By Mark Dixon, Chief Investment Officer and Jim Baird, Chief Investment Strategist
Plante Moran Financial Advisors
Executive Summary
- The recent market decline, culminating in the sharp selloff yesterday, illustrates the fear that exists related to a range of uncertainties, including the potential for a double-dip recession here in the U.S.
- Recent economic data have heightened the perceived risk of a recession, but there is also data that supports the potential that the economy may just be in a soft patch and that a double-dip recession should not be considered a foregone conclusion.
- While the credit crisis that erupted in the fall of 2008 is still fresh in the collective memory of investors, a number of key differences between conditions then and now that could prove supportive this time.
- Stock market declines of a similar magnitude to the one that we have just experienced are not uncommon, and have happened in nearly 50% of all calendar years since 1971. In fact, most market corrections do not precede a recession.
- Maintaining a disciplined commitment to one’s investment plan, including the careful consideration of one’s tolerance for risk and investment time horizon, remains a rational approach to navigating sometimes irrational markets.
The markets reacted violently yesterday to further news of a slowing economy, as well as the currency interventions that have recently occurred in Switzerland and Japan. A slowing economy and concerns of a "trade war" of sorts, had many market participants concerned that the U.S. (and global) economy may be headed for another recession, or worse.
Market reactions of this sort illustrate just how fearful the world is of that ultimate scenario. Could it happen? Is it possible that the U.S. is at the cusp of the long-feared double-dip recession? Yes, it is, but it's also very possible that the market is already in the process of purging some excesses in the economy that may help to pave the way for a reacceleration in growth (such as the precipitous drop in the price of oil and continually lower interest rates). As you know from our previous writings and, in some cases, many years of working with us, we are not inclined to concentrate on the "extreme" scenarios, nor do we recommend positioning portfolios in anticipation of low probability, extreme outcomes. Yes, they could happen, and we have recommended investments in our client portfolios that should hold up comparatively well if an extreme event did occur. However, we believe that it is preferable to take a more rational view of any situation. So, with that in mind, let's try to do just that.
In recent years, when we have described the current economic environment, we have often referenced PIMCO’s depiction of the "New Normal". We believe that what we have witnessed in the last few months is an example of this. The U.S. economy, which is saddled with excessive debt, and low consumer confidence, has been growing, but at a slow pace. Just last Friday, the Commerce Department released their first estimate of second quarter GDP growth. While that result was a modestly disappointing 1.3%, it was the revisions to prior quarters that was perhaps more noteworthy. The announcement provided a dose of frank clarity: the economy grew much more slowly in the first half of the year than previously believed. Moreover, the recession was deeper that had been previously reported and – contrary to earlier reports – data now suggests that the economy is still in recovery mode. The revisions now suggest that real GDP through June 30 has still not recovered to its pre-recessionary peak.
The slower pace of growth makes the economy more prone to recession, as the economy has less momentum to cushion either the natural business cycle or economic "shocks" from pushing economic growth into negative territory for a period of time. Between 1968 and 1982, there were four recessions in the U.S., including two that were very deep and very long. In the subsequent twenty-five year period between 1982 and 2007, there were just two recessions.....yes, two....and both were comparatively shallow and short. At that time, many prognosticators put forward the thesis that the business cycle was dead. In actuality, we believe the business cycle was alive and well, but relegated to the shadows as growth was supported by a prolonged period of ever lower inflation and ever lower interest rates. Now that interest rates and inflation have reached such low levels, there is very little tailwind left for the economy, or for the policy makers to dramatically improve the situation should a downturn occur. The debt build up that occurred between 1982 and 2007 helped to fuel economic growth, but has reached such a level that future growth will likely be constrained (not necessarily "no growth" but "slow growth"). As we have explained in past writings, this lower growth environment will likely be accompanied by more frequent recessions, due to the natural business cycle, and/or shocks. Such an environment is often accompanied by excessive volatility.
With that as a backdrop, we must acknowledge that if this economic slowdown ultimately morphs into a recession, the recent decline in the equity markets will very likely get worse. While we have continued to utilize alternative investments to help to mitigate some of the volatility in our clients’ risk allocations, a recession would undoubtedly weigh further on risk asset prices. However, we still firmly believe that investors with a time horizon of at least five years have a high likelihood of achieving a positive return in the stock market, and a high likelihood of outperforming the current 5-year U.S. Treasury yield of approximately 1.09% over that full time horizon. Unfortunately, returns over the next year, much less the next month, are very difficult to predict; as a matter of practice, we do not attempt to do so. While the market is clearly concerned about the deterioration of the economic environment, and conditions could certainly worsen further from here, we believe it’s important to acknowledge some key differences between today's environment and that which existed in the period leading up to the 2008 crisis.
1) In 2008, most market participants believed the economy was strong, and were "surprised" when developments turned quickly and sharply negative. Today, the general consensus seems to be that the economy is on its last legs; consumer confidence has been lingering around levels consistent with prior recessions. Policymakers know this as well, and while many were looking the other way in 2008, our belief is that policymakers are very attuned to the situation today.
