Market Turbulence and Central Bank Policy Shifts

Following the recent market turmoil, Litman Gregory chief investment officer Jeremy DeGroot shared his thoughts on the investment environment with an audience of our private wealth management clients. We’ve excerpted his comments in a question-and-answer format:

Can you provide your thoughts on the dramatic market moves in early February?

Of course. First, while the precise timing and magnitude of the declines were unpredictable, the circumstances and catalysts that triggered them and then exacerbated them were all things we’ve discussed in our investment commentaries. Specifically, we’ve discussed the potential for an inflationary surprise to raise fears of more aggressive Federal Reserve and central bank monetary policy tightening. In this case, it was an economic data point released on Friday, February 2, which showed that wage inflation had unexpectedly jumped to an eight-and-a-half-year high. That triggered a market decline and then market psychology switched from greed to fear, and even some panic, as the initial wave of selling fed on itself and short-term performance chasers and traders reacted to falling prices with further selling in a self-reinforcing cycle.

The second point I’d make is the following: the fact that we experienced a stock market decline of 5% or 10% is not unusual or surprising. What was unusual, abnormal, and unsustainable were the huge stock market gains and lack of volatility in the markets over the past year-plus. The S&P 500 Index was up 15 months in a row through January of this year. That had never happened before in the history of the index.

And here’s another factoid: up until the market’s recent drop, the S&P had rallied for more than 400 days without registering as little as a 3% decline from its high. That was the longest streak in 90 years of market history. So a market correction was overdue and, again, is completely normal. Furthermore, we believe investors should be prepared for continued volatility rather than expect things will revert back to the unnaturally smooth markets we experienced in 2017.

We believe an awareness of market history is important to being a successful long-term investor. The chart below puts the recent market moves in a historical context. It shows that equity investors should expect drawdowns every year of at least 5%, and market corrections of 10% or more historically happen in about two out of every three years. Going back 38 years, the median drawdown was a decline of 12% for a calendar year. So that’s why we say stocks are risky.

Equity Investors Should Expect Drawdowns Every Year

Finally, the third point I’d make about the recent market drop is that despite the dramatic news headlines and market volatility that might suggest otherwise, the global economic and corporate earnings growth outlook has not materially changed or deteriorated from what it was just a couple of weeks ago. The underlying economic fundamentals still look pretty strong. In fact, the economic news that triggered that recent selloff again was not a report of economic weakness but one that suggests the economy might be getting a bit too strong, with a tight labor market finally translating into higher wage growth.

Can you explain a little further what you’re seeing from the broader economic indicators?

We’re not economists, and we don’t make macroeconomic forecasts, but certainly knowing roughly where we are in the economic cycle is important to our investment outlook and positioning. Most economic indicators—both concurrent indicators and leading indicators—suggest the global economy remains in a synchronized expansion. This is the strongest expansion since the financial crisis. And the consensus view is that there is little risk of a U.S. or global economic recession over the next year at least. U.S. economic data are beating expectations by the most in nearly six years. However, our analysis suggests the positive economic outlook has already been discounted to a meaningful degree in current U.S. stock market prices. So while the economy is strong, the stock market has been reflecting this for a while. Outside the United States, economic growth also continues to surprise on the upside. The eurozone is enjoying its fastest economic expansion since 2011, while above-trend economic growth in emerging markets has helped companies there deliver strong earnings growth as well. So we have strong growth, still-ample liquidity from central banks, loose financial conditions, and low inflation. All of these have produced an extended period of exceptionally low volatility across global stock and bond markets. But again, inflationary pressures may finally be starting to build.

With quantitative easing coming to an end, a continued rise in interest rates is likely. Can you share some thoughts on the Fed and the uncertainty about what will happen to the equity markets as the era of “easy money” ends?

This is a theme we’ve talked about a lot over the past several years, which is the unusually heavy influence of central bank monetary policy on the financial markets in the aftermath of the 2008 financial crisis, and the unusually strong sensitivity of markets to perceived changes in central bank policy.

Since the financial crisis and the recession, stock market price-to-earnings multiples have expanded despite pretty subpar economic and earnings growth. And now, while there are always a multitude of factors that drive markets, certainly a strong argument can be made that the unprecedented stimulative monetary policies that started in late 2008 contributed to and supported the bull market and stocks. The charts below show the tremendous increase in central bank–held assets from their quantitative easing asset purchases, and you can see that these quantitative easing purchases coincided with the bull market in stocks. Now, correlation is not causation, but clearly these policies have an effect on the markets. And Fed chair Ben Bernanke explicitly wrote about the Fed’s desire for quantitative easing was to push up stock prices in order to cause a hoped-for wealth effect that would boost consumption and GDP. While he got the stock market effect that he wanted, the boost to the real economy and GDP growth was much more muted.

The market cycle that we’re in now faces the prospect of an unprecedented unwinding of the unprecedented monetary policies put in place after the financial crisis: trillions of dollars in central bank asset purchases and low or negative interest rates that have yet to be normalized. Given the boost to asset prices from these policies, it’s reasonable to wonder what the impact will be as these policies are unwound as quantitative easing turns to quantitative tightening and as central banks increase interest rates. The Fed is already starting to sell some of its assets and later this year, the European Central Bank (ECB) is also expected to start unwinding their balance sheet. So net bond purchases will turn into net sales—very large buyers of bonds, the central banks, will turn into net sellers and that will have an impact.

Central Banks Fuel Global RecoveryCentral Banks On Track to Remove Stimulus

So far, the Fed has moved in a very gradual fashion and telegraphed its intentions to the markets in order to minimize any unpleasant surprises. You may remember we saw some volatility in 2013 with the so-called Taper Tantrum. The Fed clearly wants to avoid a repeat of that. But there are still many miles to go on the road to policy normalization and the recent market hiccup was clearly driven by uncertainty about how the Fed may react if wage growth and inflation pick up even a bit more than expected.

A couple of other points related to this. There is a new Fed chair, Jay Powell, and several new voting members on the Fed’s policy rate–setting committee this year. That creates more potential for a market surprise. At the very least it raises the potential for increased market volatility, as is often the case when there is a new Fed chair. There’s an old saying that what’s good for Main Street isn’t always good for Wall Street. We may be moving into that type of environment now. While an initial rise in wage inflation and interest rates would reflect optimism about stronger U.S. economic growth, at some point, higher interest rates become headwinds for further growth. And more meaningfully tightening monetary policy and financial conditions have historically been a primary cause of bear markets and recessions. It seems that we’re still probably a year or more away from that outcome, but it is a scenario we view as likely sometime within the next five years. As always, the precise timing is uncertain. We also know that the consensus outlook has never successfully forecasted the next recession.

—2/14/18

 

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