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THE DISCOMFORT ZONE

John Gorlow | Mar 08, 2016
Intense Volatility, Then A Mid-Month Rally
 
Plunging stock prices in early February drove worldwide stock markets to multi-year lows, casting a long shadow over near-term prospects for the global economy. As the rout intensified, robust investor demand for safe haven assets pushed the yield on the 10-year Treasury note down to 1.64%, its lowest level in more than a year. The price of gold surged to a 12-month high.
 
By the close of trading on February 11, the S&P 500 was down -5.7% month-to-date (MTD) and -10.5% year-to-date (YTD). International developed markets, as measured by the MSCI World ex US Index, were down -6% MTD and -14.2% YTD. And developing markets, as measured by MSCI’s Emerging Markets Index, were down -3.9% MTD and -12.4% YTD.
 
After the sell-off, global stock prices rallied considerably from their mid-month lows, narrowing losses to negative -0.14% for US large caps, negative -1.4% for international developed stocks, and negative -0.16% for emerging markets by month’s end.
 
Still, YTD global stock returns remained solidly in the red at -5.09% for US large caps, -8.18% for international developed stocks, and -6.64% for emerging market equities.
 
Optimists Vs. Pessimists
 
While February’s mid-month rebound in stock prices provided some respite after January’s steep declines, the direction of the markets is anyone’s guess. Is the latest decline yet another buying opportunity or is it a prelude to a bigger slide? Nobody knows, but the pundits have plenty to say.
  
Martin Feldstein, a Harvard professor and former Chairman of the Council of Economic Advisors under President Reagan, believes the American economy is in better shape than the financial markets fear. In a Wall Street Journal article (21-February 2016), he writes that recent steep declines in the prices of stocks and junk bonds are not the precursor of an economic downturn but rather an inevitable recalibration of financial asset prices. “Fortunately the necessary financial corrections are happening when the US economy is strong,” he says, pointing to nearly full employment, an annualized increase of 3.5% in household disposable income, and a 7% rise in total home value. Feldstein dismisses concerns about the “potential contagion effect” on the US economy of weak demand from China, Europe, Japan, Russia and Brazil, noting that “the drag of lower exports on our GDP in the past six months has been less than 0.25%.”
 
Others are not so sure. In last month’s blog, we pointed to Paul Krugman’s concern that business cycles across nations are “often more synchronized than they should be” if one judges only by the numbers (New York Times, 8-January 2016). Psychological contagion from China’s slowdown could have a crippling, disruptive effect on other economies.  And if that happens, Krugman believes US monetary policy would be a limited tool with current near-zero interest rates, and there’s no political appetite for a stimulus package from either Europe or the US. In other words, no easy fixes.
 
There’s more gloom and doom in a 20-February 2016 Barron’s article (Stock Rally Masks Rising Risks by Jonathan R. Laing), which quotes respected financial thinkers including Charles Gave, Robert Shiller and former US Treasury Secretary Larry Summers, all of whom believe that precipitous market declines are a near-term possibility. From Summers: “Signals should be taken seriously when they are long-lasting and coming from many markets.” As reported, Shiller somewhat sheepishly admitted to having dumped about half the stock holdings in his retirement accounts during a low in stock prices last August.
 
Determine Your Risk Tolerance, Then Hold Steady
 
As I have stressed many time before, markets go up and markets go down, but our inability to assess the probability of different outcomes and events in security prices reinforces the importance of proper asset allocation, diversification, and a long-term perspective. What’s your alternative?  Should you attempt to forecast future market activity through nonstop parsing of information from news and other sources? Of all the investment principles investors should heed, one stands above all: It's time in the market that builds returns, not market timing. Missing only a few days of strong returns can drastically impact overall performance. As always, my best advice is to stay diversified according to your risk tolerance and stick to a low cost, proven strategy that captures market returns during all seasons. 
 
Fixed Income: Positive in February
 
The majority of fixed income indices closed positively for the month of February. Investment grade corporate bonds, as measured by Barclays Intermediate AA Credit Index, posted a 0.45 total return for February and 1.40% YTD. Higher-quality Muni Bonds, as measured by Barclays 5-year Municipal Bond Index, posted a 0.38 total return for February, returning 1.53% YTD. Barclay’s Corporate High Yield Index posted a 0.57% return for the month but remained in the red at -1% YTD. Inflation Protected Securities posted a 1.11% return for the month and 2.6% YTD.
 
Regaining its luster, gold posted a 9% return for the month and a 15% return YTD. Meanwhile, US crude-oil prices snapped a three-month losing streak to gain 0.4% in February.
 
Super-Low Interest Rates: Cause for Concern?
 
Very low or negative interest rates are now a worldwide trend, and that’s causing alarm in financial circles. Broadly speaking, the economic theory behind negative rates is that they encourage banks to lend money more cheaply and savers to spend more freely, while discouraging overseas money from flowing in and pushing currencies lower.
 
But what happens when everyone jumps on the bandwagon? Sweden, Switzerland, Denmark, the Eurozone and most recently Japan—adding up to almost a quarter of the global economy—have all introduced some form of negative interest rate policy. Some analysts believe the Federal Reserve will have to follow suit, despite its expressed intention to slowly raise rates. Janet Yellen has not ruled it out.
 
In just the past few weeks, the five-year US Treasury note fell to 1.1%, its lowest yield since June 2013. And as mentioned earlier, the 10-year US Treasury note fell to 1.64%, its lowest yield in over a year. Interest rates in other developed markets are even lower. For example, the yield on 10-year government bonds in Germany is 0.24%, 1.18% in Canada, 1.45% in the UK and negative 0.04% in Japan. 
 
Critics believe negative interest rates are a sign that policymakers have run out of options to invigorate growth. Indeed, if major government bond markets are right, the global economy is sliding towards recession (Financial Times, 7-February 2016). Equally worrisome, some believe this unconventional monetary policy could backfire with unknowable long-term negative economic consequences for the financial sector.
 
William Poole, former President and CEO of the Federal Reserve Bank of St. Louis, warns that “Negative central-bank interest rates will not create growth any more than the Federal Reserve’s near-zero interest rates did in the US. And it will divert attention from the structural problems that have plagued growth here, as well as in Europe and Japan, and how these problems can be solved.” (Wall Street Journal, 9-February 2016.) “It is impossible for every country in the world to depreciate its currency relative to others,” he points out, a zero sum game that could result in a “damaging currency war” and the collapse of one or more central banks.
 
Our Advice
 
So what’s an investor to do? One can sympathize with those who want to flee from dramatic price fluctuations (and yet find no solace in current bond prices). Truth is, the markets will always reflect new developments in securities pricing—both positive and negative—as quickly as possible. As fast as the market falls off a cliff, it can climb back up. We saw evidence of that in February and many other months over the past decade. If 125 years of financial history is our guide, those who stay diversified and stick to a proven, low-cost investment strategy through good times and bad will be the long-term winners.