The Good, the Bad and the UglyLearn more about this firm
- Interpreting equity declines as relatively “good”, “bad” or “ugly” provides context on how investors should react.
- We are experiencing a “good” correction as investors have focused on the level of sustainable economic growth and concluded that it is lower than they hoped.
- I am modestly positive about risk assets and believe investors will get significantly more impact by looking at sectors and individual securities rather than broad markets.
The opening week of 2016 has been ugly for equity markets. For those experiencing the stress of a market correction it is hard to believe that a correction can be “good”. Interpreting equity declines as relatively “good”, “bad” or “ugly” provides context on how to react.
Good – a market correction that rebases the level of future growth rates and or the sources of growth. The correction reduces the risk of excessive expectation building in the markets leading to even greater disappointment later. Sentiment does not change linearly with market moves. Therefore, while investors are nervous about the current correction, the release of excess expectation now helps reduce the risk of panic should a larger setback be required. This is similar to reducing the pressure in a container to prevent an explosion; it is better to lose some of the material in the container than all of it.
Bad – a market correction that reduces the expectation of future growth below zero for a short time. The level of the correction is likely to be greater, but expectations for positive economic growth and corporate earnings will improve over six months.
Ugly – a very severe selloff in the market due to expectations of prolonged recession and structural damage to the financial system. This is rare, but most investors experienced this scenario recently in 2008. Because of the reasonably recent financial trauma induced by the global financial crisis, investors are experiencing “recency bias”. Behavioral research has demonstrated that we tend to assume crises will occur more frequently than is really likely after a major trauma. This does not mean they cannot occur, but we tend to assume every setback is going to be another meltdown.
I believe we are experiencing a “good” correction. Investor expectations of growth were too high given demographic trends, the transformation of the economy in China, and significant geopolitical risk. The Federal Reserve tends to change interest rates in response to something they are worried about. They raise rates to fight inflation or reduce rates to fight recession. Last month’s rate increase was based on relief that the U.S. economy is looking healthier and that risks from abroad are manageable. Consequently, investors have focused on the level of sustainable economic growth and concluded that it is lower than they hoped.
We are seeing a continuing escalation of geopolitical risk. The response to falling oil prices by Russia and OPEC has been to produce more oil, rather than cutting supply like U.S and European producers. Some countries face an enormous cash squeeze as they fund internal social programs. The necessity to fund these programs is symbolic of restive populations and geopolitical tensions. Our analysis of when such tensions affect markets is tied to three things: 1) whether oil is involved, as in a disruption to the supply, 2) whether it is a threat to the financial system and 3) whether there is a superpower involved. Clearly, tension in the Middle East between Saudi Arabia and Iran has implications for oil. Syria is escalating from a tragic regional problem to a potentially global problem because of the direct contact between Russian and U.S. forces. While I think they are making an earnest attempt to coordinate, the heightened risk was evidenced in November when Turkey shot down a Russian plane.
Despite the geopolitical tension, I am modestly positive about risk assets. Investors are concerned that rising rates is bad for equities. They may be, although I think 10-year Treasury yields rates may be flat or lower versus current yields at year end. Even if they rise modestly, it may be positive for equities as expectations of economic growth and inflation will have increased thereby reducing risk premia. I believe the reduction in the market risk premium will be greater than the increase in yields. As investors realize that a 2% annual GDP growth rate is actually quite good given other circumstances, I think the general reaction from equities will be positive.
Corporate earnings are approximately twice the level they were in 2008. This has been achieved while two important changes occurred. Financial sector earnings are higher than 2008 with substantially higher capital bases. Therefore, the earnings were generated via conventional means rather than financial leverage and should be more reliable. Second and not surprisingly, energy earnings are considerably lower and materials are flat. Consequently, the level of earnings in the broad market have less financial leverage and cyclicality in their make up.
I expect the pace of future interest rate increases to be very modest and consistent with evidence the U.S. economy is healthy. The consumer appears to be relatively healthy, and a modest rate increase could help corporations. Corporate pension plans benefit from rate increases as it reduces the present value of their liabilities, potentially enhancing opportunities to invest in other things. We need corporate investment to offset the general fall in capex related to energy and materials.
Lastly, I think investors are going to get significantly more impact by looking at sectors and individual securities rather than broad markets. The current selloff is evidence that markets are not cheap. Outside of emerging markets, valuations are not particularly compelling. So while opportunities still exist for risk assets, I don't think we will be pursuing them via traditional allocations (U.S. vs. non-U.S., Japan vs. Europe, etc.). It may come down to what we see happening within individual sectors where we think growth is sustainable or the stimulus of rising rates will have the most positive impact.