Market Recap: Is this the Correction?

Posted on October 21, 2014 by Gemmer Asset

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Market Recap

MarketRecap 10212014

It was a crazy week in the markets!  For the first time in a long time we had hints of panic selling during Wednesday’s trading.  At one the point the Dow index was down over 450 points and bond yields were falling dramatically.  We haven’t seen such dynamics since 2011 when people worried the U.S. would default on its debt.  As it turned out, the Wednesday panic proved to be a market low (for now) and we saw a bounce on Thursday and Friday.  The S&P lost 1.0% over the last five days but small-cap equities actually gained +2.8%.  The bounce in the overseas markets on Friday also pushed them into positive territory for the week.  The developed EAFE added +0.4% and emerging equities gained +0.5%.  A weaker dollar helped international returns for U.S. investors.  The euro gained +1.2% for the week.


If anything the bond market was even more volatile.  The 10-year started the week at 2.31%, but at one point early on Wednesday it hit 1.87%.  You normally see such bond market rallies only in the context of an equity market crash.  In some ways the bond market volatility is more unnerving than the equity market volatility.  Yields spiked higher on Thursday and Friday and closed the week at 2.20%.

Catalysts for a Correction


So what is behind the volatility of the last few weeks?  Interestingly, it is hard to point to any one factor, and that is what makes today’s situation a bit of a head scratcher.  It is as if the selling in stocks and buying in bonds took on a life of its own around the middle of the week.  Certainly none of the points discussed below (both good and bad) are new.  They have been with us for some time, but investors simply chose the last few days to pay attention to the bad points.




The biggest reason for the latest swoon is the growing fear about the European economy.  These fears were stoked a couple weeks ago when industrial production in Germany fell into negative territory, as you can see below.  This raises the specter that Europe is headed towards a triple dip recession.

German Indus Prod 10212014



Furthermore, we are seeing political turmoil once again in Greece.  It is becoming increasingly likely that Greece will hold snap elections in the weeks to come even though the country is seeking an early exit from its IMF bailout.  There is a worry that Greece can’t maintain its huge debt load if it exits the IMF rescue scheme.  Greek stocks have fallen by magnitudes last seen in the depths of the eurozone crisis.  The yield on Greece’s 10-year bonds also jumped from 7% to 9% in a matter of days (chart below).

Greece 10 year 10212014



What this means is that Europe continues to slip further towards Japanese like deflation.  For example, consumer prices for all 18 EU countries rose by just 0.4% in September, the lowest annual rate of inflation since September 2009 (chart below).  Eight members saw outright declines.

Tumbling Inflation 10212014



The market is now calling the European Central Bank’s (ECB) bluff.  They promised to do all they could do to prevent a deflationary spiral in Europe.  The market is questioning if they really mean it.


Tail Event Risk


Tail events—such as the Ebola outbreak—become potentially more harmful in the context of weaker global growth.  While the risks of the Ebola outbreak in terms of contagiousness, morbidity and mortality are difficult to pin down (thus the characterization as a tail event), they are potentially more harmful during a period of slower global growth and worsening expectations.  Ebola in particular is unnerving because, like SARS a few years ago, it has global repercussions.


U.S. Growth – Is the Fed Making a Mistake?


Some of the recent economic numbers in the U.S. have been on the soft side.  Retail sales and the Philly Fed manufacturing survey were disappointing and hit sentiment unusually hard.  This is focusing attention on Fed policy (again).  Many worry that the Fed is ending their support for the economy at a time when things are very fragile.  Europe remains a problem and the U.S. really isn’t growing at a self sustaining pace.  The Fed is telling us rates are headed to roughly 3% by the end of 2016 (blue line in the chart below), but the market is pricing in a rate of only 1.5% (dotted line in the chart below).

Fed rate projection 10212014

If the Fed is on track to 3%, the thinking goes, they are making a huge mistake.

Don’t Lose Sight of the Positives


The U.S. is Still Growing


If you could measure the bearish commentary about the U.S. economy you would have seen a massive spike the last couple weeks.  You would almost think we are headed towards a recession.  Certainly after the weak retail sales number, growth in the third and fourth quarters does not look as good as it did a couple weeks ago, but expectations remain decent.  Consensus still sees growth of +3.2% and +3.0% for the third and fourth quarters respectively.  This puts us on track to grow at about +2.3% this year.


Furthermore, a big positive shock for the economy is the recent dip in crude oil prices.  As you can see below, prices are down 26% over the last few months (this is for Brent).

Brent Oil Price 10212014



This typically has a positive impact on global growth.  To quote The Economist:


“…falling oil prices would boost global growth.  A $10-a-barrel fall in the oil price transfers around 0.5% of world GDP from oil exporters to oil importers.  Consumers in importing countries are more likely to spend the money quickly than cash-rich oil exporters.  By boosting spending cheaper oil therefore tends to boost global output.”


Certainly the dramatic fall is symptomatic of weaker global growth, but plentiful supplies are also driving down prices. U.S. production is strong, Libya’s production is soaring, and Saudi Arabia’s recent comments that the world needs to get used to lower prices is a sign they are not going to play the role of Grinch this Christmas.  Monthly supply this year has been roughly 1 million to 2 million barrels a day higher than it was last year, and in September global output was 2.8 million barrels a day higher than September 2013.  Global growth will receive a welcome boost from such trends.


