By: David Francis, Vice President, Head of Equity Investments and Mark Simenstad, Vice President, Fixed Income Mutual Funds August 26, 2015
The fact that it was bound to happen eventually has not made it any easier to watch. After climbing nearly nonstop since March 2009, the U.S. stock market has come under severe selling pressure recently, along with most other stock markets around the world. The reasons for the selloff are not insignificant, but neither are they insurmountable.
Slower Chinese Expansion Could Hinder Global Growth
The contrast between market sentiment before and after last week is striking. Prior to last week, stock markets across the globe had been in various stages of advance or correction depending upon their own unique circumstances. Last week, nearly all began to move lower in sync, registering sharp declines as new economic data, particularly from China, cast doubt on the outlook for the global economy. From Tuesday of last week through Tuesday of this week, the Standard & Poor’s 500 Index fell 234.83 points, or 11.2%.
To be sure, many of the world’s stock markets were relatively expensive heading into this correction, so the idea that they might be poised for a downturn was not farfetched. But valuations alone are poor predictors of market behavior. Before the selloff, investors were willing to accept higher-than-normal valuations because they were generally confident the global economy would be strong enough to drive corporate revenues and profits higher, ultimately justifying higher stock prices.
The shift in investor confidence last week seems to have been sparked by a disappointing report from China regarding that country’s Purchasing Manager Index (PMI), a leading indicator of economic growth. It is unlikely, though, that any single data point triggered the market’s decline. In addition to the worrisome PMI data, investors were hit with disappointing import and export numbers from China, and a devaluation of the Chinese currency that was soon mirrored in other emerging market countries. All of these factors combined to cast doubt on the pace of China’s economic growth.
That was significant not only because China is the world’s second-largest economy, but also because it has accounted for an outsized portion of the world’s incremental growth in the current economic cycle. China’s strong performance has offset weaker recoveries in the developed world. The worry now is that slower expansion in what has been the world’s primary growth engine will have negative economic consequences for other countries.
Investors are troubled, too, by the sharp decline in commodities prices, particularly the price of oil, which is viewed as a predictor of future economic growth. Excess supply has been a factor in the oil market, but investors also are concerned about softening demand, especially in a slower-growing China, which could be a harbinger of slower economic growth globally. Investors are focusing on the negative short-term impact on countries and companies that produce oil, but are generally overlooking the longer-term benefits of lower oil prices, which eventually will cascade through the world economy as businesses and consumers spend less on energy.
While the recent selling seems to have hit stock markets around the world indiscriminately, there are many reasons for concern about individual markets on a country-by-country and region-by-region basis. Japan’s economic recovery appears to be stalling, for example, despite extraordinary monetary and fiscal efforts to revive growth there. Europe, while seeing better economic activity on the domestic front, is a major exporter to China; Germany in particular sells a lot of its goods to that country. In the U.S., second-quarter corporate earnings announcements were notable for the increasingly negative impact of a strong dollar on both top- and bottom-line growth.
The Prequel: Credit Markets
Although the selloff in the stock markets started just last week, the credit markets have been soft since the start of the second quarter. Investment-grade credit spreads – the difference between the yields on investment-grade corporate bonds and U.S. Treasury bonds – have widened by more than 50 basis points and are now at three-year highs, evidence that investors are losing confidence in corporate bonds and looking for safety in government securities. Prices in the high-yield bond market also have been sliding since the second quarter, although the large majority of that market’s decline has been in energy bonds and CCC-rated bonds, with the latter ranking among the most speculative of all bonds. Emerging market bonds have actually absorbed the brunt of the selling, although dollar-denominated sovereign bonds have fared much better than nondollar sovereigns. In short, the action in the credit markets globally could be viewed as a prequel to the recent selloff in global stock markets.
Interestingly, while fixed-income investors have been concerned about deteriorating credit fundamentals, U.S. domestic credit metrics overall, as measured by earnings, cash flow and leverage, are still reasonable. On the other hand, liquidity in the credit market remains very poor due to the record amount of investment-grade bond supply. Corporations have been issuing bonds at a furious pace to fund stock buybacks and strategic acquisitions, but increasingly these bond issues have been met with weak investor and dealer demand. This lack of liquidity has greatly exacerbated market weakness in both the stock and fixed-income markets.
Concerns About Monetary Policy
Since the 2008 financial crisis, investors have been operating on the belief that policymakers, particularly central bankers, will provide additional monetary support to global economies and financial markets should economic growth weaken. Now, there is increasing concern that additional actions by central bankers may not be possible or may not prove effective, making active fiscal policy necessary to sustain growth.
It would be disingenuous to suggest financial markets are overreacting. Many of the issues worrying investors are legitimate concerns that are just now coalescing after years of unusually strong returns by stocks, accompanied by unusually low levels of volatility. In the U.S., major stock market indexes have been climbing since early 2009, and have advanced more than 100% since the summer of 2011 without any meaningful pullbacks along the way. While those rallies were supported for a time by solid growth in corporate revenues and profits, revenue growth has since moderated, profit margins have flattened and profit growth has declined. Across the globe, many stock markets have seen sharp advances in prices driven primarily by expansions in price-to-earnings multiples that are yet to be validated by earnings recoveries. If economic growth stalls, expectations for future growth in corporate earnings will likely contract.
For all that, stock markets generally do not become bear markets in the absence of a recession. It has happened in the past, but infrequently and briefly. Right now, it is difficult to find the types of excesses in the U.S. economy that would normally be associated with a recession, primarily because this recovery remains a moderate one by historical standards. The energy sector will be problematic as long as oil prices remain depressed, but as in the early 1980s – a period not too dissimilar from recent experience for the oil industry – the rest of the economy should ultimately benefit from lower energy prices, outweighing near-term negatives.
Globally, the picture is more mixed. Many emerging market countries have taken on substantial amounts of debt to fund big projects – infrastructure and manufacturing initiatives in China, for example, and commodity-based investments in the energy and resource-rich economies of the rest of the developing world. While those investments may look troubled today, the global economy ultimately should benefit, to a much larger degree, from the lower prices they help to produce for commodities.
China remains critical to global growth, of course, and collectively China and other emerging markets now represent 50% of the world’s gross domestic product. This makes them much more relevant to the world outlook than they were in the past. China’s policymakers are well aware of the issues contributing to the recent selloff in the financial markets, and are taking steps to continue moving their economy toward one dominated by domestic consumption rather than government investment. They will likely be successful in the long run, but it will take time.
Meanwhile, the odds of a global recession are low even though monetary policymakers are unusually active right now. This activity is good in many respects, but it does heighten the risk of a policy error. Stock prices have obviously corrected some of their valuation issues. Risk assets in general – stocks, corporate and high-yield bonds, commodities – have all adjusted to the recent news. Yield spreads in the credit markets are now at levels historically commensurate with a recession. Yet with recession a low probability, in our view, corporate bonds now look relatively attractive. We continue to believe that stock markets can advance at mid- to high-single-digit rates annually over the next few years, albeit accompanied by greater volatility.
These are anxious times for investors, and not without reason. But the broader economic outlook, and financial market fundamentals, suggest this is not a time to panic.
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