Will Tapering and Slow Global Growth Kill the Recovery?
Volatility, after falling to pre-financial crisis levels earlier this year, returned to the financial markets during the third quarter. While data on the US economy continued to support the narrative of slow improvements in economic growth, employment and consumer spending, the economic picture in Europe and several key emerging markets became more negative. Eurozone GDP grew at an anemic 0.70% during the twelve month period ending June 30, 2014. Several emerging market economies, most notably Brazil and Thailand, have been in recession. Most likely, the recent selloff in the US stocks reflects concern over risks to corporate profitability from rising interest rates, wages and weak overseas sales further diminished by the strengthening dollar.
What the Fed has Really Been Doing
Financial markets are focusing heavily on the impending wind down of quantitative easing, commonly termed as ‘tapering’. Over the past few years the Federal Reserve purchased trillions of dollars’ worth of Treasury bonds and mortgage-backed securities. While many pundits accuse the bank of creating money ‘out of thin air’ and warn of impending inflation, this is not an inflationary process. The corresponding liabilities to these assets on the Fed’s balance sheet consist of reserve deposits made by the banking sector. The Fed, beginning in 2008, now pays interest on these deposits. Essentially banks have been able to hand over longer term bonds in exchange for short term deposits. The goals of this program consist of increasing the stability of the financial system by creating an incentive for banks to hold more reserves, and putting downward pressure on long term interest rates by reducing the supply of Treasury bonds and mortgage-backed securities. In both regards the program worked successfully. Bank reserves with the Federal Reserve rose from under $100 billion before the financial crisis to nearly $3 trillion today (a figure well in excess of the $2 trillion in estimated losses from the Financial Crisis) and long term interest rates are at historic lows.
Just as the value of a stock or corporate bond stems from the future cash flows of the issuing company, the value of government debt is tied to investors’ confidence in the future tax revenues that will service the debt. While Milton Friedman’s quote about “inflation always and everywhere being a monetary phenomenon” remains perhaps the best known economic quote among the general population, the fiscal dimension of inflation is of equal, if not greater, importance. Expectations drive inflation, not past results. If people believe today that the government cannot honor its debts in the future without resorting to the printing press, we will have inflation today – not when the liabilities come due in the future. The record fiscal deficits during the Great Recession did not cause inflation because the market understood them to be temporary and believed they could be repaid once the economy recovered. In this regard, the market has been correct. The US fiscal deficit, as a percentage of GDP, has declined from a peak of -10.1% at the end of 2009 to the current sustainable level of -3.1%. As nominal GDP grew at 4.3% over the past 12 months, a deficit of -3.1% translates to a falling debt / GDP ratio.
The Real Inflation Concern
While there is little reason to worry that the Fed’s tapering will lead to a period of high inflation, the longer term budget picture does give real inflation risks. The Medicare and Social Security obligations to the Baby Boomer generation will, according to the Congressional Budget Office, cause debt / GDP ratios to exceed 100% during the next decade. If markets doubt that the government will make the difficult choices necessary to bring entitlements back to a sustainable level, a period of stagflation (a nasty combination of high inflation and low economic growth) will likely ensue. The eventual outcome of these future budget challenges hinges on the US political process, making predictions a largely worthless endeavor.
The Remedy for Volatile Markets is a Strong Balance Sheet
With the fiscal and monetary system in good shape over the near future, the focus of the equity and credit markets will remain on the business cycle. With both corporate profitability and valuations at peak levels, the downside risk from disappointed expectations increases with each new market high. Valuations are comparable to the 2005-2006 period. However, the speculative excesses that would lead to the 50%+ declines like those experienced in the 2000-2002 and 2008-2009 bear markets remain absent. It would take approximately a 20% decline in value to place the S&P 500 at its average P/E of 17, using normalized earnings. This is a higher valuation than at the bottom of the financial crisis, but well above the bottom in 2002 after the Tech Bubble burst.
Assuming that a 20% decline is a reasonable downside estimate, the issue then becomes not knowing when this decline and subsequent recovery will occur. We may be in the midst of this correction now, or markets may recover from this recent volatility and the bear market will occur several years from now. Making the additional assumption that earnings and dividends grow at 5% results in a 7% return (5% growth + 2% dividend yield) per year until the 20% correction hits at some unknown point in the future. The arithmetic of a 7% annual return with a 20% decline occurring at some random point over the next five years translates to 2.1% annualized return – which breaks even with current intermediate–term bond yields.
While volatility in the equity markets cannot be avoided, investors should work to minimize risks of permanent capital loss. This most commonly occurs in one of two ways: either a stock goes into financial distress or it was purchased at such a high valuation that a return to more modest levels would result in a catastrophic loss that takes years to recover from. The former was how most money was lost during the 2008 Financial Crisis whereas the latter typified the late 1990s Technology Bubble. The best protection against either situation is to focus on investing in high quality businesses with strong financial positions that are trading at reasonable valuations. This is the value that active management can bring. In the example above, a manager that managed to match, net of fees, the market’s positive 7% return but only participated in 90% of the decline, falling 18% instead of 20%, would deliver a 0.60% annualized additional return above the index over that five year period.
Current equity valuations, unlike the situation in the late 1990s or the mid-2000s, do not contain a significant risk of permanent capital loss. The Federal Reserve’s exit from Quantitative Easing can be accomplished without serious economic disruption but will likely drive short term volatility. Remember that recoveries from market declines generally happen very fast – usually with a significant portion coming over just a few days. Daily gains of 10% were not unusual during the recovery from the Financial Crisis lows. Just as in 2009, investors who went to cash and waited for an ‘all clear’ signal to get back in accomplished nothing but making their losses permanent. The key to investment success is holding strong, well-capitalized businesses that can survive the ups and downs of the global economy and maintaining an adequate reserve of liquidity to support cash flow needs to avoid being a forced seller of stocks at depressed prices.