Inflation is MIA


We have contended for a while that the biggest threat to today’s world order is an outbreak of inflation.  Policy choices in many countries are predicated on inflation remaining low.  If this was to change we’d likely see severe re-pricings in the asset markets.


With the trends we noted above there is little chance of an inflation outbreak any time soon.

The rally in the dollar and the fall in crude prices the last couple months is another deflationary shock for the U.S. economy on top of the deflationary pressures out of Europe.  As a matter of fact, inflation indicators are at levels last seen when the Fed announced major policy actions.  The chart below shows the market’s estimate of 5-year inflation rates 5-years from now.  The first three circles show when the Fed introduced QE2, Operation Twist, and QE3.  We are essentially at the same level today, meaning inflation is in a zone that has typically worried the Fed.

CPI Swap Rate 10212014



This doesn’t mean they are going to introduce new programs, but we think the odds heavily favor the Fed backing off their planned rate hikes next year.  A big part of the reason the markets bounced back on Friday is hope about the Fed moderating their planned tightening schedule.  On Thursday St. Louis Fed president James Bullard said the central bank should think about postponing the end of its bond purchases.  This seems a stretch as we are so close to the end of QE3, but there is a growing view that Janet Yellen will push out the commencement of rate increases until late next year.


Interest Rates Remain Exceptionally Low


An obvious byproduct of falling inflation expectations is falling bond yields.  For example, the yield on the 2-year Treasury note has fallen dramatically to just 0.28%, as you can see below.

US 2 Year 10212014



The yield on the 10-year Treasury hit a low of 1.87% just a couple days ago, and more importantly for the economy, mortgage rates have taken a serious dip.  30-year fixed rates fell decisively to 4% this week (chart below).  To the extent they stay at this level housing should receive another boost.

US 30 Year Mortgage 10212014



Market Corrections are Actually Normal


It is easy to lose sight of the fact that market volatility is normal given the one way nature of things the last couple years.  If you look at the market since 2010 there have been some pretty large corrections.  As you can see below, the S&P 500 sold off by 16% in 2010, 19% in 2011, and 10% in 2012.  This was all in the context of a bull market.

S&P Drawdowns 10212014



This latest correction has seen a high-to-low fall of -7.4%, pretty much in line with those of the last few years.


Pulling it all Together


So where does this leave us?  It is easy to make a list of positives and negatives, but deciding what it all means is the art that complements the science.  Our take is that we are essentially where we have been for the last five-and-a-half years with an added wrinkle.


  • The global economy remains fragile.  While the U.S. has done a decent job of healing, Europe remains problematic.  There are no easy solutions for what ails Europe.
  • Deflation remains a far bigger risk than inflation.  For all the talk about how the Fed’s money printing would create hyper-inflation, the fact is that deflationary tendencies remain strong.  Europe is likely to see contracting prices, and the recent fall in oil and rally in the dollar will keep a lid on U.S. inflation rates over the near-to-intermediate term.
  • It is going to be tough for any central bank to take away the punch bowl.  As much as the Fed, for example, might want to tighten rates back towards 3%, we suspect the global economy and the markets will make it tough on them.  This means rates are likely to stay low as long as the global economy is fragile and deflation remains a threat.  If anything we could see renewed stimulus in certain regions.  There is a strong chance the ECB tries full blown quantitative easing in the months to come.  Even the Fed may temper their somewhat hawkish language.
  • Bond yields are also likely to remain low globally.  It is tough to make the case that long-term bond yields are headed higher in a significant way any time soon.  Central banks are likely to anchor rates for months to come, and falling inflation globally combined with continued strong demand for government paper means there are few catalysts for a move higher.
  • The wrinkle today compared to the markets five years ago is that few assets are cheap.  U.S. equities are on the pricy side, and valuation arguments hinge on the fact that equities look cheap against bonds.  On an absolute basis they are expensive.  Europe and emerging equities are much cheaper, but at least in Europe, it is tough to make the case the economic headwinds will abate soon.
  • Higher valuations do not mean equities are on the cusp of a bear market, only that returns are going to be harder to come by, and we are likely to see higher volatility in the quarters to come.  We still think the markets grind higher going forward, but as we noted in our recent quarterly letter, we probably all need to ratchet down our return expectations and learn to live with greater fluctuations.
  • Finally, the one clear lesson of the last 20 years is that increased volatility makes us do irrational things.  We keep coming back to the chart below that we have shown a number of times.  It shows various asset class returns over the last 20-years compared to the average investor return (red bar).  Despite moderately strong returns on almost all asset classes, the average investor has returned only slightly more than 2% compounded over this period.  The reason for this is simple.  Volatility makes us all do crazy things.  We chase tech stocks in 1999, panic out after 9/11, buy energy stocks in 2007 before the financial crisis, and go to cash in March 2009.  We shouldn’t let the latest bout of volatility shake us out of our current investment strategy if it still makes sense for our time horizon.

Average Investor Returns 10212014



As always, if you have questions or concerns don’t hesitate to contact your financial advisor.

– Charles Blankley, CFA

Chief Investment Officer

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