Navigating through the conundrum

After hitting a record high of 2,011 on Sept. 18, the Standard and Poor 500 Index spent the next four weeks erasing nearly $2 trillion in market capitalization. The fast and steep decline in American stock values left many investors pondering whether a deeply rooted market dislocation had finally taken place.  

The alarm bells of this most recent sell-off have been sounding for some time. With little change in news headlines, investors seemed to have been caught off guard as they witnessed the market plummet 7.2 percent over 20 trading days. Now that the panic has finally subsided, what is it that fueled the plunge and record movement in volatility across almost every asset class?  

Notably, the International Monetary Fund’s downward revision to global growth did not bode well for markets. A cooling euro area economy, very low inflation and the possibility of the German economy on the brink of yet another recession added much fuel to the fire. The Volatility Index (VIX) surging more than 100 percent to a 28-month high is indicative of investors’ deep concern about the current economic backdrop. Adding even more to the mix are the deep structural slowdown and uncertainty in China, the Islamic militants’ uprising in Syria, and a previously low probability event becoming reality when the Ebola virus made its way outside the African continent.  

While collectively these factors may be valid reasons for a market pullback, when compared to broad-based economic fundamentals, the scale appears to be skewed to the right. The fall-off in oil prices, while negative for energy producers, is a significant stimulus to spurring economic growth.  

From a monetary policy perspective, markets continue to garner strong support from global central bankers on their very accommodative stance. The recent roiling in markets was only subdued following a speech by James Bullard, president and CEO of the Federal Reserve Bank of St. Louis, supporting a delay to the end of quantitative easing.  

European Central Bank president Mario Draghi’s plans to purchase Italian-covered bonds also provided a much-needed boost as a sign of good faith in his commitment to do “whatever it takes.”  

On a macro level, the U.S. economy appears to be holding its own. Armed with second-quarter GDP at 4.6 percent and consensus forecast for the third quarter at 3 percent, the U.S. economy will experience moderate growth amid very low inflation for 2014. Housing, one of the major components in gauging economic activity, has shown steady improvements driven by pent-up demand and increased affordability as a result of declining mortgage rates. Continued improvement in jobs below the 5.9 percent unemployment rate further represents significant potential for new homes as more people with jobs seek to achieve that small piece of the American dream. Other economic data on auto sales, consumer confidence and corporate earnings are all projecting upwards, with renewed optimism in select areas of the markets for the few who dare to be brave.  

With one eye on policymakers undergirding the economy and the other on rapidly changing esoteric factors, how do investors navigate these uncertain waters? Admittedly, the fall-off in global growth can have an adverse impact on the U.S. If the dollar continues to appreciate, exports will be negatively impacted, disrupting the Fed’s 2 percent medium-term inflation target. However, given the economic significance of falling crude prices and the drop in long-term rates, the adverse impact from a waning global recovery could be offset, leaving real economic growth in the U.S. intact.  

While most market participants are moderately optimistic on the U.S. economy, it is best to err on the side of caution and await confirmation that progress will be maintained. Given the risk on/risk off propensity marking the recovery, investors are poised to benefit from strategic entry into markets, taking advantage of mispricing while diligently off-loading positions approaching fair value.  

Nonetheless, vigilance and flexibility are essential in this market cycle. Any improvement in the global economy, coupled with signs of wage pressures, may very well force the Federal Reserve to raise rates much earlier than anticipated. 

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The bank accepts no liability for errors or actions taken on the basis of this information. 

 

Statistics and Data Source: Bloomberg LP, IMF, S&P 500 and VIX Index   

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