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Stocks and bonds reacted quite negatively to the latest testimony from Federal Reserve Chairman Ben Bernanke June 19. The S&P 500 indexdropped 3.8% on Wednesday and Thursday combined, while international equity markets fared even worse. The domestic bond market continued its selloff, with long-term bonds dropping 2.7% and emerging-market bonds sinking 4.1% in the same two-day period.
This spasm of volatility is a normal side effect when market participants adjust their positions to a new expectation for the future of monetary policy. Even though the policy adjustment being discussed at the Fed is minor – i.e., a gradual tapering of quantitative easing (QE) – the timing of the change was sooner than many investors expected, so trading volume jumped.
The collective activity of traders repositioning their portfolios can create self-reinforcing feedback loops of volatility in the markets. The majority of the volatility that occurs in asset markets is driven by interconnected feedback loops. So-called fundamentals like earnings, inflation and the economy account for less than 30% of the observed volatility in markets, according to extensive research on the subject.
It is easy to interpret big moves in the market as a signal of something important, when many times it’s just noise. The recent volatility in the asset markets is more noise than signal. Encourage investors to consider behaviors that fit with this outlook, such as:
- Accelerating the buy-in process for investors averaging-into the markets with cash.
- Adding to positions in the equity or fixed-income markets for investors sitting on excess cash.
- Considering longer-term bonds in the fixed income markets as a complement to a ladder of shorter maturities (i.e. looking at 4-7 year maturities with new cash, as opposed to 1-3 years).
- Not selling out of the equity markets right now.
Four developments hold clues as to whether my benign forecast might be wrong. They are:
- Inflation
- China
- Japan
- The eurozone
I will discuss each of these factors in brief below.
Inflation
It is critical that inflation remains tame. More importantly, investors’ expectations about future inflation need to remain subdued. In order for the Fed to unwind its extraordinary monetary policies smoothly, it must execute the withdrawal process on its own terms. This should be possible as long as inflation doesn’t rise to a level that forces the Fed to act sooner, or more forcefully, than the economy or the markets can tolerate. I am tracking standard inflation data and the spread between Treasury inflation protected securities and Treasury yields for signs that my constructive outlook for inflation might be wrong. Right now, the data support my baseline forecast of subdued inflation.
China
There is more to the recent downturn in the asset markets than just the Fed. Another source of stress has been the interbank lending markets in China, where yields have recently spiked in a manner reminiscent of the financial crisis in 2008. China’s financial system is structured differently than that in the U.S. or Europe, so comparisons with the crisis in 2008 are not entirely appropriate. Nonetheless, investors are justified to worry that these sudden changes in the Chinese lending markets could signal something sinister down the road.
Japan
The Japanese stock market took off last fall due to enthusiasm for a bold economic agenda promoted by Shinzo Abe, a dynamic new prime minister. The plan has three elements, or “arrows.” The first two arrows have gone smoothly thus far: an ambitious fiscal stimulus program focused on infrastructure projects and very aggressive monetary policy involving massive purchases of Japanese government bonds. Japan’s monetary police is similar to the Fed’s QE program, but it is much larger in relation to the size of the Japanese economy.
The third element of the plan involves structural reform of Japan’s inefficient legal and regulatory framework. This third arrow fell flat when it was first unveiled in May. The Japanese stock market has been in a near free-fall ever since. Prime Minister Abe vows that his initial proposals for structural reform were just down payments, and there is much more to come in the fall.
This will be an important development to watch. Japan has the highest ratio of government debt-to-GDP among any country in the developed world. Its situation is only manageable today because Japanese interest rates are among the lowest in the world. Many economists believe the only hope for Japan to escape its current precarious state without a crisis is for all three arrows in Abe’s plan to succeed simultaneously. Initial indications for the third arrow were not hopeful, but there is still time for things to improve in the fall.
Eurozone
European policymakers have managed the symptoms of the eurozone crisis well since the summer of 2012, when Mario Draghi, the head of the European central bank (ECB), famously vowed to do “whatever it takes” to defend the euro. Unfortunately, much less has been done to resolve the structural problems that caused the crisis in the first place.
Similar to the situation in Japan, aggressive monetary policy is buying time for politicians to implement the difficult structural reforms necessary to restore growth to the region. The best place to watch for progress on this front is the European bond markets. Low and stable interest rates are good signs. Volatile and rising rates are not. Although volatility recently picked up in the European credit markets, conditions remain vastly better than before the ECB pledge last summer.
Reacting to market signals
Managing risk requires a combination of fundamental analysis and quantitative approaches. A primary quantitative indicator I rely on is the spread between yields on sub-investment grade corporate bonds (“junk bonds”) and U.S. Treasury bonds. Most of the time this spread fluctuates between 3.5% and 5%, but occasionally it widens. My firm’s research shows that spreads in excess of 6.4% have historically correlated with poor returns in other risk markets such as stocks and commodities. This makes sense, because rising yields in the junk bond market signal stress in the private sector.
I would be much more concerned about the recent volatility in the global equity markets if it were confirmed by excessive spreads in the credit markets. So far it is not. Indeed, spreads were at 4.2% as of June 20, near the lower end of their historical range.
Investors should behave as if the recent volatility in the equity markets is more noise than signal. Future adverse developments in inflation, China, Japan or the eurozone might eventually prove me wrong. But based on historical data, widening spreads in the credit markets will flash a warning signal in time for us to reduce clients’ risk profiles.
Keith Goddard is the CEO and Chief Investment Officer at Capital Advisors, Inc., a Tulsa, Oklahoma, based asset manager with offices in Dallas, Houston and Oklahoma City. As of December 31, 2012, Capital Advisors served as manager and advisor to approximately $1.1 billion in client assets.
Read more articles by Keith C. Goddard, CFA
