Some market corrections are like sudden hysterical meltdowns – dramatic and immediate. They erupt and send everyone to man the panic stations – and then just like that they are over. Investors come wading back in to snap up bargains and the world moves on. Most of the market corrections during the Great Bull Market of 1982 – 2000 were of this variety, most notably the short-lived freefall of Black Monday in 1987.
Other times, though, bear witness to a different kind of correction, and right now we are in one of those times. This is more like a slow-burning funk than a dramatic meltdown. The S&P 500 reached its 2011 high point (to date) back at the end of April. Since then the index, and most other equities indexes, have been stewing in a six week funk. The stock market’s losses have been the bond market’s gains – the Russell 3000 ended June 7 up 3.3% for the year to date, and the Barclays US Aggregate Bond index closed at 3.2% for the same day – virtual parity.
It is worth recalling that this pattern is not entirely different from one year ago, indeed for some of the same reasons. Then, as now, concerns about Greece and other Eurozone tinderboxes were spooking risk asset markets. The global economy was trying to find its footing and getting there in fits and starts. Summer usually means lighter trading volumes than usual, so price trends tend to be accentuated. But there was one significant difference. Last summer the Fed announced its intention to embark on a new plan of monetary stimulus in the form of quantitative easing – QE2. That announcement sparked a rally that took equities and other risk assets sharply higher through the end of 2010 and into this year. Now, QE2 is coming to an end this month. In a press conference on June 7 Fed Chairman Bernanke appeared to stick to the Fed’s position that there will not be a QE3. Markets promptly resumed the slow-burning funk after being comfortably higher for most of the trading day.
The easy answer to formulate from this is that investors lack the confidence to flip the “Risk On” switch without regular fixes from the Fed’s store of steroid juices. There is no doubt some truth to that, but in our opinion that is not the important story. Indeed, the expectation going into yesterday’s Fed conference was that there was no QE3 plan anywhere visible to the naked eye. If Bernanke had suddenly announced a plan it would almost surely have turbo-charged the markets for a day or so, but it would also have meant that the Fed took another look at overall conditions and came to the conclusion that the economy was still unable to stand on its own two feet. Euphoria would have quickly ceded to sobriety and fears that things were much worse than they appear. Analysts would start revising their earnings expectations downwards and market valuations would follow as surely as night follows day.
So here we are with the training wheels off, taking the first hesitant pedals without Uncle Ben keeping the bike steady. If we can keep from falling over in these first few moments, that could be a sign of a more tractable and sustainable underlying strength that could in turn pull risk assets out of their funk.
Just two months ago the beleaguered second-tier European economies were the darlings of global equities. As of March 25 the MSCI Greece country index was up 22.9%, while Spain, Portugal and Ireland were all turning in double digit performances. Their debt problems hadn’t gone away, but investor sentiment appeared predisposed to look on the troubled nations with kindness and favor. For Greece, anyway, that song is over for now. The MSCI Greece index closed on May 24 at -7.6% year to date, thus falling 30% from its springtime highs. Feel like déjà vu all over again? May was crisis month in the Eurozone in 2010, and thus it is again. It’s the same set of problems – a moribund economy with no catalyst for organic growth as far as the eye can see, against a backdrop of global economic uncertainty and a great deal of internecine bickering among EU parties as regards what to do – or what not to do. Of course, when you say that you have the same problems you did a year ago it doesn’t really mean they are just as bad – it means they are one year worse.
The Eurozone debt crisis has not really been a front page issue for most of 2011 – it has been crowded out by numerous other stories of a seemingly more dire nature, from crisis flashpoints in the Middle East to natural (and man-made) disasters in Japan, sky-high oil prices and all the rest. But it has never gone away, and its presence acts as a continual reminder of the fragility in market valuations. The year to date has on balance been kind to risk assets – the Russell 3000 is up around 7% – but it has not been the kind of solid performance that inspires confidence. Indeed, many of the market’s bright spots so far in the year have been in those European equities markets. The MSCI EU index is still up 7.2% year to date, but the luster seems to be fading that region. Japan is already dragging broader developed international indexes lower – the MSCI EAFE index is up only 2.4% year to date largely because of Japan’s weakness and generally lackluster performance so far in the developed Asia Pacific markets of Singapore, Hong Kong and Australia (New Zealand, oddly enough, is doing quite well in comparison to its regional brethren). And emerging markets in general have been having a bumpy ride of it so far this year, with the key growth markets in a bit of a holding pattern and the usually dynamic regions of Asia and Latin America trailing the broader indexes.
