Addressing the Recent Volatility in the Market
In response to the recent volatility in the markets, we wanted to share with you a few perspectives from underlying managers we use and our own thoughts as we continue to manage allocations across diverse asset classes.
The stock market (DJIA) has had 12 moves of more than 100 points up or down so far in June. Considering investors’ current level of uneasiness, that number will probably increase before month-end. This is the most in any month since November 2011. Volatility has clearly returned to the markets. What makes the most recent moves more significant is that it has happened across all the traditional asset classes. Bonds have taken significant losses since Ben Bernanke laid out his plan to start tapering stimulus later this year. Stocks are down 7% from their highs earlier this year due to fear that economy will falter on its own without more stimulus to keep rates low. Commodities and precious metals are also down significantly with a stronger dollar and demand weakening from emerging markets. Other interest-rate sensitive investments such as REITs, dividend paying equities, and MLPs, have been hit the hardest the last few weeks. Even uncorrelated investments such as managed futures have struggled given the quick reversals and increased volatility in many markets.
Last week, the press conference held by Ben Bernanke was the pivotal event for the markets. The official policy language did not change. However, the Fed was much more optimistic about the economy and its view of the recovery over the next 12 months. This laid the groundwork for many investors to believe the Fed would move quickly to remove stimulus and rates would rise much faster than previously believed. We believe these investors confused two main points of discussion. First, there is a difference between tapering stimulus and when the Fed begins to raise interest rates. The tapering that Bernanke speaks of just means less stimulus money, not ending stimulus. The government’s balance sheet continues to grow at historic rates. Ben used the analogy of letting up of the gas pedal versus actually applying the brakes. Even in his rosy scenario, rates do not begin to rise until 2015. Second, although he painted a hopeful scenario of an economic recovery over the next 12 months, he fully maintains the ability and desire to “reapply the gas pedal” if needed and will increase the stimulus to keep interest rates low.
Investors are now rotating out of bonds and bond-like investments aggressively. It appears they are moving to cash and not to equities, as equities continue to see outflows as well. Very few, if any, saw this knee-jerk reaction coming. Now that the pain from the initial reaction is gone, the question is what to do next? We believe that most investors have focused on the end of the historic monetary experiment underway, rather than listening to what Bernanke actually said. There are two possible outcomes: (1) the economy continues to improve and the need for more stimulus gradually fades; or (2) the economy weakens or remains choppy and the stimulus will be extended.
Many believe the short term chaos is overdone. We would tend to agree that this was an overreaction. The 1% jump in the 10-year Treasury is a historic move. Many short-term traders expect that the rates will decrease as people calm down. We would not recommend selling into the fear. As wise investors have stated, “Be fearful when people are greedy, be greedy when people are fearful.” However, a potential rate decrease would probably be only a short-term trade. Interest rates are likely going to increase over time and investors need to prepare for it. However, we believe it is a fool’s game to try to predict the exact path and timing of the moves. It will most certainly be choppy at best.
The U.S. economy continues to move along at a snail’s 2% growth pace, but it’s probably the best it can do for now. Even if growth improves, we believe we will struggle to get to the target of 6.5% unemployment level in a couple of years. The global economy continues to deteriorate, with China becoming a bigger concern over Europe.
As we have discussed in prior newsletters, we began to allocate to more flexible bond funds this year. However, over the last month no bond fund was really spared from the spike in rates. We also want to point out that increasing interest rates is not the same thing as increasing inflation. Most would have thought that money coming out of bonds would have moved into stocks. But that did not occur because stocks felt the same pain of negative performance as bonds. Over the last month, we have seen interest rates begin to move up. However, inflation year-over-year is pretty much non-existent. Inflation is not a problem for the economy, nor is it expected to be for a while. That is why commodities have struggled over the last few years. Even with all the stimulus provided by the government it has not moved into the system to push up prices. All the stimulus has essentially sat on either banks’ or the government’s balance sheet and has not moved.
On the traditional side of investing, volatility is likely here to stay for the summer. Washington will be gearing up for a debt ceiling debate later this summer. The next Fed meeting is not until September. We do not recommend short-term trading this summer, but we hope to see opportunities to buy into for longer-term investment strategies. These would include emerging markets equities and debt, municipal bonds, MLPs, REITs if the real estate markets continue to recover, and other areas that have been hit the hardest over the last month. We also continue to prefer tactical managers such as Good Harbor which can provide some defense. We are currently performing due diligence on a few new managers in this area.
On the private side, we continue to seek opportunities to take advantage of the insufficient access to debt and capital for businesses and real estate companies. Groups like Keystone and Omninet are expecting to deploy client’s capital into several transactions this summer. As well, Virtu continues to market properties for sale taking advantage of the higher prices and yield-chasing investors. All of these investments produce income which is not directly affected by the stock market’s daily fluctuations, adding stability and predictability to clients’ portfolios. We also continue to allocate to managed futures as they have historically provided value in times of distress due to their low correlation to other asset classes.
As always, every client’s objectives are unique so please contact us if you would like to discuss your portfolio or if you have any comments or questions. We appreciate your trust in the Cornerstone team.