Recent market volatility has implications from Shanghai to D.C.
August 27, 2015
By David Hillmeyer
A shift away from accommodative monetary policies generally leads to higher volatility and today is no exception. However, one must ask if we are now observing signs in the marketplace that central bank policies, including zero rates and quantitative easing, are reaching their limit.
Are recent developments enough to prevent the Federal Reserve from raising rates when the U.S. economy is still expanding, job growth is still reasonably healthy, and housing has been showing further signs of improvement? Although we can’t say with certainty, rest assured it will be the most difficult decision Janet Yellen has faced since assuming the position of chair of the Federal Open Market Committee.
We have had the view that we ran the risk that something would interrupt the Fed’s ability to raise interest rates for the first time in more than eight years. The recent volatility playing out in emerging markets, and in particular China, may be the catalyst that prevents the Fed from moving away from the zero bound at September’s meeting. If the Fed does initiate a rate increase, it will be during a period when many of the world’s economies will be exporting deflation. This trend will likely accelerate on further dollar strength, making the next increase more challenging.
As the Fed has said multiple times, it is important that we focus on the pace of tightening rather than the actual rate increases. With this economic backdrop we would anticipate that rates should remain relatively low for longer.
By Francis X. Morris
The recent increase in the volatility and the subsequent correction in small-cap equities, while stressful to watch, remains at this point in time just that — a correction. The main reason for the correction appears to be the sharp deceleration in China’s growth rate and the subsequent currency devaluation. Additionally, commodity prices, particularly oil, have come under increasing pressure. Corrections often serve to improve the overall valuation of the marketplace. This is true for small-caps where the overall valuation has declined to approximately 17x next year’s earnings, down from more than 19x. While still not cheap by historical standards, it is nonetheless a significant improvement.
We would remind investors that small-caps derive the vast proportion of their revenues and earnings from domestic-oriented sources. And while a global slowdown is not good for all investments, and will require close monitoring, it has not changed our emphasis on investing in companies on a stock-by-stock basis. In light of this we have taken the opportunity to add to positions that have corrected and in which we still see significant upside potential based on company-specific analysis.
Global and International Value Equity
By Margaret MacCarthy Bacon
China is now the world’s second largest economy and currently represents 15% of global gross domestic product (GDP). Investors have concerns regarding the Chinese government’s ability to manage the crisis. While the government’s strategy of providing excessive credit and investment helped fuel China’s rebound from the crisis in 2008, it also created risk exposures in the real estate and financial sectors. According to a recent International Monetary Fund (IMF) report, some progress has been made — credit growth and residential real estate growth have slowed, more flexibility has been allowed in interest rate settings, and the new budget law has been established. However, the country needs to develop a more open and market-based economy to ensure that companies can have access to financing and are able to expand. State-owned enterprises need to be reformed as well to allow the private sector to develop further and create more jobs.
Regardless of how China’s reforms will actually develop, equity markets must weigh in real time both the high significance of those prospective actions and the high uncertainty regarding their nature and timing. While this pattern persists, elevated market volatility and high levels of risk aversion may well prevail. Ultimately, we believe that a company will succeed or fail on the strength of its management, the competitiveness of its productive asset base, the quality of its balance sheet, and the structure of its global market positioning. We tend not to focus on where a company is domiciled but more on what its real underlying risk exposures are. We focus on companies with good free cash flow, strong balance sheets, and capable management teams. In combination with notable valuation, we find these companies have historically provided the most consistent source of relative outperformance.
Large-Cap Value Equity
By Ty Nutt
There’s no question for us, the recent market volatility has made a September increase in U.S. rates less likely. It will hinge on what happens with U.S. stock prices from this point forward. The Fed’s radical steps during and since the financial crisis were designed to create asset inflation. To the extent that asset values fall, affecting the mood of investors (and consumers) and potentially slowing U.S. economic growth, the Fed will have to put its plans on hold.
For a long time now (years not months or quarters), our team has positioned the Large-Cap Value portfolio fairly defensively. We’ve overweighted the more defensive sectors and underweighted the more economically sensitive sectors, with the exception of energy. We’ve emphasized quality— that is, stronger balance sheets and more predictable earnings — believing it would contribute to the defensive character of the portfolio. Naturally, we’ve also continued to insist on companies with low price multiples versus our universe of candidates. Lastly, our dividend yield is above that of the Russell 1000® Value Index and well above that of the S&P 500® Index. None of this will guarantee outperformance in a down market, but we hope it will help.
It’s just too early to tell if this will remain a correction or turn into a cyclical bear market. Either path is possible. Our basic stock market outlook remains the same. From this starting point, in terms of overall market valuation, it’s hard to expect anything more than modest total returns. In other words, we could remain in a flattish market over the next 5 to 7 years. And that scenario, of course, would likely include significant upward and downward moves in prices.
Real Estate Securities and Income Solutions
By Bob Zenouzi
The slowdown in China is real and we expect there to be continued volatility as China’s economy adjusts from investment to consumption. While the stock market has been a roller coaster, the actual economy continues to struggle. We have been worried about the emerging markets, and China specifically, for quite some time, so we are overweight the developed markets (specifically the U.S.) and underweight emerging markets. While this trade was unpopular during the first few months of the year, we have started to see it reverse as investors accept lower global growth and search for stable income.
The United States offers stable income at a discount relative to the globe, and as such we remain overweight the U.S. real estate investment trusts (REITs). Despite worries about China and a global growth slowdown, debt markets continue to operate functionally with liquid access to low-cost capital for public real estate companies in developed markets. Again, we favor these markets in this environment. Additionally, we note that chasing yield (given the performance of REITs, utilities, and master-limited partnerships year-to-date) has underperformed in a down market. They were just too expensive and now we are seeing the downside.
Small / Mid-Cap Value Equity
By Christopher S. Beck
Situations similar to the one we are currently experiencing do give opportunities to reshuffle some names and “high-grade” the portfolios. We do not envision any wholesale dramatic change in sector positioning unless the valuations are favorable to do so.
We would expect the volatility to continue (both up and down) until the global financial markets become more stable. We believe the current situation most likely rules out any Fed rate increase in September. The U.S. continues to look like the most stable economy and, in our view, will likely outperform global economies. This should be a positive for small-caps as they derive more of their revenues from domestic sales than do large-caps and mid-caps.
We do not intend to be “heroes” by trying to pick off bottoms, but we will be active in buying higher-quality names as they often decline as much as lower-quality names due to their having better liquidity.
The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market.
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