The Rise of Economic Antagonists

On October 31st, millions of children across the U.S. donned costumes and went door to door filling their baskets with candy. Thousands of costume parties were thrown for the adults that enjoy Halloween and many people parked themselves in front of a screen to watch scary movies. There is plenty of research on the psychology of horror films allowing researchers to clearly identify that there are both people who enjoy these movies and those who will not subject themselves to scary movies for any reason. Regardless of which group you fall into for Hollywood horror movies, we were all forced to watch market volatility increase in the month of October as various economic “antagonists” came to the forefront.

October started the quarter with a slide, as the International Monetary Fund (IMF) lowered their prediction for 2015 global economic growth. The initial prediction was 4.0%, and it was lowered to 3.8%. The growth revision downgrade comes amid increasing concerns in developed Europe and certain emerging markets countries. Germany, Europe’s largest economy, saw its economic growth forecast reduced by one-third. France, Italy, and Spain are currently in an economic quagmire, and the dynamics of the Eurozone economies becomes more concerning as it is difficult for economies to catch up on “lost” growth. Mario Draghi, President of the European Central Bank, has declared the ECB’s intent to use monetary policy much like the U.S. to stimulate the Eurozone; however no real action has been taken.

Ebola took center stage in October as a nurse who treated the first confirmed Ebola patient in the U.S. tested positive for the disease. Concern grew when a second nurse and colleague of the first tested positive shortly thereafter. Medical experts have stated that the likelihood of a significant outbreak of Ebola in the U.S. is very low, but the “fear factor” was strong as markets traded swiftly on news of the cases. If we look at other historical examples of outbreaks—SARS, bird flu, and swine flu—there is very little effect on macroeconomics.  For example, the SARS outbreak in Hong Kong in 2003 caused retail sales to drop roughly 10%. Ebola is one of many headlines that spooked investors.

Energy stocks experienced large losses as oil prices fell to levels we have not seen since 2012. America’s changing role as a major player in the global oil markets is a complete game-changer. The U.S. has become a larger producer of crude oil at a clip of an additional four million barrels of production per day, and some economists attribute the drop in oil prices to the change in supply dynamics. On the near term, falling oil prices could keep inflation concerns at bay as consumers get some help at the pump. However, the face value of the drop in oil prices has frightened investors and energy companies alike.

If we look at financial markets in October as a horror film, we can look at these three issues – slowing global growth, Ebola fears, and the changing energy landscape – as the larger driving catalysts for fear. Volatility indexes like the VIX increased to levels not seen since 2011.

Where is the protagonist? There is little debate that the U.S. is leading the charge in global economic growth. U.S. Gross Domestic Product (GDP) was abysmal in the First Quarter, however it was followed by a strong Second Quarter (+4.6%), and Third Quarter GDP growth was recently reported at 3.5%. Unemployment remains below 6%, and even the broader U6 unemployment figure dropped slightly in recent months (Note: the U6 figure measures underemployment and part-time employees that have decided to stop looking for full time employment).

One of the major players in our story is the Federal Reserve. Investors have been acutely tuned into language used by the Fed in minutes and press conferences. Deutsche Bank has even gone so far as to create a chart comparing  the word count of Fed statements  to the size of the Fed Balance Sheet, which is likely a lighthearted jab at the Fed, as opposed to earth-shattering data which would provide any real clarity to the markets. Still, the results are interesting.

The Fed statement issued on October 29th officially put Quantitative Easing to an end, and investors now seek clues for the first hike in the Fed Funds rate. The expectation remains that rates will go higher in the second or third quarter of 2015, however there is some speculation that the Fed might tip their hand at their next press conference.

A very late development for the month occurred as the Bank of Japan announced plans to expand its “Quantitative Easing” program just a few days ago. The decision to increase the stimulus program was passed with a vote of 5 in favor and 4 against, and the move will seek to lessen deflation fears.  Investors welcomed the news with a flurry of activity, and markets closed higher to finish the month.

Growth in the United States continues to persist at a slower pace than we typically see in a healthy economy, especially one rebounding from a recession. A strengthening dollar is evidence that the U.S. is doing well in relation to its peers.  Inflation has remained right at or below 2% for the year. Accommodative monetary policy provides another tailwind for U.S. business, but the question that looms for many investors is “When will the bull market end?” Historical data tells us that typical expansionary cycles last 62 months, however post-bust recoveries have often been longer due to slow, albeit positive growth.  The average expansion for a post-bust recovery is more than 100 months. (Note: 67 months have passed since the market bottomed in March of 2009).

It is extremely difficult for most investors to remain focused on long term fundamentals. Dalbar, Inc. releases annual updates to its study which shows that the average investor makes the wrong decision at the wrong time, much like the guy or girl in the horror flick who runs and hides in the one room in the house where the mutant wearing the hockey mask is waiting, and exactly at the wrong time. People, by nature, are designed to fight or flee in the face of harm, and many investors did the latter throughout the month of October. As investment managers, we “fight” risk and uncertainty in capital markets with a disciplined and unemotional investment approach. Remember, some risk taking is necessary to reap upside return. However, we seek to limit exposure to unnecessary and detrimental risk.

 

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