By Steven Wieting
Editor's Note: This is excerpted from a longer report written by
Wieting, global chief investment strategist with Citi Private Bank,
a unit of Citigroup. Shawn Snyder, a Citi Private Bank vice
president, also contributed to this commentary.
A host of uncertainties have confronted investors throughout
2014. So, is it really a coincidence that the S&P 500 hit its
recent peak (2,011) on the day following the U.S. Federal Reserve's
latest monetary policy update? We'll explain why subtle shifts by
the central bank helped awaken dormant market volatility.
In addition to its carefully telegraphed quantitative easing
program, over the past three years, the Fed aimed to achieve an
extraordinary additional measure of accommodation with its
"long-term monetary policy guidance." Up until very recently, at
any point in the past three years, an investor could say with good
certainty that U.S. cash yields would be no higher than zero
looking out at least 12 months.
U.S. monetary policy is now described by Fed Chair Yellen and
others as "data dependent." That may sound benign. Tightening, if
it does occur in 2015, is indeed dependent on a strong
forward-looking outlook for growth (assuming limited consumer price
inflation). That's all good news if we are so lucky. Yet such a
policy is simply not as predictable and supportive as the Fed's
earlier commitment to stay at zero regardless of how well the U.S.
economy performs.
In most of the past three years, disagreement was completely
wrung out of the monetary policy outlook This helped suppress
financial market volatility in a historical aberration.
The bad news we must deliver - and a Citi Private Bank theme for
2014 - is a return to more volatile norms across global markets.
Compared to the past few weeks, some measure of calm will return.
But when markets do periodically correct lower, the corrections
will most likely be deeper than the shallow declines that have been
experienced since 2012.
Importantly, for market declines to persist, confirmation of
fundamental weakening will be needed, and we believe such
confirmation will be lacking. The weakness in German manufacturing
activity in August, one of the other catalysts for the global
growth panic, seems no more convincing to us than weather-hampered
U.S. activity measures during ice-covered January 2014.
While some fundamental slowing in the core of Europe is
possible, drops in both U.S. and German factory orders and
production in August were driven overwhelmingly by volatile and
narrow transportation industry segments and calendar distortions.
In the case of German auto production, we already have source data
for September showing a near doubling back after a comparable
halving in the assembly pace in August. What will markets make of
it when German production data due in early November almost
certainly surge back, reversing the August decline?
In the U.S., unemployment claims data through mid-October are
suggestive now of outright labour hoarding. This should begin to
thaw a trend of suppressed U.S. wage gains, which have managed to
drive growth concerns despite large monthly net job gains trending
in the neighbourhood of 225,000 per month. China, another perennial
driver of growth panic, just reported double-digit export growth,
retail sales growth and accelerating production for September.
Still, investors and economists both judge the future outlook
for the economy by the extent of movements in asset prices, which
are literal forecasts of the future. As such, it's reasonable to
ask if any budding stock and credit market correction is an early
warning sign of a future economic contraction not yet evident in
hard data. In such cases, the earliest warnings may seem like mere
road bumps on the way to a fallen bridge.
But history shows moderate asset price declines have more often
been false warning signs. Since 1950, the U.S. stock market has
seen 29 discrete declines of 10% or more, but only 10
recessions.
Research shows that with rare exception, financial markets and
important fundamentals don't part ways for very long. But they do
part ways over the very short term. For example, no new global
recession took place in 2011 when U.S. shares fell 19%. There were
fundamental fears at that point of a new sovereign-led financial
catastrophe that would undermine global recovery. But it didn't
happen.
In 2011, U.S. shares spent just two months below their
pre-collapse level, with world equity markets following that
recovery with a lag. After recouping losses, U.S. shares posted
+34% and +44% total returns over the next 12 and 18 months
respectively, the period matching Citi Private Bank's tactical
investment horizon.
Simply put, corrections not associated with recession have been
much shorter in duration. While we don't believe the longer-term
return outlook is now as promising as that earlier (lower priced)
starting point in 2011, Citi Private Bank sees a good likelihood
that cutting risk allocations now would essentially do so only in
time for markets to rebound.
Investors should see in the latest selloff that markets can move
far faster than portfolio managers can reasonably be expected to
alter long-term portfolio holdings. Market liquidity for buyers and
sellers - as we suspected in another CPB 2014 theme - was
overestimated. Those who were bearishly positioned may have done
well in October, but only at the expense of long-term
underperformance.
Those who were hedged going into the turmoil could now have
profits to offset market losses and remain invested for recovery.
Investors should keep this opportunity in mind if markets resume
their collective "slumber" again while the underlying market regime
suggests a return to more volatile norms.
Comments? E-mail us at editors@barrons.com
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