We started Monday morning with the screens full of red, again. Over the last few days the equity and commodity markets have been under pressure, especially in the emerging world. Through Friday the S&P is off -6.8% from its high while the Dow is down -9.4% (including dividends). Emerging equities are off -21.2% and China is off roughly -25%.
Overnight China was down another -8.5% and today the S&P lost roughly -4%. This brings the losses YTD for the U.S. indexes to roughly -7%. While not a particularly large number, the speed of the decline has taken everyone by surprise. Below are our thoughts as of Monday morning:
- Trading on Thursday, Friday, and today have a definite hint of panic. Tensions are high.
- The problems in the emerging world are real. China is undergoing a large economic slowdown, and this is impacting the rest of the emerging world and the commodity producers in the developed world such as Australia and Canada. This is serious because China has been a locomotive of growth for much of the emerging world.
- The problems are being compounded by the fact that emerging currencies are falling which is leading to capital flight out of the region. We have also seen rapid debt growth in many emerging countries which makes them more fragile.
- But today isn’t 1998. The odds of outright sovereign default, like we saw in 1998, are low. Certainly corporations in the emerging world and possibly some oil companies will see bankruptcy, but emerging countries are in far better shape today than they were in 1998. In general they hold significant reserves to meet debt payment needs
- In some ways this is analogous to the situation in 1998 when the emerging world fell in crisis and pulled global equities temporarily lower.
- The operative word here is temporarily. Even in 1998 markets eventually recovered after the authorities intervened aggressively and the panic eventually burned itself out.
- We appear to be following a similar script even though the situation arguably isn’t as bad as 1998.
- Our exposure to the emerging world is limited. We cut our allocation to this region in June of this year, and our Risk Zone 8 and 6 allocations have 5% and 1.9% exposed to emerging equities respectively. This exposure is largely through Matthews Growth & Income. Matthews is a balanced equity fund that typically holds a mix of stocks and other, less volatile assets. The fund has far outperformed the emerging market index so far this year.
- Our exposure to China is minimal. In our Risk Zone 8 and 6 portfolios we hold less than 1% in direct Chinese exposure.
- A couple weeks ago we also cut our allocation to high-yield and other risky segments of the bond market through the sale of Loomis Sayles Bond. We added to core bonds with this trade as a defensive maneuver.
- We don’t anticipate making any dramatic changes in the days to come. We have found that when the markets are gripped with panic it is easy to make irrational trade decisions that you ultimately regret. We want to give the markets some time to settle down so we can assess what has truly changed in the global economy.
- We suspect the fallout for the developed world will be limited. The United States has little direct exposure to China given that we export less than 1% of GDP to the country. Certainly the market turmoil will hit confidence over the short-term, but fundamentals such as consumer spending, housing, employment, etc. remain solid.
- Japan has greater exposure to the emerging world, and we will look at this regional allocation closely once volatility settles down.
- The picture in Europe is mixed. As late as last week Europe notched up some notably solid economic reports. Certainly Germany is exposed to a China slowdown because it exports so much, but we suspect policy support in both Europe and the U.S. will play a key role in preventing deeper economic problems.
- This last point is important. In part the turmoil of the last few days is due to worries about a Fed hike in September. We suspect the Fed blinks and pushes any rate hikes out to a later date. If there is a catalyst for a market turnaround this could be it. We are also likely to see steps in China to support the economy.
- This is obviously a stressful time for investors in part because of the speed of the correction, and also because we are not used to them. You have to go back to 2011 for the last 10% correction. The last four years have been unusually tranquil.
- While no one, ourselves included, saw this turmoil unfolding quite like it has, we have made allocation changes over the last two months to reduce our exposure to the emerging world and commodity producers. We also have limited exposure to China.
- We caution against making rash allocation moves when panic is in the air. Our plan is to give the markets time to settle down so we can assess the broad global economic backdrop. We don’t want to make rash decisions that are driven far more by emotions than fact.
Since 2011 we have three gut check moments – the euro crisis in 2011, the fiscal cliff in 2012-2013, and taper tantrum in 2013. Each moment was scary and gut wrenching, but ultimately was blown out of proportion. We suspect for the developed world at least the China/emerging market crisis of 2015 could turn out similarly.
If you have any questions or concerns please don’t hesitate to contact your financial advisor.