Markets sustained sharp losses in the past week. Friday was particularly unnerving and today looks to be even worse. Having reached record highs just three months ago, global equities have fallen by nearly 15% marking this slide an official correction. Yet, as ugly as the price action is, we recommend staying the course. The current negative sentiment and price momentum are exacerbating three fears: slowing global growth led by a slowdown in China; falling oil prices; and higher rates from the Fed. Surprisingly, given the level of volatility, there is relatively little trading volume.
Economic fundamentals are a good deal better than the financial headlines would have one believe. The US is fine, generating more than 200,000 jobs per month and building 1.2 million new homes this year. Europe is growing far better than consensus expectations of just a few months ago, with strong growth from Germany and the UK and solid recoveries in Spain, Ireland, and the Nordics. Even Greece is being sorted out. Yes, there are valid concerns. There always are. China is maturing and transitioning to a more balanced economy and will undoubtedly experience rough spots along the way. Its growth will likely decelerate toward a rate of 5% but it’s still 5% from the second largest economy in the world. Oil is down sharply as are many other commodities, not because demand has suddenly disappeared but because capacity and supplies have expanded too much over the past several years. As production declines on these lower prices, this supply/demand imbalance should stabilize. Lest we forget, there is tremendous economic stimulus derived from lower oil and commodity prices even for China, which is a significant net importer. Finally, yes, the Fed will likely begin to raise interest rates this year in September or later, but for good reason: growth is sustainable without an ongoing zero interest rate policy. We will be far more concerned when the Fed has been raising rates for a period of time and then stops. This usually presages a recession is at hand and a big market correction – big being 25% or more is forthcoming. While this is a possibility, we do not think it to be the case today.
Consequently, if we are in a correction, what has history shown us and how concerned should you be? As noted, we believe fundamentals are generally positive and supportive of continued growth for three or more years in this business cycle. It has been almost four years exactly since the last significant confidence crisis. In August 2011, the consensus was convinced Europe was on the verge of collapse and the Euro would be dissolved. Then, the consensus was far too pessimistic. The Euro did subsequently decline by over 20%, but this allowed the continent to recover, driving European and global markets to new highs. This was a great opportunity to tax loss harvest and remain invested, which we did at the time for our clients. Today, markets are obsessed with slowing Chinese growth and in particular were alarmed by China’s 3% devaluation of the Yuan two weeks ago. In reality, the Yuan has traded significantly higher against the US Dollar for the past several years and has become ‘rich’ versus the Euro, Yen, and many Asian currencies. Given their significant foreign currency reserves, China has the ability to hold the Yuan at current levels or reset it lower. Either is possible, but we suspect a slight and gradual depreciation of the Yuan. This should enable China to regain some of its competitiveness and export growth over time.
In the short term, sentiment plays a major role in capital markets and the current level of volatility is seriously impacting it. This is partly a frame of reference issue. Post 2011, annual volatility has been abnormally low at 4-6% so the current level feels frightening. Over the past 35 years, intra-year declines of 8-20% have been the norm. Since 1980, the average decline has been 14%. Take out the down years and the average annual correction for the 27 up years has been 11%. Even in those years in which the Fed has initiated a change in policy from loose back to normal, the average correction has been 12%—before recovering all of this over nine months and subsequently going to higher highs over the ensuing three plus years.
We believe we are in a normal corrective phase in the markets and not the beginning of something worse. Since the mid-May highs, global equities are off 15% while US municipal bonds and Treasuries are up about 1%. Everything else: alternatives, credit, and real assets, are largely in between. Year to date, equities are down about 5% and quality bonds are flat. If we are right in our views and this correction plays out in line with historical averages for depth and duration, 2015 will likely be a flat to slightly down year. Historically, after periods of mediocre returns, the markets have been quick to recover and quite well, in fact. According to data from S&P, since 1918, there have been 11 instances of calendar years in which the S&P 500 was up or down by 3% or less. In the subsequent calendar year, the market rose an average 13.3% and gained in price 82% of the time. Up is the persistent direction over time, albeit with short term swings.
As always, please call with any questions or concerns.
Chief Investment Officer