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.
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.
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.
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.
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.