Over the past two weeks, the global financial markets have experienced a rough start to the New Year. The following pages provide an explanation of recent volatility, our outlook for global markets, and our views of prudent investor responses.
Reasons behind Recent Volatility – We see two primary influences behind the recent decline in stock prices:
Reason 1: Slower Growth in China
China, the world’s second largest economy, is undergoing an economic transition. Policymakers are seeking to rebalance the economy away from export and manufacturing dependency, common among emerging economies, and toward increased household consumption and services. As a result, China’s growth rate is naturally slowing from a double-digit pace experienced for much of the past 25 years. This will be a longer-term transition, but one with positive and negative repercussions across the world economy. More recently, we have seen the negative impacts of slower Chinese growth on commodity producers. A successful longer-term transition should prove positive for the world economy as China’s large and fast-growing middle class increases consumption of goods and services common among developed economies.
It is certainly not easy to transition a $10 trillion economy. Despite the challenges, policymakers in China have made good progress. Services have grown to 51% of the economy, up from 44% just five years ago. Today, China is growing at a more sustainable 6.9% year-over-year pace. While growth is expected to slow further, the country does not need to grow as fast to have the same influence on the world as it did just a few years ago given its larger size (now 15% or world GDP, up from 9% just 5 years ago). What is America’s exposure? China accounts for 7% of U.S. exports or less than 1% of GDP. China comprises 20% of U.S. imports, so as its currency has weakened, imported goods have become less expensive for American consumers. Countries most exposed to the China slowdown are those with higher levels of exports to the country, including Australia, Taiwan, South Korea, Brazil, and Japan.
Reason 2: Investors are Questioning the Federal Reserve
A second key driver of market volatility has surrounded expectations for Federal Reserve policy. The Fed is seeking to gradually withdraw emergency stimulus applied during the credit crisis of 2008. The Fed believes economic conditions are strong enough to slowly return rates back to normal levels. However, the view of “slow” between the markets and Fed appears to be different today. Fed members expect four rate hikes in 2016 compared to two hikes expected by the financial markets. Efforts by the Fed to raise rates have fueled strength in the U.S. dollar, which has risen 25% over the past 20 months. A stronger dollar, while benefitting consumer purchasing power, has hindered corporate profits and exacerbated declines in the commodity markets. In essence, we believe the markets are sending a cautionary message to the Fed that the global economy may not be able to handle the pace of rate increases currently anticipated. We suspect the Fed will listen to the markets message as it has many times before.
There have been few areas to hide amid the market sell-off with most major indices (both domestic and international) down between 8-12% in 2016 alone. Continuing weakness prevalent last year, the S&P 500 is now down 12% from prior highs. However, looking under the hood reveals the average stock has fallen more than this index would suggest. 56% of stocks in the S&P 500 have already declined over 20%. Looking to other areas of the global markets, small cap stocks have declined 23% and foreign stocks are down between 22-30% since July 2014. Returns of the S&P 500 index have been buffered by a handful of stocks termed the FANGs (Facebook, Amazon, Netflix and Google). While these four stocks have not escaped selling pressure this year, they have gained 55% since the beginning of 2015 versus -13% for the other 496 stocks in the index.
Assuming the brunt of market weakness have been economically-sensitive companies, particularly those in the energy sector. Oil prices have fallen 73% since the June 2014 highs, posing difficulties for producers with business models and financing dependent upon higher prices. When commodities declined to low levels in the 1980s, consumers benefitted greatly, but the industry landscape for producers changed considerably as weaker companies succumbed to new pricing dynamics. We are seeing many similarities today.
Because of the increased risk of default among commodity producers, high yield bonds have struggled, declining 3% this year and more than 12% from prior highs. The investment grade portion of the domestic bond market has fared better with the BarCap Aggregate Bond Index returning 1.0% this year. While bonds have provided valuable capital preservation this year, gains in the asset class have been limited by todays low-rate environment.
How to Approach recent Declines
While investors are unable to control the markets, we can control how we respond to changing conditions. We think the following considerations make sense in light of recent market developments:
- Recognize investor sentiment and media reports are very negative today. Investors have to be careful not to be swayed by dramatic predictions or overly pessimistic articles. With the 2007-2009 global credit crisis still fresh in investors’ minds, people are naturally referring back to this latest crisis and fearing a repeat. While there may be more challenges ahead for the markets, we believe things are very different today compared to 2008. U.S. fundamentals are relatively solid and we see little sign of financial excess in the U.S. that typically ends economic expansions (such as those that existed with real estate and subprime debt in the mid-2000s or technology in the late 1990s). Remember, extremes in market sentiment have historically proven as good contrary indicators longer-term.
- Be prepared for higher volatility in the near term. The recent sell-off has certainly raised concern. In reality, intra-year declines of 8-12% are relatively common, as seen in the chart below. Over the past 35 years, there have been 18 instances where the intra-year decline has been greater than 10% and in 11 of those 18 years the S&P 500 finished positive for the year. Furthermore, the market has typically seen 10% corrections once every 12 months and 20% corrections once every 3 years. While we have not officially seen a 20% correction since 2011, many stocks and global indices have already seen similar or greater declines, as highlighted above. In the absence of a recession it is difficult to see the average stock down a lot further.
- Remain diversified and avoid trying to time the market. Recent market performance trends may encourage (1) a departure from a prudent asset allocation; (2) abandoning a global approach to investing; or (3) attempts to time the market. All three of these responses have the potential to hurt long-term results. Diversified portfolios have been penalized over the past several years due to a narrowing market advance and S&P 500 dominance. We expect the benefits of diversification reassert themselves.
- Savers should consider dollar-cost averaging idle cash since recent declines should eventually prove as an opportunity. With bond yields near record lows, commodities likely entering an extended low trading range, and cash earning little to nothing, global equities remain the most attractive asset class on a longer-term basis in our view.
- For clients relying on income from investments, a primary consideration should be to assure sufficient cash is available to meet upcoming spending needs. Remember, the investments getting hit the hardest in the current decline are your longest-term assets. In a properly diversified portfolio, cash and fixed income can be used as sources of liquidity until equity prices recover
- Tax-loss harvesting can be used within taxable accounts to realize losses and offset future gains.
- Pursue attractive income and suppress volatility through dividend-paying strategies. 42% of stocks in the S&P 500 yield more than 10yr Treasuries and 73% of European stocks yield more than the European bond yield. Dividend-paying strategies often outperform during periods of volatility and have been out-of-favor after poor performance in 2015. We expect better results in 2016
- If market volatility is too much, consider shifting asset allocation rather than going to cash. We have found over time, investors have a tendency to sell out at the wrong time when emotions are high, only buy back in after markets have long recovered. Changing the asset mix is a less dramatic step that leaves a portfolio invested and more consistent with longer-term goals
- Favor large over small caps. Periods of volatility and rising credit spreads have historically posed challenges for small caps.
- Dont get bitten by the FANGs. The handful of companies leading recent market returns (i.e. Facebook, Amazon, Netflix, Google etc.) appear expensive and warrant caution even though they appear to be great businesses. Conversely, there is attractive rebound potential among economically sensitive sectors, which are currently inexpensive following several years of sharp underperformance.