We expected and prepared for a period of market turbulence at the end of the third quarter of last year and took decisive steps to lower our exposure to global stock markets accordingly. We do not yet see reason to change course further.
This has been the worst start to the year for global stock markets by almost any measure. After the first two weeks of 2016, the S&P 500 index has fallen about 8% (closer to 10% when looking at the All Country World index) from its year-end level. Many investors pay particular attention to January’s performance, as they view it as a leading indicator of how the remainder of the year will unfold. The Stock Trader’s Almanac, for instance, famously quipped, “As goes January, so goes the year.”
To assess whether that is likely to be the case in 2016, let’s examine the underlying causes for so much angst today. There are two reasons driving concern that the global economic outlook is deteriorating, which is being exacerbated by a third worry that policymakers are not heeding the markets’ messages. Firstly, commodity markets continue to slide. Oil fell below $30/barrel this week, and the price of copper (often referred to as “Dr. Copper” for its accuracy in forecasting future economic growth) continues to collapse. Secondly, the Chinese currency and stock markets are experiencing further pressure as investors question whether the Chinese economy will be able to escape a hard landing.
This is not the first time concerns about the global economic outlook have cropped up since stock markets bottomed in 2009. What is aggravating the situation today is that for the first time in seven years, the Federal Reserve (Fed) is no longer there to cushion the impact of pockets of turbulence when investors question the outlook for their fundamental drivers. By beginning to raise interest rates in December, the Fed has judged that the US economy has enough momentum, despite the darker clouds over the international outlook, to weather their preferred path for gradual, “data driven” normalization of monetary policy.
The bottom line is if commodity prices continue to collapse and choke off growth in the emerging world and China continues to experience economic difficulties, the Fed won’t ride to the rescue by lowering interest rates or buying bonds as they have done for so long. This raises the possibility of financial accidents amongst those that have been overleveraged to the assumptions of rising commodity prices and the Chinese secular growth story which have underpinned the bull market in risk assets for so long.
So far, none of this year’s events have been a surprise to us. Consider the following:
- Our steadfast view to be patient and resist calling a bottom to the oil price has so far proven correct. The areas we have avoided (e.g. commodities in general, the energy sector including Master Limited Partnerships, high yielding value stocks, emerging markets and high yield bonds) are starting to look even more attractive to us now, but not yet.
- We took decisive steps to lower our exposure to global stock markets at the end of the third quarter of last year. Our model discipline has been consistent in warning us about this, and we took action. The cash we raised is waiting to be invested in these opportunities when the time is right, and the greater allocations to both Safe and Manager Skill have appreciated in value since the start of the year.
- Last October, Adrian Cronje’s presentation “Making Sense of it All? What Capital Markets Will Tell Business Owners Before Economists Will” articulated a dashboard of indicators (key components from the models we use) we are watching closely to discern whether the markets’ messages are suggesting something more sinister may ensue. Since we published that piece:
- Commodity markets have continued to decline. The Goldman Sachs commodity index is down a further 20% since the end of October 2015.
- While still elevated, US credit spreads have not widened much further. High yield bond spreads over Treasuries have risen from 5.3% to 6.8%. This compares with 8.2% during the summer of 2011 when ratings agencies downgraded the credit quality of US Treasury bonds.
- The final shoe – the slope of the yield curve – has still not dropped. It has flattened further, but has not yet inverted. The yield spread between 2-year and 10-year maturities has declined from 1.42% to 1.24%, while at the longer end, it has remained flat between 10-year and 30-year maturities.
These are the three indicators we are watching most closely for signs that the risks of a global and even US recession have risen. If that were to occur, the odds of an extended bear market in stocks will increase, and the rest of 2016 may echo what has unfolded so far in January. That assessment would lead us to take further steps to reduce our exposure to global stock markets, but for now the seatbelt light remains on.
In the meantime, our 2016 Capital Markets Forecast (which will be released in the coming weeks) will articulate our key priorities over the next few months:
- Be selective in public markets and emphasize areas where policy is driven by an effort to implement structural reform and long-lasting growth (e.g. Japan).
- Initiate exposure to asset classes where the risk we are taking does not depend on the direction of bond or stock markets, such as our recent allocation to Reinsurance within Manager Skill.
We are pleased with how our approach of managing risk ahead of return is protecting client capital during these turbulent times. As always, thank you for the trust and confidence you place in us.
 Our Q3 2015 Quarterly IST Letter “A Bull Market Correction or Something More Sinister?” provides more details on this allocation change.
 No inference ‘Safe’ assets cannot lose value.
 Please contact us to request a copy of recent client communication on these specific allocation changes.