In the US the performance leaders continue to be in midcap generally and in growth over value. Interestingly, though, the Russell 200 Megacap index and the Russell 2000 Small Cap index have just traded places for the first time since January, with megacaps now turning in a slightly higher performance for the year to date. There is no small contingent of US equities investors who would love to see their long-awaited megacap rally take place – it’s been a case of Waiting for Godot for longer than any of them would care to remember. Time will tell. The economic picture continues to be muddled – housing figures and durable goods numbers posted this week were underwhelming, the consensus economics forecast is below 3% again (it was around 3-3.5% at the beginning of the year) and the jobs outlook continues to be muted even though weekly jobless claims have continued to fall. It may well be time to recall the time-honored adage: Sell in May, go away. Or not.
It’s not like we didn’t have enough to worry about, after all – tepid economic growth, budding asset bubbles in debt and commodities, and sundry debt crises are more than enough thank you very much – so why did the head of the IMF have to go and wind up on suicide watch in Rikers Island jail? Dominique Strauss-Kahn may not have much in the way of judgment-exercising capabilities in his personal life, but by all accounts he has been a linchpin figure in the protracted financial problems in the Eurozone, reputed to be just about the only financial policymaker to whom German Chancellor Angela Merkel will listen. This is not a good time for yet another X-factor to suddenly emerge from its quantum superposition into our observed reality – but here we are.
It is a measure of Strauss-Kahn’s success in managing the process of dealing with the Eurozone debt crisis that it has largely stayed off the front pages of the financial media and has failed to spook equities markets unduly. But the lack of visibility does not by any means indicate an imminent resolution. The fixes applied to keep Greece and Portugal from going over the edge are wobbly, and the kind of organic economic robustness that would improve the competitive positions of second tier European countries is not visible to the naked eye. Tough decisions will have to be made in the near term, and Strauss-Kahn has shown himself to be that rather rare specimen of technical bureaucrat with the force of personality to make the tough decisions. All the more pity that the “force of personality” was so completely and inappropriately directed as pertains to his off-duty adventures.
What are the immediate implications for market performance? Well, as we noted above, anything that adds to the already potent cocktail of volatility is most unwelcome. Assuming that regardless of how his legal predicament works out, Strauss-Kahn has put himself beyond the pale as a viable ongoing leader of the IMF, it may be some time before we fully appreciate the practical implications of his stage exit for the Eurozone. But turning up the volatility dial can accelerate what we see as in high probability the biggest concern in markets today – the expanding bubble in debt and commodities prices. Energy, metals and agriculture prices have tumbled in recent days but continue to spike up and down by large leaps on a daily basis. Yields on the 10-year Treasury note are down about 12% from their levels three months ago, leaving one to wonder what pixie dust can continue to sprinkle over government debt markets to keep their prices from going into a severe nosedive. Curiously, when you look at market performance in the year to date the most stable returns trends seem to be in equities. That could of course change on a dime if the froth in other asset markets continues to build up. The probability of a very bumpy second half of the year appears to be gaining ground. It is indeed a shame that one of the better financial policymakers out there had to take himself out of the action in such an ungainly manner.
“May you live in interesting times” goes the ancient Chinese saying – whether a blessing or a curse is presumably up to the individual. 2011 has been a most interesting year so far from the standpoint of financial markets. It has been a good year for many asset classes from US and European equities to real estate and, of course, the seemingly irrepressible energy, agriculture and precious metals commodities. Even the bond market – where one could logically suppose that higher inflation and a weaker dollar would conspire to pull US Treasury rates out of their low single-digits – has been rallying in recent weeks.
