In a much-celebrated quote on his 50th birthday, the late David Bowie boldly declared to an audience at Madison Square Gardens, “I don’t know where I’m going from here, but I promise it won’t be boring.” Recent financial markets carry echoes of those immortal words. In the opening days of 2016, action has been anything but dull, and investors are once again disoriented. Where to from here?
At panic points like this, it is useful to revisit the role of the portfolio manager: Why do clients pay us to manage their wealth? It is not for flawless clairvoyance. Rather, we are paid to anticipate probable risks, prepare for opportunities, and importantly, not proverbially lose our minds when everyone else has lost theirs. That requires a disciplined, unemotional process. In that spirit, let’s proceed with rational faculties intact.
The market that fell to earth
To be sure, markets are reacting to some legitimate macro fears. The U.S. Federal Reserve has taken a step (albeit, a baby one) away from ultra-accommodative policy, China’s longer-running agenda has been poorly communicated, and global demand remains structurally deficient.
Yet, apparently no one – not even the usually bullish chorus from mainstream media – can find a positive catalyst. Not even one. Really?
Consider the following factors, all of which argue that a global recession with an attendant bear market is not yet in the cards:
Stop worrying (or how you can learn to love low oil prices)
Investors have been treating the decline in oil prices as a leading indicator of weakness in global demand, even though it is much more of an oversupply story. This view is reinforced by the always-immediate appearance of the downside of collapsing oil prices in the regions and sectors that experience difficulties. And it is evident in market action. Incongruously, correlations between oil prices and the U.S. stock market are the highest in years.
Consider the flip side
Cheap oil is a very powerful stimulant for global growth. This will become more apparent as the positive impact on global consumption, investment, and liquidity materializes over time. In fact, falling oil prices have never correctly predicted an economic downturn.
On all recent occasions when the oil price has at least halved, faster global growth followed. Conversely, every global recession in the past 50 years has been preceded by a sharp increase in oil prices.
Huge wealth transfer is now underway
Because the world burns 34 billion barrels of oil every year, a $10/barrel decline in oil shifts roughly $340 billion from oil producers to consumers.
Thus, the enormous price fall since August 2014 will easily redistribute more than $2 trillion annually to oil consumers, providing a bigger income boost than the combined U.S. and Chinese fiscal stimulus in 2009.
“Sell everything” sentiment
Since 2008, we have argued that post-financial crisis periods are a different animal. Investors, still carrying crisis-made scar tissue, tend to cling close to shore. Endless financial crisis fears prevail. Yet markets continue to scale a “wall of worry.”
This time has not been different. Recent stock market losses have again brought out bearish voices announcing an imminent crisis 2.0. (prompting one colleague to wryly observe that if the bears are right, this would be the “most forecast crisis of all time”).
Our behavioral models paint a different picture. Whether measuring retail fund flows, futures positioning, or investor sentiment, all point to maximum pessimism. That argues negative views are already discounted in markets, paving the way for positive surprises ahead. Here, a number of catalysts exist – a firming eurozone recovery, a clearer agenda communication from Beijing, or even better-than-expected U.S. corporate profits due to topline revenue gains.
Central bank hawkishness under pressure
In recent years, reputations of central bankers came close to deity-like status. While many investors rightly recognized unsustainable global imbalances and the reality of slow growth, they also respected the “central bank put.”
But how long can this reverence for the world’s monetary priests last? And is the modern monetary toolkit a work of divine brilliance, or are they truly “making it up as they go along”?
With the Fed dithering over minuscule rate hikes and the European Central Bank fumbling around with a motley crew of policy tricks, the central-banker image may indeed suffer an irreparable blow. The priesthood, after all, is fallible. Yet central banks have become the lead sponsors of rising asset prices, effectively becoming victims of their own success. The Fed is now a creature of financial markets rather than a steward of the real economy.
Cushioning volatility creates instabilities
Is this good? Of course not. Attempts to cushion the volatility always end up creating instabilities in the future. Yet seven years after the financial crisis, here we are.
In the run-up to the Fed rate decision in December, many observed that stock markets continue to rise for some 12-18 months even after hikes commence. However, that narrative was always suspect. Why? Because rummaging through postwar analogs yields no useful comparisons.
Exiting from the normal postwar interest rate regime is starkly different than retreating from a Mardi Gras of bank bailouts, low interest rates, and quantitative easing. Recent criticism from the World Economic Forum held in Davos, Switzerland in January highlights the issue. While the International Monetary Fund urged the Fed not to raise rates, it is now respected investor Ray Dalio who says, “There’s not a country in the world that should not ease its monetary policies.”
The central issue is that policymakers have not yet resolved the deficiency of world demand. That means we may have only scratched the surface in terms of unorthodox policy. The next stage will likely be central bankers endorsing higher budget deficits to sponsor infrastructure projects or even tax cuts. To be sure, these are all grubby policies, but they are also widely supported – and wonderful for asset prices.
Fragilities remain in global markets
We are closely monitoring the probability of another worldwide credit crunch.
Yet a more likely scenario is more of the same – a long period of slow growth, rising asset prices, and further forays into unthinkable policy measures. And the end to China’s rapid industrialization era will continue to provide tail winds to the new leadership – including commodity-importing countries that have not been complacent about structural problems through the post-crisis era.
In this climate, investors should stay widely diversified with global ETF portfolios. That should always the first line of defense in managing volatility. After all, financial markets never promised to be boring.
Courtesy Fundata Canada Inc. © 2016. Tyler Mordy, CFA, is President and CIO of Forstrong Global Asset Management Inc. Securities mentioned are not guaranteed and carry risk of loss. This article is not intended as personalized investment advice.
