It is hard to differentiate the “chicken” from the “egg” these days as investors seek to determine what forces are driving the turmoil in financial markets. The day-to-day moves have been gut-wrenching as investors experience one of the worst starts to a year in generations. In conditions like these, it is important to maintain some level of calm and a longer-term perspective to differentiate true fundamental signals from financial market noise. That sense of perspective helps us assess the events creating the dislocations and identify possible circuit breakers that could lead to an improvement in investor sentiment.
With regard to the causes of volatility, we can point to three likely triggers.
First, after shocking markets with a steep devaluation in the yuan of roughly 5% last August, China’s authorities enacted further currency adjustments in early January. In a mirror image to the bout of volatility in August and September, this action has once again led investors to question the ultimate objective of Chinese currency policy. Is the goal a steeper devaluation in order to capture share of the global export markets and in doing so create a deflationary trajectory? Or is the policy a more benign attempt to manage an overvalued currency linked to the U.S. dollar and navigate a longer-term middle income transition? The answer is not readily clear, but for many investors, the knee-jerk reaction is to reduce risk.
Second, investors in the debt of financial companies in Europe and around the world were shocked in late December when Portuguese authorities confiscated principal from holders of bonds of a “good” bank, Novo Banco, and moved bondholders’ claims back to a “bad” bank, Banco Espirito Santo. This arbitrary and capricious action wiped out €2 billion in value and represented a complete turnaround in the expressed policy to remedy the bad bank situation and the principle of leaving no creditor worse off. The uncertainty created by arbitrary policy has infected other European financial institutions. Just this week, the Italian banking system has come under renewed pressure over policy concerns regarding non-performing loans.
Third, in welcoming Iran back into the global community, markets are experiencing increased supply in saturated crude oil markets. Year to date, crude prices are down a staggering 25%. While it should be unambiguous that declining energy prices are a windfall gain for global consumers and a positive for economic growth, near-term concerns about differentiating winners from losers in a financial context trump longer-term economic possibilities. The near-term losers tend to be commodity-linked emerging markets including Russia, Brazil and Mexico in addition to Middle Eastern oil producers and high yield and investment grade corporates linked to energy, metals and mining.
Now, after assessing the proximate causes for volatility, let’s consider possible circuit breakers. Last year, a few levers of stability tended to emerge during periods of market stress.
To begin with, while investors can question the long-term efficacy of monetary policy and there is some divergence in policy globally, there is no doubt that central banks still have the willingness and ability to stabilize financial conditions. We can expect further policy easing from the People’s Bank of China, the European Central Bank and possibly the Bank of Japan in the coming weeks and months in addition to dovish commentary on the willingness and ability to do whatever it takes to maintain economic recovery and meet long-term inflation targets. In fact, on Thursday morning the ECB acknowledged the increased downside risk since the start of the year and the possibility of additional stimulus in March. Similarly, after one of the most dovish hikes in history, the Federal Reserve is likely to reiterate great patience in normalizing monetary policy and great sensitivity to financial conditions and the international economic backdrop.
Also, the positive trajectory of economic growth will likely reassert itself in the data. To be sure, declines in energy prices should and will pressure global growth modestly downward (for our outlook on oil prices, please read Greg Sharenow’s blog post). In the U.S., left tail economic risks have certainly emerged but the real economy is likely to continue to expand at a healthy pace, even if the outlook for 2016 is revised down slightly.
Valuation has certainly adjusted and this creates opportunity for nimble and active investors. The yield spreads on the debt of high yield and investment grade companies not linked to commodities have widened in sympathy with the overall risk-off tone. Given a relatively stable economic outlook, we believe the credit sector is in the sweet spot for excess return potential. Within credit, opportunities exist in the debt of senior financials and bank capital. And high yield municipals may offer income and relative stability in this environment. Opportunity also exists in select emerging markets where commodity risk has pushed valuations well beyond fundamental economic risk.
The first weeks of 2016 have been harrowing for certain, but out of volatility comes opportunity.