The financial markets have encountered a number of external shocks in 2014. And with each alarming headline that hit the wires, the markets fluctuated: Volatility spiked, yields fell, the dollar rallied, equities corrected, etc. Yet after each event, the markets settled down after a few days or weeks, and investors refocused on economic fundamentals. The result: U.S. stocks (as measured by the Standard & Poor’s 500 Index) are up about 9% year-to-date through August 20.
Let’s put this good news aside for a moment, and take a closer look at some of the “headline risk” events that have transpired so far this year.
In January, fears of a bursting credit bubble in China and a run on the currencies of several export-oriented emerging-market countries helped spark a 6% correction in the S&P 500 Index and a 9% decline in the MSCI® Emerging Market Index. Then came the conflict in Crimea, which sent geopolitical ripples throughout Europe. In June, news that the terrorist group ISIS invaded parts of Iraq caused oil prices to spike 13% to $106,1 and in July, Portugal’s second-largest bank collapsed, triggering a 10% sell-off in eurozone banks—a painful reminder that the eurozone debt crisis may not be resolved. More recently, the tragic downing of a commercial airliner raised the Russia-Ukraine crisis to a whole new level, with fears of a Russian invasion and concerns about how sanctions imposed on Russia could impact the global economy. Since their June highs, European stocks are down 8%, and the S&P 500 fell by more than 4% before recovering nicely.
Lasting, system-wide impact?
These events beg the question of how we as investors are supposed to react to scary headlines of this nature. Should we pay heed? Should we ignore them? How do we know which headlines will impact the markets in a lasting way and require a portfolio adjustment of some sort? In other words: Is it systemic, or just a short-term shock? This is the lens through which investors may want to evaluate such headlines.
“Is it systemic?” means whether or not a particular event is likely to have a lasting, system-wide impact on the economy and the markets. We simply have to go back to the Global Financial Crisis of 2008 to recall what is meant by a systemic event. The subprime bubble was supposed to be an isolated incident, but due to system-wide excessive leverage, it nearly took down the entire financial system as we know it. Now that’s systemic.
Having the discipline to ask “Is it systemic?” in the face of market shocks can help take the emotion out of investing and reduce knee-jerk sell decisions based on headlines. Adopting this approach would have served investors well in the first eight months of 2014, as nearly every negative event proved temporary, or, in other words, non-systemic. In fact, the global economy has generally been in a steady but slow upward trend this year. Read Viewpoints: “August business cycle: slow, steady growthLog In Required.”
Use history as a guide
It is almost impossible to identify a systemic event the moment it happens. But there a few rules of thumb to consider when analyzing whether a disconcerting market event is likely to become systemic.
Excessive leverage: Historically, the culprit behind major systemic market events tends to be excessive leverage—meaning dangerously high levels of debt. That was certainly the case in the 2008 global financial crisis and in the eurozone debt crisis, to cite recent examples. Both of these events directly contributed to lengthy periods of negative equity market performance.
Geopolitical events: Geopolitical events, on the other hand, are less likely to be negatively systemic. However, if a geopolitical event happened at a time when there is excessive leverage in the system, then it could unleash something bigger and expose a systemic problem.
The bigger picture
If we take a step back, we can see this year’s news events have occurred during a multi-month consolidation in the U.S. stock market. Perhaps these events caused the consolidation, or at least part of it. As shown in the top half of chart below, we see that even though the S&P 500 is up almost 9% as of August 20, there have been three distinct corrections during the past eight months.
The bottom half of the chart shows how other asset classes in the U.S. and overseas fared during these three corrections. Among other risk assets, high-yield funds have suffered significant redemptions in recent weeks, causing spreads relative to Treasuries to widen by roughly 75 basis points. However, the underlying fundamentals of companies that issue higher- yielding debt remain strong and we believe the outlook for this asset category remains favorable for the next couple of years.
Elsewhere, we have seen rallies in the traditional safe havens, namely sovereign debt and the U.S. dollar. The declines in government bond yields have been especially surprising to many investors. As of mid-August, the 10-year Japan government bond is yielding a mere 0.5%, the German 10-year yield is 1.01%, and France’s 10-year bond is yielding 1.4%. No wonder the 10-year U.S. Treasury is yielding only 2.4%. In fact, one has to wonder why yields are not even lower in the U.S., given the yield differentials with other countries as well as the fact the dollar has been strengthening.
The strength in the Treasury market is a perfect example of why it makes sense to diversify risk through high-quality bonds. It’s one of the only games in town for investors looking to diversify risk with assets that offer negative correlations to equity, especially in the midst of headline-grabbing events.
Most of the market shocks this year have been geopolitical, and none so far appear to be systemic for the U.S. economy and risk assets, at least not at this point. Perhaps this is why the S&P 500 is up 9% year- to-date while many other domestic and developed international markets have lagged behind (including U.S. small caps). Yes, valuations for U.S. stocks may be higher than other parts of the world, especially emerging markets, but there seems to be a good reason for it.
Which brings us back to fundamentals. With a better-than-expected second-quarter earnings season now wrapped up, earnings per share for the S&P 500 are on track to grow an estimated 8.5% this year. That’s a respectable increase over last year’s more modest 5% growth. And if we are indeed in a new secular bull market (as some historical comparisons suggest, and as discussed in my June Viewpoints, “A new secular bull market?Log In Required”, then this sideways rotational consolidation may be as bad as things will get for the major U.S. averages, with the next phase being another sustained upswing in asset prices.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
Investing involves risk, including risk of loss.
Past performance is no guarantee of future results.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market or economic developments, all of which are magnified in emerging markets. These risks are particularly significant for funds that focus on a single country or region.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917