Macro

Market Gyrations: Sorting News from Noise

October 21st, 2014 | By Nick Sargen

Highlights

  • Volatility in stocks and bonds has surged recently following a period of calm. The common explanation is that investors are worried about a slowdown abroad, especially in Europe, where officials disagree openly about how to respond.
  • Despite these fears, the U.S. economy is not showing signs of slowing thus far, and job market conditions are improving. Weak growth abroad may affect corporate profits at some point, but lower oil prices and financing costs will cushion the impact.
  • Evidence that inflation and inflation expectations are declining around the world is more apparent and could keep bond yields low for a while longer. However, the recent gyrations in yields are largely technical in nature.
  • Our bottom line: A 10% stock market correction is not surprising following two years of steady gains, but a bear market is not in the cards, as there is little risk of recession or resurgent inflation.

Worries about Global Weakness are Exaggerated

Following an unusually calm summer, investors have worked themselves into a frenzy that the U.S. economy is vulnerable to a worldwide slowdown. However, when one looks at the batch of economic releases that have come out this month it is hard to grasp why. The recent IMF/IBRD annual meetings set the tone, as the IMF staff downgraded its forecast for global growth (once again). This was accompanied by disappointing industrial production data for Europe, at a time when officials have disagreed publicly about what needs to be done to jump start the euro-zone.

In any case, the direct impact of weaker growth in Europe on the U.S. economy is fairly small, as U.S. exports to Europe represent less than 3% of U.S. GDP. Economists at UBS estimate that lower European growth of 1% would only dampen U.S. economic growth by 0.1%. (Note: We would be more concerned if weakness in Europe spilled over to the financial system, and are awaiting the results of stress tests for European banks that are to be released later this month. We also acknowledge that the impact of weaker growth abroad is greater on S&P 500 profits than on the economy, but as discussed subsequently, there are offsets from lower energy and financing costs.)

Meanwhile, there is little evidence the U.S. economy has been impacted materially thus far, and Fed Chair Janet Yellen has indicated the economy is expanding at an adequate pace. The announcement of a bigger than expected decline in retail sales in September contributed to extraordinary volatility in financial markets on Wednesday, but it came on the heels of solid growth in the previous three months. Also, subsequent indicators have been positive: Weekly jobless claims fell to the lowest level in 14 years, and industrial production surged by 1% in September.


Global Inflation is Trending Down

By comparison, the evidence of a decline in global inflation is more prevalent. It shows up in reports for headline CPI inflation, core inflation (which excludes food and energy), and inflation expectations for the developed and developing economies. Deflationary pressures are especially evident in the recent declines in commodity prices. Viewed from this perspective, some decline in bond yields around the world may be warranted, but the magnitude of the declines is harder to justify based on fundamentals.

The most telling development is the drop in oil prices of about 20%. It has occurred against a backdrop in which world oil demand has grown more slowly than expected, and some observers are pointing to a softening in demand from China as the main culprit. However, supply factors have also influenced the price of oil, as non-OPEC supply growth has exceeded expectations and Saudi Arabia has not cut back its production sufficiently to stabilize prices.1 The likelihood, therefore, is that headline inflation will decline further in the near term.

What is surprising is that many investors view this as a negative development, because they believe it confirms weakness in the global economy. My own view, however, is that it is a positive development. First, while spot prices for oil are down, forward prices are holding steady, which indicates energy traders view the recent weakness as temporary. In the meantime, lower oil prices have the same effect as a tax cut for consumers and businesses and provide an offset to weak growth abroad. Daniel Yergin, a prominent energy expert, observes that the decline in oil prices from $110 per barrel to $80 per barrel would put an extra $160 billion in U.S. consumers' pocketbooks if it were sustained for a full year.2 He also observes that China would be a major beneficiary, as well, while Russia would be hurt.


Policy Uncertainty Lingers

A third factor influencing global markets is investor uncertainty about the response of policymakers to the slowdown abroad and evidence of lower inflation. European policymakers have yet to develop a coherent plan to jump start the euro-zone economy. Germany, in particular, remains at odds with its neighbors both about fiscal austerity and the need for quantitative easing. While some observers hope the softening of the German economy will set the stage for less austerity and more policy stimulus, there is little to indicate it is about to happen.

Meanwhile, the Federal Reserve is ending its quantitative easing program. The Fed is unlikely to alter course at this juncture, but it could delay tightening policy next year if inflation stays tame and the economy slows. Indeed, with the recent decline in Treasury yields, the bond market at one point had priced in a delay in Fed tightening until 2016, whereas it had previously priced in a rate hike beginning in mid-2015. Our take is that this is too extreme a change based on what has happened in the past two weeks.


Investment Implications

The key issue for investors now is whether the recent market gyrations represent a fundamental turning point or a buying opportunity for risk assets. Our assessment is the U.S. stock market sell-off is the long-awaited correction that many have called for, but it is not the beginning of a bear market: The latter is usually accompanied by recession or higher inflation and rising interest rates, both of which are absent today. Meanwhile, we are maintaining a moderate overweight position in equities relative to bonds in balanced portfolios, while upgrading the quality of the names in our equity portfolios. With respect to bonds, we are underweight duration in our portfolios and have added to risk exposure, given the widening in yield spreads versus Treasuries.


[1] See "Bernstein Energy: The Outlook for Global Oil Prices – How Low Can It Go?" October 16, 2014.

[2] See Daniel Yergin, Comment, Financial Times, October 19, 2014.