Two things make this performance particularly remarkable – and paradoxical. The first is that there really has not been a lot of great economic news to go around. First quarter growth in the US has been underwhelming, while spiraling commodities prices have been pushing headline inflation into uncomfortable territory. Corporate earnings are up but unemployment remains stuck around 9%. Meanwhile the major growth engines among emerging economies appear to be taking a bit of a pause – China, India and Brazil have all been more ponderous lately – and Europe has bifurcated into a small coterie of stable paymasters trying to keep the basket cases on their periphery from coming apart at the seams. The economic news is not terrible by any means, but there are reasonable concerns that the tepid pace at this stage of the recovery does not bode well for the kind of sustained growth cycle that investors have become used to during previous post-recessionary periods.
The second remarkable thing about year-to-date market performance is the relentless number of potentially destructive X-factors that have been popping into existence since the year began – the ongoing unrest all across the Middle East, humanitarian and economic devastation in Japan, flooding along the Mississippi River and year-long droughts in states just to the west of the deluge. It would seem that the combination of sudden market shocks and a generally fragile economic undertone would threaten to lead markets lower. But no – the Russell 3000 index sits above 9% (as of the 5/10 market close). True, there has been volatility aplenty, but investor sentiment (for now at least) appears to be determined to keep the good times rolling. Whether that lasts for much longer is another question. We think there is a decidedly odd tenor to the market currently. Here are a handful of things that we find strange about the current state of play:
Europe: To Default or Not to Default?
The debt problems in second-tier Eurozone nations have not gone away. Credit spreads of Greek sovereign debt to US Treasuries are over 12% currently, and spreads on Portuguese issues have nearly doubled since the beginning of the year. Just about six weeks ago the Greek stock market was the Continental high-flyer. The MSCI Greece index was at 23% year-to-date on March 25, and Portugal was up by just under 10%. As of May 6 the Greek index had plummeted and was up just 1.5% YTD. As for Portugal? It was actually 3.4% higher, closing at 13.1% on May 6. So far this year the rally in European equities has been largely thanks to the strong performance of the shakiest economies (Ireland, Spain and Italy have also been strongly outperforming the region). This does not seem like a recipe for stability – and Greece’s entry into bear market territory may be a harbinger of things to come for the region. Would that the Delphic oracle were still around…
Emerging Markets: Two Cheers for Hungary.
Likewise in emerging markets, the distribution of returns among countries and regions has been curious to say the least. Among the MSCI emerging markets countries Hungary has been leading the parade with a 30% return for the year to date. Hungary, you may recall, was another nation seemingly one step away from the poorhouse last year during Europe’s summer of woes. Meanwhile the BRIC index representing the world’s growth engine economies is flat for the year to date – and the only reason it is not deeper in negative territory is due to the least growth engine-y of that quartet – Russia, which is up just under 11%. Again – not the kind of thing that leaves us swimming in confidence.
US Debt Markets
Anyone? Of all the space oddities in this market environment perhaps nothing is quite so confounding as the US bond market. Safe haven for risk-averse portfolios? Puh-leese. Stratospheric commodities prices, a chronically weak US dollar and steadily increasing inflation are not supposed to be ingredients for bond market strength, especially when government bond yields have hovered around historical all-time lows for much of the past eighteen months. And yet – over the past two weeks yields on the 10-year note have plunged from 3.61% to 3.14% (remember that when bond yields fall, bond prices rise).
What makes bonds look so attractive that the scarlet letters of inflation and currency weakness can’t keep investors away? The CW, for what it is worth, seems to be pointing the finger at the expected end of QE2 in June. Really? If QE2 does in fact end then (which is probable but not at all certain given the Bernanke doctrine of asset price support at all costs) then all that happens is that the Fed stops buying bonds. But not buying bonds would, all else being equal, increase yields – which would be bad news for someone buying a 3.14% coupon bond today. The rationale seems to be that going off QE2 would put an end to the current rally in stocks and other risk assets (which, to be fair, really got its full head of steam during the run-up to the QE2 announcement last summer) – and that would bring money out of other securities back into bonds. We find this unconvincing and do not see anything compelling about government bonds at current market levels.
