Macro

Assessing the Fallout from the Market Turmoil

August 5th, 2015 | By Nick Sargen

Highlights

Amid extraordinary volatility in financial markets this month, I have been meeting with our portfolio managers to ascertain what has changed that is fundamental (versus what is noise or rumor) and how our portfolios should be positioned. Following are our key conclusions:

  • The U.S. economy has slowed to a “stall speed” where it is vulnerable to adverse shocks, and growth prospects are being downgraded. With the Federal Reserve on hold through mid-2013, we are positioning our fixed income strategy for sustained low interest rates.
  • The stock market is also affected by these developments, but it is too early to tell how it will shake out and we have not altered our positioning. The good news is that US corporations have adjusted remarkably well to a weak recovery. However, we are less confident about top line revenue growth if the economy stays weak.
  • The battle over the debt ceiling has damaged confidence in the U.S. Government’s ability to rein in outsized deficits, but the problem is solvable and will require a balanced approach. The next test will occur in November, when the Congressional “super committee” reports its findings.
  • Our principal concern is the unfolding crisis in the euro-zone, which has spread to Italy, Spain and even France, raising new concerns about European banks. Purchases of government paper by the ECB will buy some time, but the EFSF bailout fund will have to be augmented significantly.

Overview: A Sea-change in Expectations

In recent weeks several forces have coalesced to trigger the biggest volatility in financial markets since 2008-09. Investors have shed risk assets such as equities and high yield bonds and shifted into safe havens such as gold, cash and US treasuries. However, the current situation is very different from the financial crisis in 2008: While U.S. bank stocks have been hit hard by developments in Europe, the inter-bank market and credit markets are functioning adequately, and US banks’ capital and liquidity positions are at all-time high levels. Also, leverage throughout the financial system is much lower today.

Meanwhile, the Federal Reserve’s pronouncement that it will keep interest rates unchanged through mid-2013 raises the specter that treasury yields will remain unusually low for an extended period. Accordingly, we are reassessing our fixed income strategy.

Finally, we are cognizant of how fluid the situation is, as well as the psychological toll on investors from extraordinary volatility. Therefore, we are not being rigid in our views and will modify them as circumstances change. We are currently focusing on the implications of slower U.S. growth, the fallout from the debt impasse and contagion in the euro-zone.


Downgrading U.S. Growth Prospects

The prevailing view in the markets until recently had been that the slowdown of the U.S. economy in the first half was temporary, and many economists believed it would reaccelerate to a 3% rate in the second half. However, in the wake of continued disappointing data in July, as well as downward revisions to prior quarters, economists have been paring back their forecasts closer toward 2%. The risks, moreover, are to the downside amid uncertainty about whether consumers will scale back on spending and businesses on hiring in the wake of the market upheavals.

In a surprise move, the Federal Reserve announced that it would keep interest rates unusually low at least through mid 2013. While this has diminished uncertainty about monetary policy over the next two years, it also suggests the Fed now perceives the period of economic weakness will continue for a couple of years. Moreover, if the economy now is on a lower growth trajectory of 2% or so, it implies there is less of a cushion to absorb adverse shocks. Consequently, the risk of a mild recession has increased, possibly to 25%-30%.

In this context, we believe the outlook for corporate profits will be less robust than heretofore. Thus far, the corporate sector has fared remarkably well, with overall corporate profits now well above the record levels achieved in 2007 before the onset of the financial crisis. However, if economic growth is closer to 2% rather than 3%-4%, which many Wall Street analysts have been assuming, we believe earnings projections will be scaled back before too long.

The silver lining in the revised outlook is that headline CPI inflation, which currently is above 3%, should recede in coming months on the back of falling oil and commodity prices. The core rate, which excludes food and energy components, is likely to remain about 1 ½%. If so, it could set the stage for the Fed to launch a third round of quantitative easing later this year. Based on the experience with QE2, however, our take is that a new round of quantitative easing could bolster the stock market and risk assets, but would likely have only limited effect on the economy.


