Global equity markets have been under significant selling pressure over the past week. The volatility catalyst seems to be tied to the recent moves China’s made to stimulate their economy and let their currency depreciate. The fear is that already weak emerging markets will suffer significantly further weakness as China spreads its deflationary problems to the rest of the world.
Call it a sell-off or call it a rout. Equity markets around the world shed 5% or more of their value through the week as the realities of a slower global growth environment came to the forefront of investors' minds. In the United States, the S&P 500 Index shed 5.8% pushing it into a loss position for the year. In Asia the Nikkei 225 Index dropped 7.3% and the Shanghai Composite fell 11.5%. In Europe, the EuroStoxx 600 retraced 6.5%, and finally in Canada, the S&P/TSX Composite Index took a 5.3% haircut.
The immediate question is what was the cause? The more relevant question is where do we go from here?
First, to take the good words from Martha Stewart, investors should stay in control and never panic. In our view, the recent global pullback is a result of the equity markets letting off steam. That's not to say the markets were overheated, but rather a result of macro-economic factors (China, Greece, the Fed, etc.) that leaves one needing to vent. Although market volatility may persist over the coming days or weeks, we do not believe that current economic conditions as well as market fundamentals point to the development of something more ominous.
First off, this is unlike 2008-9. Bear markets are typically characterized by recessions following excess in the system and/or overvalued markets (as was the case in 1987). The global economy is sluggish and leaves something to be desired, but to say recessionary conditions exist would be a stretch at best. A typical recession would see an inverted yield curve, the manufacturing PMI index to fall below 50, and capital spending as a percentage of GDP peak out near 30%. We do not have any of those conditions present today.
What we are experiencing is a slower global growth environment which is not atypical of a recovery following a financial crisis. In the past, financial crises have been followed by a slow recovery that lasts longer than average with GDP growth at a rate of 1% less than the prior recovery.
In our view, last week's volatility was a direct result of a number of macro-economic factors. Within the span of the past several months we have seen three major global capital market regime changes: the breakdown of the 40-year old OPEC oil cartel and a downward spiral in crude prices; a generational shift in the Chinese economy from fixed asset spending to a consumer driven model; and a global theme of currency devaluation that breaks the spirit of the Bretton-Woods agreement. Lastly, on the horizon is the shift from the US Federal Reserve's zero interest rate policy to a tightening bias not seen in seven years. It’s a lot to take in, and makes us miss the days when all we had to deal with was a US Government shut-down.
All this is not to say the environment is perfect. The Chinese economy is slowing as it shifts from an "old" economy to "new". The countries that were dependent on China's old economy built on fixed asset investment (read: commodity dependence) are struggling with the new reality. Those that feed the consumer are still growing.
From a company reporting perspective the old measure of revenue and earnings surprises have taken the feel of a seven year old's birthday party - where everyone's a winner just for showing up. With the bar set too low and margins at record highs, the recipe for a correction is all there. With that said, outside the energy sector earnings for the S&P 500 companies grew approximately 4% for the most recent quarter on a year-over-year basis. Not stellar, but hardly recessionary.
What are the reasons to believe this is more likely a temporary pause in the current bull market? In the United States the consumer remains healthy. The labour market continues to improve and wages are growing. US housing starts rose to an annualized pace of 1.2mm in July, a seven year high yet still 20% below the long term average of 1.5mm starts.
While it is difficult to assess the magnitude of any period of panic selling in equity markets given that the performance variance of these events is so wide through time, we have conviction that the duration for this bout of weakness is likely to be measured in days or weeks, not in quarters or years. The near 15% sell-off in 2010 and close to 18% sell-off in 2011 were incredibly uncomfortable, but they did not mark the beginning of the end of the bull market. Keep in mind that the S&P 500 has experienced, on average, an intra-year drop of 14.2% over the past 35-40 years and we have had many positive longer-term outcomes.
The deepest, longest, and thus most destructive equity market sell-offs have typically been associated with economic contraction. From our lens, we believe the odds of a global recession remains rather low. European, Japanese, and American leading economic data continue to point to either healthy or accelerating activity over the next 9-12 months. This should ultimately translate into a better tone to earnings and help place a higher floor under share prices.
It is times just like these when it becomes incredibly important not to give in to emotion, but to follow your well thought out and pre-defined investment program.
Please call us if you wish to discuss your portfolio or any concerns/questions you may have.
The Dekker Hewett Group