That is by no means the end of the litany of the strange. In US stocks we have the curious case of the Toxic 200. The Russell 1000 is an index of large cap stocks which is further divided into two additional benchmarks: the Top 200 is otherwise known as the mega-cap index, and the remaining 800 stocks of the Russell 1000 show up in the Mid Cap Index. The Mid Cap has outperformed the Top 200 (and therefore, logically, the 1000 Large Cap) in just about every way possible over the last ten years and continues its run this year – and this is also true in both the growth and the value style indexes as well as the blend. It is perhaps plausible that in certain industry sectors – Big Oil, Big Finance and Big Pharma come to mind – the leading names in the sector have become too closely associated with US government policy and its attendant political risk – hence the chronic underperformance. We will be digging into this more and it will likely be the subject of further commentaries this year.
All in all, paradoxes and conundrums abound. This is not a market for feeling safe or supremely confident in performance against a single benchmark. It is, in our belief, a market in which risk management is the paramount objective – because there are risks aplenty.
Twenty years ago I was a Tokyoite – a gaijin (expatriate) living in a delightful little neighborhood called Shimouma and working for an American investment bank in the buzzing financial district of Otemachi, where our 10th floor office had a view over the Imperial Palace and where on a clear winter morning you could see all the way out to Mount Fuji’s snow-covered elegance framed against a backdrop of deep azure. Having personally experienced life in Japan, with all its oddities, charms, and vividly-remembered moments of fleeting beauty, I have to say that the images and video clips that have flooded the media since last Friday are for me indescribably searing, haunting and painful. As the world frets about potential economic loss, one must remember that this is first and foremost a humanitarian crisis. Markets will recover, portfolios will move on, but tens of thousands of lives have been brutally impacted and that recovery will be a far longer, more emotionally devastating process.
Nonetheless, we do have to take stock of what these events mean for the larger picture of the world economy and global investment markets, and that is the purpose of this Market Comment.
The world was a volatile, nervous place before the events of last Friday. Since that first 8.9-magnitude earthquake struck off the northeastern coast of Japan, devastating miles upon miles of territory and claiming the lives of thousands, that nervousness has metastasized into something more like full-blown panic (though we do not think that extreme panic will be long-lived). On Monday Japanese securities markets bravely opened for business and, predictably, bore the brunt of a massive sell-off. The Nikkei 225 was down over 6% - dramatic to be sure, but nothing close to the 20% the Dow Jones Industrial Average lost on Black Monday in 1987. There was a discipline to Monday’s trading patterns in Japan – the collective market trying to discern opportunity in the fog of chaos. But Tuesday was a different story. After developments significantly worsened at the troubled Fukushima nuclear plant, about 170 miles north of Tokyo, the market went into a tailspin and added nearly 11% to Monday’s loss. The Nikkei has lost almost 20% since the disaster began. A stock index that just grazed 40,000 at the peak of the Japanese asset bubble in 1989 is now worth 8,605.
Japan is the world’s third largest economy (having just been eclipsed by China for the number two spot last year). It is also one of the richest economies on a per-capita basis (far more so, obviously, than up- and-coming powers like China or India), a major exporter of high-value added finished goods and one of the largest foreign holders of US Treasury securities. It is also the most indebted nation in the developed world, with a debt-to-GDP ratio just under 200% (that ratio in basket case Greece, by contrast, is less than 80%). In fact there has been very little good news to tell about Japan’s socio-economic story for quite some time. The population is the oldest in the developed world and in decline, chronic deflation has produced years of either recession or anemic growth, and the political system is dysfunctional even by the very low standards of national governments just about anywhere these days. If any country did not need the crippling body blow of a category-five natural disaster, that would be Japan.