Global equity markets retreated by some 8-15% in the third quarter, with the preponderance of the damage occurring during an eight-day span in mid-August. During this short period, the S&P 500 Index fell by 11%, the small cap Russell 2000 Index by 9%, the Dow Jones Industrial Average by 11%, and the international MSCI EAFE Index declined by 10%. On August 11th, China made a small (2%) devaluation of its currency versus the US$, ostensibly to gain entry in the SDR “reserve currency” bucket, which upset Asian and commodity markets. By August 18th, various technical indicators flashed red, leading technical and momentum strategies to sell aggressively and lower net exposures. At that point, quantitative and ETF strategies went a bit haywire, and likely exaggerated the scope of the declines, inducing disorderly trading and some degree of panic in mid-August. This is our current interpretation of the sequence of events. Leading up to that point, stocks were not acting “good” so to speak, with small cap stocks, industrial cyclical stocks, semiconductor stocks, and transportation stocks all in some degree of broad decline from their highs attained earlier in the year. Most markets bounced following this trading episode, only to retreat again following the FOMC September meeting, at which time the Fed passed on raising interest rates. The Fed decision quashed most financial stocks, and the rest of the market just followed suit. Through September 30th, most global indices were down a high single digit to low double digit percentage in US$ terms on a year-to-date basis.
The top-to-bottom moves do not quite qualify as a full-fledged bear market (a >20% decline), but do register as a fairly steep correction, with broader global declines in developed markets of roughly 14-17%. The worst developed market performer has been Germany, down a full bear market 24% since early April, as a consequence of the substantial industrial concentration in the index and a fairly shocking scandal at the country’s largest employer, Volkswagen. China’s impressively speculative “A” share market declined by 43% from June to late September, ending the quarter about flat for 2015. This is a locals-only stock market that should not be viewed as a serious indicator of China’s financial conditions. Other emerging markets have shed a copious amount of value in dollar terms this year.
The declines this summer are reminiscent of a similar explosive downside move in August 2011. At that time, the United States’ sovereign credit rating was lowered by rating agency S&P to AA+ from AAA, triggering fears of profound capital markets dislocations and malfunctions. While this downside scenario did not come to pass in the US (bond yields declined actually following the downgrade), European bond and interbank credit markets did indeed seize up – leading to existential questions about the survivability of the Euro and the appropriateness of monetary policies in Europe and Asia. Global growth prospects deteriorated, resulting in sharp valuation compression for many corresponding growth businesses. Since 2011, the US stock market and economic strength have dwarfed the rest of the world. Many of the above-mentioned uncertainties were resolved constructively, and the 2011 episode turned into the best buy-point in the markets since the early parts of 2009. Seasonally, late September to October tends to be the optimal time of year to be a buyer versus a seller. This factoid is (strangely) reliable over the years.
There are faint echoes of 2011 in the recent declines. The China currency move was similarly unplanned for, and credit costs have risen for corporate and high yield borrowers since the Spring. Markets are unsurprisingly skittish about the future of US interest rate policy as well as the likelihood of the first significant credit losses in the current business cycle emanating from commodity businesses. Stocks tend to be highly correlated with high yield bond prices, such that the high yield market will need to get better in order for stocks to revisit their high water marks from earlier in the year. Outside of bond spreads widening, the issues at hand tend to be less definitive; in this sense, time and patience will be valuable assets for investors. I believe the following factors should be monitored, but should resolve themselves in some more durable (read: less uncertain) form over the next 12-24 months.
What is the real story in China?
We detailed these issues at the end of the second quarter rather presciently (The China Syndrome). China’s economic leadership, once well regarded as forward-looking, has been rather left footed of late. For example, though the Chinese currency devaluation in August was just 2%, the move undercut the Yuan-$ peg, a basic principle of stability in markets, and brought into greater focus the issues surrounding China and that nation's large role in overall global growth this century. The Yuan may have been devalued for a credible reason (to gain inclusion in the SDR basket of reserve currencies), but was ineptly telegraphed to the markets. On the back of China's stock market follies and clearly implausible official economic statistics, it creates a credibility problem for the government and its ability to foster stability in the context of a very obviously difficult economic transition. Capital flight from China has unsurprisingly grown. We share the market’s skepticism, but would note that a lack of demand for physical infrastructure materials and pricey items (like cars) may not translate into diminished demand for smaller personal luxuries.
