Highlights:
- After a multi-year period of relative calm, volatility returned to the equity markets late in the third quarter and has carried on into the fourth quarter. Although unsettling, levels of volatility seen would not be historically extreme. Indeed, Federal Reserve officials see this as favorable, under their belief that investors have a tendency to take inappropriate levels of risk when markets are too tranquil.
- Global (European and Chinese) growth concerns seem to be a main culprit of recent market volatility. U.S. consumer spending has been resilient, but far from robust enough to support a global recovery. A boost to real incomes in the form of higher wages and lower energy prices could go a long way towards strengthening consumer demand and market sentiment.
- The drop in equities has corresponded with an increase in treasury prices that has in turn lowered mortgage rates. The combination of a strengthening job market and lower mortgage rates could help more traditional homebuyers qualify for mortgages, which would be a big help to a real estate market that is struggling to replace investors that were a large part of the initial recovery.
- Europe continues to flirt dangerously close with deflation, yet policy makers, primarily in Germany, remain hesitant to enact quantitative easing programs that were deployed successfully in the U.S., U.K. and Japan.
- Reports that recent stimulus efforts appeared unsuccessful and comments by the Chinese Finance Minister that no new stimulus measures were imminent created fresh worries about slowing growth in China.
Comments:
Earlier this year Federal Reserve officials expressed concern that equity market volatility was unusually low, which tends to lend itself to investors taking more risk than what is appropriate. Such a low volatility environment risked compounding the dilemma the Fed has been facing for a number of years now – wanting to keep interest rates low to boost economic growth, hiring and inflation, but cognizant that such policies can have unintended side-effects on financial markets. As the third quarter came to a close and the fourth quarter began, this is likely one less worry for the Fed as volatility has spiked in global equity markets. Global economic expansion since the 2008 financial crisis has been excruciatingly slow, but a recovery nevertheless. As the crisis originated in the U.S., it is not surprising that the recovery began here as well.
From a cyclical perspective, economists had hoped that rising consumer confidence in the U.S. would fuel demand at home, which in turn would increase demand for imports and help Europe and other regions of the world accelerate their own economic recoveries. Unfortunately, U.S. consumer spending has been steady, but far from robust enough to have much of an impact outside of its own borders. A surprising drop in U.S. retail sales in September, coupled with declining manufacturing output and producer prices, drove home this point. Help may be on the way though as the recent fall in the price of oil (down 13% in the third quarter) raises real incomes and gives consumers more purchasing power. Nevertheless, it is likely the Fed will terminate its extraordinary bond buying program shortly. Although the equity market seems to fret over this prospect, it is a good indication that the domestic economy can stand on its own without extraordinary measures.
Also working in the U.S. consumer’s favor is a job market that seems to finally be shifting the balance of power from employers toward employees. With the unemployment rate down to 5.9%, a six-year low, initial jobless claims at its lowest level since 2000, and the number of job openings across the U.S. at a 13-year high, it would appear that a tightening labor market may finally be raising pressure on companies to boost worker pay. A tighter labor market increases the probability of higher wages for U.S. workers, which would be a welcome relief after seeing real incomes fall by 3.1% in the five years since the recession ended. Stronger purchasing power from rising incomes would generally have a propensity of giving a shot in the arm to consumer demand.
The recent volatility in the equity markets could also be a blessing for the real estate market, where home sales have slumped recently due to fewer purchases by investors that were a big part of the housing-market rebound. As investors leave the market, demand shifts squarely to traditional home buyers, including first-time buyers, who typically need a mortgage. In this regard, tight credit underwriting standards continues to be an impediment to many families from obtaining a home loan. The recent volatility in the equity markets has corresponded with a spike in treasury prices that has resulted in falling mortgage rates. The combination of a strengthening job market and lower mortgage rates should over time strengthen debt-to-income ratios that are a critical variable for most families in securing a mortgage loan.
As the U.S. economy takes one step forward, the euro zone seems to take two steps backward. Europe’s largest economy, Germany, saw its biggest industrial drop in five years, which is not promising for an economy that was already showing signs of contraction. Euro zone inflation is at a five-year low of 0.3% and on the precipice of deflation. Yet at a time when the euro zone is flirting with outright deflation, the European Central Bank (ECB) remains hesitant to enact quantitative easing programs that were deployed successfully in the U.S., U.K. and Japan. The decentralized nature of this region, exasperated by opposition from Germany and other Eurozone governments that believe it is a mistake to rely on public debt to lift growth, remains an obstacle in putting together a coordinated effort to stimulate growth.
The disparate nature of the many economies and politics within the euro zone complicate the implementation of a monetary policy strategy that was probably more straight-forward in the U.S. Although it will be a difficult test for the ECB, there is no reason they should not be at least somewhat as successful as the Fed in fostering higher investment spending by Germany and European Union institutions while maintaining stronger economic overhauls in France, Italy and similarly situated countries.
Further, fresh worries about the slowing pace of growth in China has also played a role in the recent downturn in the financial markets. Economic data that suggested that stimulus efforts had failed to improve lending and housing sales, two weak segments of China’s economy, was then fueled by comments made by the Chinese Finance Minister that China won’t meet its full-year economic growth target of 7.5% and no further stimulus is anticipated in the near term to revive relatively weak growth. This most closely affects other emerging market countries whose commodity-driven economies have been fueled by strong demand from China for many years and allowed them to keep supplies tight and prices high. Recent protests in Hong Kong, Russia’s deepening rift with the West and escalating tension in the Middle East also rattled financial markets in the third quarter and into the fourth quarter.
Despite the significant drop and increased volatility in global equity markets over the last several weeks, corporations remain flush with cash and equity valuations remain quite reasonable based on historical averages. Thus, we believe the odds of a 1998 dot-com crash or 2008 financial crisis are remote and what we are currently experiencing is a normal result given a number of years of relatively stable, straight line equity returns. These periods of increased volatility are as inevitable as they are unpredictable. For this reason, we continue to suggest that the only funds that should be deployed to equities are those in which you have reasonably determined will not need to be accessed for several years. Funds anticipated for near and intermediate term requirements should be allocated to cash and fixed income exposure. An investment policy that is structured in this manner eliminates market timing and positions your portfolio to realize a return premium over the longer term.
Urban Financial Advisory Corporation - October, 2014