Cause for Concern?
At this point, the return of volatility to the markets is old news. Over the course of this year, we’ve already encountered plenty of market fluctuation across geographies and asset classes. However, what made this quarter of particular interest is that we are beginning to get a clear picture of what might be driving these gyrations. While many believed an impending withdrawal of accommodative monetary policy in the U.S. would be the culprit, it turns out that there may be other factors at play here, namely slowing Chinese growth. Though rumors of deceleration in China have persisted for years now, a number of data points, as well as action from Beijing, made such fears seemingly more tangible this quarter. With clear and potentially grave implications for global growth, it is only natural that volatility would spike as many market participants rapidly change their risk profile. While we believe that this can present opportunities for long term investors, we do believe that it is important to be cognizant of the uncertainties we face.
Undoubtedly, the ongoing rout in global commodity prices and worries over Greece’s fate in the Eurozone had already done plenty to weigh on risk assets over the course of this summer. However, early August saw a new surge in volatility as the People’s Bank of China moved to devalue the renminbi three times in as many days. While the Chinese government claimed this was a step to make the currency more market-driven, the moves were generally interpreted as a confirmation of slowing growth. Markets around the world were roiled by the decision, with volatility reaching levels not seen since the summer of 2011. Undoubtedly, these events have led many to rethink the trajectory of global growth going forward, unsure of the impact a Chinese “new normal” will have on the rest of the world.
In some situations, the implications of slowing Chinese growth are rather clear. Though commodity markets have been soft for some time, emerging markets reliant on the export of raw materials to China are likely to continue to suffer. Particularly impacted will be those economies already facing structural headwinds, as has been the case of Brazil, whose credit rating was reduced to junk status in September. In other regions, geopolitical risk was a concern, as was the timing of a U.S. rate hike, making this altogether a markedly bad quarter for emerging markets.
Developed markets, though faring better than EM, also had a poor showing in the third quarter, as investors considered potential indirect consequences of a slowdown in China. Some of the world’s largest multinationals, though based in North America or Europe, are deriving an increasing share of their revenues from the emerging world. How developments in China will impact these companies remains to be seen, but many saw their share prices fall sharply in August. Concerns about Chinese contagion were certainly on the mind of the Federal Reserve, which ultimately chose to hold off on raising rates at its much anticipated September meeting. Though not too long ago many expected this to be the “lift off” date for rates in the U.S., the Fed ultimately decided to delay action given worries about the global economic outlook.
While a decision by the Fed to stay the course has been celebrated in the past, markets certainly did not react positively this time. Granted, the reasons given by Fed chair Yellen as to why rates did not rise were in and of themselves enough to spook markets. However, many believe that we have hit a point where Federal Reserve inaction is actually contributing to market uncertainty, at a time when we need it the least.
With so many market pundits discussing the level of uncertainty in the markets, it can be easy to miss an important point: there is always uncertainty in the markets. While there are many who envisage a Chinese “hard landing” that takes the global economy with it, this is by no means a forgone conclusion. With its large foreign currency reserves and the option to lower interest rates, Beijing has plenty of options to steer the world’s second largest economy back on track. What’s more, while many have raised concerns about contagion to the U.S., it is important to remember that domestic economic data remains generally strong. While numbers that come in the months ahead may paint a different picture, we have no reason yet to believe the recovery has been derailed.
However, none of this is to say that we do not believe caution is required going forward. While some opportunities may present themselves, so too do many threats. China may well be unable to adroitly navigate slowing growth, and this could easily impact economies around the globe. China fears aside, we must also own up to the fact that this economic expansion has now lasted longer than average, with signs of frothiness definitely apparent. To that end, continued inaction by the Federal Reserve could aggravate such excesses, while at the same time send a mixed signal to investors regarding the health of the economy. Though markets have begun to recover from the past quarter’s tumult, we believe that risks abound for markets going forward, with volatility likely to persist.
As such, the bulk of our efforts this past quarter have been dedicated to assessing how best to position client portfolios going forward. On the one hand, as we’ve mentioned in the past, one component of this has been taking advantage of new opportunities that this volatility has presented. However, we have also spent a great deal of time reviewing our current holdings, contemplating whether recent developments have changed our views on any portfolio companies, or the capability of our outside managers. Naturally, exercises such as these are a central part of our research efforts, but we believe that an extra layer of diligence in times of market volatility can serve many purposes. While it certainly helps with managing risk, looking at markets through a rational lens when many are doing anything but can reveal unseen, but compelling trends. Overall, we feel well positioned for whatever may come as we move into the balance of this year and into 2016. We greatly appreciate your business and thank you again for your support and trust.
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