Second, greater skepticism about China means greater skepticism about commodity and industrial demand longer term. It is no surprise that these sectors have underperformed as the China growth story appears questionable, squishing longer term futures curves further; commodity sectors are now likely to generate credit losses in 2016+. Overcapacity is a very real problem globally, which does not bode well for industrial stocks (broadly speaking). We are starting to see some opportunities as the selling becomes more indiscriminate, but would view these as case-by-case, versus a broader buy signal for the sector.
Third, we can now add Fed uncertainty to the mix. The Fed has gone out of its way to provide clarity on its policies and their expected duration since QE and ZIRP (zero interest rate policy) began in 2008-09. This approach continued into 2015, with a clear trigger to move away from a 0% Fed Funds rate on unemployment and labor slack, along with "confidence" about its 2% long term inflation target being realized. Having taken a pass on a widely telegraphed September move off of zero – notwithstanding high nominal private sector GDP growth, 5.1% unemployment rate, and 40-year lows in new unemployment claims (all consistent with nearly full employment) – markets now can no longer concisely articulate what the Fed is looking at precisely, or how it will respond to such data. We had declared a Fed liftoff in late 2015 as being the most important financial event of the year, and though it may yet occur in the next 6 months, the Fed has created needless uncertainty, which has indeed tightened global credit conditions. Having recently traveled through Asia, it was clear to us that local governments have equated the Fed uncertainty to the equivalent of 3 or so tightenings. Getting it (a raise in rates) over with has value. In academic circles, there is a healthy debate on the merits of continued ZIRP or moving off of 0% for the sake of some policy normalization. Without conceding to either argument, it is clear enough to me that policy uncertainty is quantifiably worse (more restrictive) than a small tightening could be. Has 8 years of sustained ZIRP actually caused any tradable goods inflation, or just asset price inflation? Expressed differently, perhaps the financial system would function more smoothly with a positive interest rate, increasing money velocity? These are fair questions to ask, and there are not definitive answers.
We still think the Fed will move, eventually. As we best understand it, the Yellen Fed is rather afraid of making a “mistake” by prematurely raising rates above 0%. In Washington, there is residual political pressure on the $4+ trillion size of the Fed’s balance sheet, meaning that the bar for any further QE is very high should a mistake indeed be made. So the more we think about it, the Fed has painted itself into a difficult corner, and may need a big inflation-print to actually raise rates. A reactive versus proactive central bank is a net negative. Financial stocks and bond spreads have accordingly become more discounted. This isn’t a bad thing for investors necessarily looking forward (a more favorable risk-return is presumptive), but it is not an ideal situation.
Last, volatility and poor technicals tend to be self-fulfilling until they exhaust themselves. Take the aforementioned items together, and it means a lot of stocks have been soft – leading to poor breadth and a difficult tape. The average US stock is down 15% since mid-April, and the average international stock has declined 17%. Broad weakness in equities has caused a technical breakdown in the markets, and triggered a fairly standard run out of the markets by leveraged players, which in turn pushed up volatility to levels not seen since 2011 (and that was pretty ugly). As market indices fall below their moving averages, the selling begets selling, and people cash out their winners quickly as frustrations mount. A decline in volatility would probably have a more positive/reversing effect. That said, markets are generally higher than in 2011 and the business cycle is further advanced; as such, a recovery from the lows may be more modest, especially with a general election looming.
We have ventured broad analyses of key business sectors in our quarterly letters in the past few years. What better time than in the wake of the on-going frustration of indeterminate Fed Policy uncertainty than to ponder the value of investing in bank stocks at this point in the cycle?
To continue reading the full commentary please download it here.
We appreciate your confidence in Cambiar Investors.
Brian M. Barish - President