2) In 2008, bank credit was easy (too easy), and liquidity provided by the credit markets was very high (due to excessive bank lending). When this liquidity dried up and credit markets seized, it caused a tremendous strain on the financial system, exacerbating the problem. Today, liquidity is being supplied predominantly by the central banks, and while bank credit is not "easy", it has been "loosening." Bank capital also appears to be much stronger today than it was in 2008.
3) Interest rates are much lower today than in 2008. While this potentially means there is less "dry powder" to be used by central banks to influence the economy, lower rates are generally very positive for corporate profits and consumers.
4) Credit spreads moved substantially higher in 2008, and began that move well before the Lehman Brother's failure and the onset of the credit crisis. While long-term Treasury rates have definitely fallen to a level that one would historically associate with recession, credit spreads have recently made only a small move higher. As such, bond market participants currently appear to be of the opinion that these credits are almost as good today as they were even a few months ago. This may be due in part to the incredibly strong balance sheets that exist for much of corporate America today.
5) The London Interbank Rate (LIBOR) remains very low and has not moved meaningfully higher as in some time. It also remains well below its level of late spring 2007, when it began creeping higher more than six months before the last recession began. After Lehman failed, the LIBOR rate spiked sharply in a very short period of time, but had already been drifting higher for some time.
A related measure is the “TED spread” (or the difference between LIBOR and short-term U.S. Treasury debt), which also remains very tight. Why does this matter? The TED spread is a commonly used measure of market perception of global credit risk between financial institutions. A wide spread indicates a breakdown in trust between banks, which is exactly what happened in the fall of 2008. The TED spread had moved sharply higher in the summer of 2007 before blowing out in September 2008.
Any or all of these measures (LIBOR, the TED spread, and credit spreads) could still expand if economic data deteriorates further, but by these measures, the bond market today does not appear to be reflecting the increased stresses that one would expect if a repeat of the fall 2008 credit crisis was imminent.
6) The July job report that was released this morning was a relative positive. An estimated 117,000 jobs were created in July, while the net revision that increased estimated job creation by 56,000 over the previous two months was also a positive. As we’ve consistently stated, labor market conditions are consistent with a weak economy, but it’s important to note that the economy has not reached the point of net job losses that typically occurs when the economy is contracting.
7) Market valuations today are lower than they were in 2008. By many standards, stocks are less expensive. Of course, as we have discussed in our Equity Market Outlooks, profit margins are at historical highs, and will undoubtedly fall if we have a recession. However, in October of 2007 (the prior peak in margins), Price/Earnings ratios on stocks were approximately 17x earnings; today, P/E ratios are less than 14x earnings, more than 20% lower.
The recent decline in stock prices of about 10% is not uncommon, having occurred in nearly half of all calendar years since 1971. A market decline of this magnitude often precedes a recession, but more often than not, it does not. We continue to believe that, while the economy remains in a soft patch, it is too early to conclude that a double-dip recession is a foregone conclusion, let alone that a second act in the credit crisis is imminent. The risks are certainly there, but evidence is far from conclusive.
The issue, as is often the case, is time horizon. Our view on risk assets has always been that a minimum five-year time horizon is required to reduce the chance of "loss". That view has not changed. Investors that do not feel as though they can keep their assets committed to an investment policy for five years should set aside enough cash and short-term investments to allow them to tolerate the inherent risk in stocks and maintain a five-year time horizon for the remainder of their portfolio. Within that risk budget, we will continue to look for opportunities that may allow for lower volatility, higher returns, or both.
As we have conveyed in recent months, yesterday’s selloff reinforces the heightened perception of risk in the market. As our perception of both potential risk and return has evolved over time, we have previously taken steps to position risk portfolios to better defend against downside risk while still participating in potential upside. In time, should equity prices slide further – particularly if it becomes clear that the economy will reaccelerate rather than slip further – an opportunity to increase risk exposures may be created.
In closing, we are reminded of Warren Buffett’s simple maxim: “Be fearful when others are greedy and greedy when others are fearful.” While we would not recommend adopting a “greedy” stance taken to an extreme, we also don’t believe that Mr. Buffett was espousing the negative elements of greed. At the margins, we believe that not fearfully selling into the teeth of a market correction is good advice, particularly when evidence doesn’t more clearly point to a recession or credit market disruptions. In that sense, maintaining your disciplined commitment to your long-term plan and, in time, even taking opportunities to invest further at more favorable prices, is a rational approach to navigating sometimes irrational markets.
Disclosure: Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.
Data sources for peer group comparisons, returns, and standard statistical data are obtained from recognized statistical services or other source believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.
Plante Moran Financial Advisors provides this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors or strategies mentioned herein may not be appropriate for you. You should consult a representative from Plante Moran Financial Advisors for investment advice regarding your own situation.