Risk-Off Was Inevitable

Stocks opened significantly lower this morning, and the current sell-off has the S&P 500 about 8% below its all-time high in May of last year. In light of this news, I thought it might be helpful to send out some of the thoughts I shared with my portfolio managers this morning.

The current downturn is significant. We have been suggesting that a risk-off phase was inevitable as the Fed ends QE and begins to hike. It is happening.

But that’s not the whole story now. Not only are U.S. equities trying to price for a world without QE, China’s market is falling dramatically, and Saudi Arabia and Iran are facing off in the Middle East. Importantly, the U.S. sell-off so far this year has been driven by foreign market drops and headlines, like the news that North Korea tested a hydrogen bomb. As U.S. shares have fallen, they have done so in an orderly fashion, with trading volumes only about average. There hasn’t been a volume surge on down days, which suggests to me that this is not a U.S. market panic; this is a U.S. market repricing to adjust to a changing environment. This is important because there is no suggestion of a bursting equity bubble in the U.S.

Oil traded at a $32 handle this morning. Many on Wall Street are pointing to oil as the problem that is eroding our markets. I suspect that oil’s drop is more of a leading indicator for global economic growth as well as an indicator of over-production and surplus inventories. Markets are discounting mechanisms, and as the global economic environment reveals significantly slower growth in key economies (like China), the price per barrel will fall to anticipate lower demand in the future. There has also been a surge of production that now overwhelms storage capacity and current global demand. This is a perfect storm for energy prices. Prices will likely continue lower, but keep in mind that: 1) trends tend to extend to excess; and 2) when the overwhelming consensus believes that there is no floor for oil prices, the price will almost certainly be poised for a rebound.

The August low for the S&P 500 was 1,867. It closed yesterday at 1,990 and is currently about 1,960. I think investors will watch these levels and perhaps become more constructive if/when the index falls below 1,900. A decrease to these levels would represent a correction of about 10% from the all-time high close of 2,131 in May 2015.

The flight to quality is reflected in bond prices: the yield on the 10-year Treasury has now fallen to 2.16%, down from its recent high of around 2.3% in mid-December. Interestingly, the U.S. dollar is holding in at $1.08-09 vs. the Euro as the Euro is also catching a flight-to-quality bid from those exiting China and other emerging markets. Remember, as China devalues its currency (the Yuan), other emerging markets will lower their currencies to remain competitive. Currencies wars like this are never constructive.

All of this creates a much more difficult growth environment for the U.S. economy. While lower energy prices are a positive, the stronger dollar, tepid consumers and the downturn in manufacturing will produce GDP growth well below government estimates. I question if we will see another increase in Fed Funds rates this year. Our consistent theme throughout the past few years is that the U.S. and global economies are not strong enough to withstand meaningful increases in interest rates. Each time we have encountered an increase in rates, economic data have deteriorated and rates have fallen again. We expect more of the same in 2016.

Folks who have been bearish for the past few years are beginning to crow even though they’ve been wrong for three years. Media reports will sound dire. We need to remind clients that ours is a world of discipline and research that is constantly barraged by noise. In storms, you keep your bearings, you keep your wits, you focus on your course, and you thank goodness that you have an experienced crew with decades of experience at the helm.

When speaking with clients, be serious but not dour. Be calm. We have seen hard markets before. We have been calling for a re-allocation of risk away from high-flying stocks like Facebook, Amazon.com and Netflix. Our client portfolios are very well positioned as this process is occurring.

Finally, Markets go down from time to time. It is never pleasant but it is normal. Emotional decisions are the surest way to ruin a perfectly good portfolio.