctuated wildly due to the recession of 1937-1939, the second World War, and the boom that followed that war. Inflation was briefly negative at a couple of points during that time frame, and also reached near 20%. And the yield on US Treasuries never rose above 2.5% because of the Fed.

The point is that Keynes, the noted economist, might have been wrong about many things, but one statement stands out as solid – the markets can remain irrational longer than you can remain solvent. Of course this statement requires an ending phrase – particularly when the market is driven by a guy with a printing press!

Source: Rodney Johnson, HS Dent Investment Management

The Truth About Sequester Cuts

Brinkmanship over sequestration has reached a fever pitch as the next deadline draws near.  According to the administration and other Washington actors, the cuts that have been scheduled for the past eighteen months will have a devastating affect on such things as teachers, air traffic, medical science and deployment of aircraft carriers, etc.  So why are the investment markets largely discounting these so-called “draconian” measures?

Most likely the reason is that investment professionals are used to deciphering accounting reports and cutting through the spin to get to the real story.  In this case, the real story is that sequester cuts are not actual decreases in spending.  They are mostly cuts in the rate of increases in government’s spending of our tax dollars – and they are relatively small cuts at that.

The Congressional Budget Office (CBO) has provided spending projections before and after sequestration.  In the first year, the federal government would spend $3.62 trillion with sequestration versus $3.69 trillion otherwise.  By 2021, the government would spend $5.26 trillion versus the $5.41 trillion expected.

Taking this all into consideration, economists are projecting that sequestration will still have a negative impact on GDP.  Since stock markets tend to lead the economy, it is curious that the markets continue to rise in the face of what is looking more and more like an eventuality.  For the time being, it appears that investors are not buying what Washington politicians are selling.  Of course, this could all change very quickly which is why a nimble, active investment approach continues to be warranted.




Late Night Fiscal Deal is Done

As many expected, Congress put together a deal to avert the fiscal cliff at the eleventh hour.  The bill heads off the massive tax hikes that were scheduled to take effect and shuts down the automatic spending cuts that were negotiated back in 2011.  Removing this lingering uncertainty has cheered investors for the time being, and markets have moved up on the news.
While the Bush-era tax cuts were made permanent by the bill and the most dire fiscal cliff scenario was averted in the near term, the deal still contains tax hikes on just about everyone.  It raises income taxes for the “wealthy”, dividend taxes, death taxes and payroll taxes.  These are on top of new Obama-era tax hikes (for example, Obamacare tax on net investment income).
Unfortunately, this particular deal does not meaningfully address spending or job creation.  Further, as the bill was rushed through in the dark of the night, Congress managed to stuff pork-barrell programs into the package.
It remains to be seen what the impact of this bill will be on the economy.  Early estimates are that it will shift $600 billion out of the private economy to spend on government programs.  Also, Congress has once again kicked the issue of spending cuts and entitlement reform down the road setting up more of the same brinkmanship later this year.


What’s all the fuss about the Fiscal Cliff?

If you are like most people, you probably are getting tired of hearing about the so-called fiscal cliff.  At its core, this issue is about government spending and tax revenue.  Most citizens, unlike many of our elected officials, understand that our current spending levels are unsustainable.  This is largely because our entitled programs, which make up the majority of government spending, are broken.  Simply, they are projected to pay out more than they are taking in.  Legislators in Washington – at least the ones who believe the programs are broken – cannot agree on how to fix these programs.  The others are just willing to pass the problem along to future generations.

But what about the revenue side of the equation?  Some feel that raising taxes particularly on the rich can solve the problem.  This is another point of contention.  Any discussion of raising taxes should start with some basic understanding of taxes and rates.  Following is a link to a video that offers a very good explanation of this topic.  You may find this helpful as you filter the news about the ongoing fiscal cliff brinkmanship in Washington D.C.