Paring Down the Recent Market Volatility

Dirk Steinhoff

By Dirk Steinhoff  

If you find yourself a bit dazed and confused the past few weeks, wondering to yourself “what just happened”, you aren’t alone.

Unless you’ve been cut off from the world, you know that from August 21st – 24th, we witnessed a huge sell-off in the equity markets worldwide, where in the course of a Friday through Monday alone, the S&P 500 corrected 7%. Developments rippled around the globe. That Monday, the 24th, where the S&P 500 decreased by nearly 4%, was quickly dubbed “Black Monday” by many in the media.

Since then, we’ve had a rebound and the equity markets are off their lows. But most major indices are still in negative territory for the year.  Now, we’ve seen the FED hold interest rates, bowing to the worries of financial market volatility and the shaky global economy, amongst other flashpoints. Cries of a recovery have given way to concerns of tightening financial markets.

Is there more behind the recent market volatility than meets the eye and what do we really need to be concerned about moving forward?

Let’s pare down the layers of what happened in late August in an attempt to look forward to what we can expect. Will fixing the problems, soothing investors’ minds, and investing ever be the same again?

Market volatility was destined to happen

Were the market movements of the last weeks simply an overreaction to the economic slowdown in China? Or, was it a reaction to the panic selling that was going on in China, where the CSI 300 Index lost almost 40% of its market value since their highs in June? While the developments in China could be looked to as the catalyst for the developments in the world markets, they are hardly the root cause.

As we’ve stressed at different times, we expected an increase in the volatility of the equity markets. With seven years of excessive central bank interventions in the markets, interest rates near zero and elevated valuations, markets are clearly in a fragile state.

The volatility we recently witnessed is simply the manifestation of the current underlying fragility of the markets. We expect the period of increased volatility to continue and do not see a true normalization – if anyone can really define what “normal” is any longer – of the markets any time soon.

With investing, as with many other things in life, to prepare yourself for how you will do it, you first need to know what you are preparing for. In other words, taking a look deeper into what the root problems are now will help in planning for what to do next.

What’s different this time?

The bull market we’ve seen since 2009 has been mainly a liquidity-driven rally. Central banks worldwide have lowered interest rates to previously unseen levels and pumped enormous liquidity into the market. This has driven asset prices up and made things a lot rosier than they are.

But the problem is that the central banks don’t have any arrows left in their quiver. And we largely mean the U.S. Federal Reserve here, even though all central banks are currently in some stage of monetary easing.

Think about it: the Fed is in a tough spot compared to several years back when they in essence had a clean canvas to work with. On the one hand, meaningful tapering has become increasingly difficult as this would add to the deflationary pressure the US is experiencing due to the stronger USD and weaker commodity prices. Deflation was exactly one of reasons the FED gave for not raising interest rates.

On the other hand, short of yet another round of QE or negative interest rates, there is not much the Fed can currently do to “stimulate” the economy in the case of a recession.

After seven years of muddling through, market participants are picking up on the fact that central bankers are not omnipotent and that they cannot “stimulate” the market forever. This became clear in China, where Chinese authorities and the central bank failed to contain the drastic sell-off in the equity markets despite their desperate attempts.

This is not to say that another “Whatever it takes” comment by a prominent central banker wouldn’t elevate markets again, but trust in central bankers continues to fade. When market developments are so closely related to the actions of central banks, they become inherently fragile and prone to volatility.

We have come a long way since the lows we witnessed in 2009 and equity valuations are relatively high by a historical comparison. However, due to the current interest rate level, they seem attractive on a relative basis to many investors. What would you rather own, a German government bond with a negative yield or stocks in Siemens offering, for example, a dividend yield of 3.8% and the potential for capital gains? Put in front of this choice, many investors are choosing the latter.

You will find little argument and the choice is clear, but the question remains whether it is better to stay on the sidelines or actively monitor risk to be able to hedge potential risks when markets seem bloated.

And then there is debt. Wasn’t that the cause of the previous crisis and hasn’t that been resolved? Well, no, not really. In the past seven years alone, the Debt-to-GDP ratio of the US government increased from 65% to 103%. China had an even more drastic increase. Its total debt (considering not only government debt) quadrupled from 7$ to 28$ trillion from 2007 to 2014. Debt is not, per se, an “evil”. If used productively to generate an added value in the future, it can be a very useful tool leading to prosperity.

However, this is not the case today where debt is more often used to finance current consumption, to buy assets, or to finance unproductive projects. These developments tend to lead to bubbles, because when interest rates are close to zero, pretty much any investment makes sense. Once interest rates normalize, which they eventually will, the unsustainability becomes clear.

Was what happened in August different than where we were at several years ago? We believe it is, particularly in the sense that we are in unchartered territory when it comes to monetary easing and debt levels. Don’t expect to constantly hear “Subprime Mortgages” on Bloomberg or CNBC once the next financial crisis hits, as the ultimate catalyst will surely be a different one than the last.

Yet, to put it in the words of Mark Twain “History doesn’t repeat itself, but it does rhyme”. The catalyst and the course of the next crisis will surely be unique, but the outcome will be the same: the bubble will burst. And with the volatility we saw in lately, the question is not if, but rather when.

Finding the crystal ball with how to invest

When it comes to investments there is no one size fits all solution for everyone’s needs. However, there are some key aspects you need to remember. First, remember one of the oldest investment rules: Diversification. Simply put, don’t put all your eggs in one basket! Broad diversification is the best hedge one can have against the unforeseen.

Furthermore, uncertain times require active risk monitoring. You need to be able to quickly adapt to situations and implement a hedge when necessary. In our next issue of BFI Insights, we will give you an overview of different ways to hedge a portfolio that need to be considered and implemented.

Although, we mentioned that equity markets have elevated valuations we would like to put this into context. Saying “equity markets are elevated” is similar to saying “the average life expectancy is 71” although in truth life expectancy ranges from 46 in Sierra Leone to 84 in Japan.

Equity markets are similar! In market situations like the one we are in, setting the right focus on undervalued sectors and sectors less prone to crises like consumer stables can add value to your portfolio.  Setting the right geographical focus is also just as important.

Investing today has certainly changed from the ways you could do it in the 00’s, and many of the methods and patterns used then have been turned on their head. In any case, while it is clear problems still lie ahead, we have yet to find anyone that has the crystal ball and can tell when the house of cards will come tumbling down.

Until then, we too are adapting to the change in the rules, if you want to call them that, and can help you position yourself for the uncertain times ahead.

Dirk Steinhoff is the Chief Investment Officer at:BFI Wealth Management (International) Inc.Bergstrasse 21 | 8044 Zurich | Switzerland

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