Fallout from the Debt Impasse

Amid these developments, the imbroglio over the debt ceiling damaged confidence in the U.S. government at a time when the economy appears vulnerable. One immediate consequence was S&P’s decision to downgrade U.S. treasury debt on grounds the actions taken were inadequate to stabilize the rapid growth of government debt.

In my view, the downgrade of US treasury debt was a non-event for credit markets, as professional bond managers are capable of making their own assessment. Indeed, treasury yields declined on the news. Yet the reaction in the stock market was much greater than expected, and it precipitated extraordinary large gyrations in U.S. and world equity markets.

Against this backdrop, a newly formed Congressional “special committee” will convene in the Fall to achieve a second round of deficit reduction totaling $1.5 trillion. The latter is expected to include cutbacks in entitlement programs and increased revenues from closing tax loopholes. However, if the committee fails to act, or if Congress refuses to adopt its proposals, an array of prearranged cuts would kick in amounting to $1.2 trillion.

My bottom line is that these negotiations will be highly visible and will undoubtedly contribute to heightened market volatility, which could further impact consumer confidence. The key dates to keep in mind are the special committee reports its findings before Thanksgiving and Congress votes on the proposals on December 23. This could make a very interesting holiday season!


Contagion in Europe

While recent developments in the United States have been unsettling, we find Europe’s predicament to be even more serious: Conditions in the euro-zone today are substantially worse than they were one year ago and there are no solutions yet in sight. Indeed, the long-term viability of the euro-zone is now being called into question.

The most disturbing development is that the crisis has spread to Italy and Spain, which are the third and fourth largest economies in the euro-zone. Both countries are also much more integral to the world’s financial system than Greece, Portugal and Ireland. This past week, for example, European and global markets were rocked by reports that some French banks were in trouble, although these rumors were not substantiated.

The European authorities will have to take bolder actions to reassure investors that the problems can be contained. In this regard, the European Central Bank’s (ECB) decision to purchase Italian and Spanish government paper has helped to lower their bond yields temporarily. And we expect the ECB will hold off in raising interest rates further. But it is also increasingly clear that the EFSF bail-out fund, which was created to address the needs of Greece, Portugal and Ireland, will have to be augmented substantially to back stop Italy and Spain.

Compared to the United States, the challenges in Europe appear daunting: The euro-zone is a monetary union, but not a fiscal union, and negotiations require the involvement of the 17 member countries. Therefore, there is no final solution in sight. Meanwhile, the U.S. and global markets are likely to continue to feel the after-shocks from Europe.


Portfolio Positioning

In the wake of these developments, we have not made major changes to our investment strategy. The principal reason is that a lot of what has happened in the markets appears to be “noise” rather than “news”. When equity markets are as volatile as they have been, it is easy to panic or to get whipsawed. Therefore, we are riding out the storm until there are clearer signs of how the U.S. and global economies are faring.

The most newsworthy developments are (i) the downgrading of US growth prospects into 2012-13, and (ii) the Fed’s commitment to keep short-term interest rates near zero through that period. Accordingly, we are less concerned about a rise in interest rates and are structuring fixed income portfolios with duration close to the Barclays Aggregate Index. In non-government sectors, we still favor modest over-weights to CMBS and High Yield, where spreads versus treasuries have widened out. We also believe short duration mortgages offer favorable yields relative to cash and short-term treasuries. At the long end of the maturity spectrum, we favor high-quality corporate bonds and treasuries to take advantage of the steep curve.

Finally, the big unknown is whether the market turmoil will weaken the economy further or prove to be temporary. While the stock market has been a poor predictor of recessions, we recognize that consumer confidence, which dropped to a three decade low this month, could tip the scales. The August releases for the ISM and jobs report at the beginning of September will provide the first indications, and we will update our assessment then.