These continue to be challenging times for investors, as sharply falling global interest rates, declining global equity markets, weak commodity prices and increased volatility feed anxiety.
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Traders work on the floor of the New York Stock Exchange
Risk and uncertainty are elevated now, and there is the perception that the range of outcomes is simply broader. The market hates uncertainty. Variability around growth and inflation outlooks, the trajectory of interest-rate policy in the United States, and the effect of negative interest rates in the European Union and Japan have resulted in a re-pricing of risk in the marketplace. If you think risk is riskier, you will drive prices down to reflect that. We think this is the case today.
While many characteristics of this downturn are relatively isolated — the decline in energy prices is most likely a result of oversupply, for example — there is the danger of a feedback loop developing, connecting these highly correlated markets in a more fundamental way.
We believe risk markets are overreacting to current uncertainty. We also believe that the global economy will avoid a recession and that, ultimately, fundamentals will overwhelm investor emotion and markets will stabilize. But it will take time, and will depend in part on stability in energy markets, stability in the outlook for European banks, clarity on the path of central bank policies (including but not exclusively the Federal Reserve) and more certainty regarding the global growth outlook.
Here are five key things to understand about the current market volatility:
1. Investors are second-guessing themselves. With increased fears of global recession meeting uncertainty around central bank policy and effectiveness, investors are second guessing their outlooks.
The risk of recession is elevated in the midst of a continued reduction in global inflation expectations. While we continue to assess the impact of sharply declining oil prices that are at 13-year lows on top of a slowdown in emerging market growth, there are new worries concerning European banks and the effect of negative interest rates on profitability, capital and credit creation. Investor sentiment has been made fragile under the weight of these concerns, and in this environment selling tends to beget selling.
We focus on the key variable here: the overall health of the global economy. The Global PMI Composite continues to point to expansion, including solid results from Europe. In the United States, we continue to expect slow but positive growth. We weigh the obvious areas of weakness in the U.S. economy (manufacturing and energy) against the clear and continued strength in the labor market.
2. U.S. growth will be a positive surprise in 2016. We think that global equity markets have gone too far in repricing risk, and that the probability of a recession is far less than the market anticipates. In fact, we think that U.S. growth will surprise on the upside in 2016 relative to the drastically reduced investor expectations. We maintain that global growth will be muted, but positive. While oil continues to try to find a bottom, we believe that energy markets will stabilize in mid-to-late
2016 as supply is curtailed and demand growth remains low but positive. We are sensitive to the challenges and headwinds to corporate earnings in 2016, and we have adjusted our global earnings expectations downward; however, we continue to expect positive earnings growth in the low single digits.
3. Global markets are uncomfortable with negative rates. It is clear that global central banks are watching conditions as they evolve, and are sensitive to the increased volatility in financial markets. Investors were disappointed, however, in the Federal Reserve's recent comments, hoping for more dovish rhetoric to support the growing consensus call that the Fed will remain on hold through 2016.
While Janet Yellen did acknowledge the global tightening of financial conditions, she maintained that the U.S. economy was on a healthy course and that the Fed would continue to be data dependent in its decision-making process. In the meantime, the Bank of Japan recently joined the European Central Bank, and the central banks of Sweden, Switzerland and Denmark by imposing an explicit policy of negative interest rates on deposits. This negative rate of interest is intended to do two things: spur economic growth as "holding" cash becomes uncomfortably expensive versus investing, and encourage related inflation as economic activity rebounds, asset prices inflate and the yen depreciates.
Unfortunately, the onset of the policy met the opposite result: the yen appreciated and risk asset markets depreciated. What happened? In contrast to the central bank's proposition that if low rates are good, negative rates must be better, it is clear that the global markets are becoming increasingly uncomfortable with negative rates as a policy tool. Unfortunately, this discomfort has occurred just at the time when many central banks have become more comfortable, including the Fed. Global markets have a decidedly different interpretation: negative rates threaten to create more market distortions, undermine banks' profitability and capital buffers, and may counterintuitively result in an increase in savings over spending as investors assess the impact of negative rates on long term retirement income.
4. Risk cases: China and the Fed. We continue to view China as a key risk to global risk assets and highlight the risk of a disorderly devaluation of the renminbi as an outward reflection of an economy facing a "hard landing" and a People's Bank of China ill-equipped to deal with the downturn. We believe that this is a manageable risk at this point, and note that the use of foreign-exchange reserves to support the renminbi has been effective thus far.
A second risk case involves the Fed, as we believe a policy mistake would have a lasting and damaging effect on both economic activity and investor risk appetite. Interest-rate expectations, as reflected in the federal-funds futures market, are forecasting a pace and trajectory of rate increases that is meaningfully slower and lower than the Fed has forecast. We believe that the Fed will revert down toward the market expectations in light of the increased risk to their outlook.
5. There is light at the end of the tunnel. We believe this market turmoil will pass, and that, ultimately, risk assets will recover as the focus on fundamentals resumes. When investors refocus on corporate earnings, and we begin to see the vast benefits of $30 oil through the consumption channel, animal spirits will re-emerge. Bear markets outside of recessions are relatively rare, and the good news is that they are meaningfully shorter and shallower than recession-induced bear markets. To call a bottom here may be premature, but that is simply a matter of timing. Risk assets will find a bottom when we see stabilization — not even improvement necessarily — in the growth outlook, energy prices, inflation expectations and, importantly, when faith in the efficacy of global central bank monetary policy is restored.
Staying the course during times of market stress is oftentimes the most difficult, but frequently the best course. We remain committed to the concept that assets serve a purpose. This intentional asset allocation effort, incorporating goals and risk preferences to drive asset allocation, enables you to stay the course during inevitable periods of elevated market volatility.
Commentary by Katie Nixon, the chief investment officer at Northern Trust Wealth Management.
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