Before last week’s rebound, with few exceptions, equity markets around the globe had registered declines in excess of 20%, the magnitude commonly considered to indicate a “bear market.” The convergence in market performance is striking. Over the period between the markets’ peak reached on October 12, 2007, and the low point of July 15 last week, global markets as measured by the MSCI World Index declined by 21.0%. Over the same period, the MSCI EAFE Index, widely used as the benchmark for the advanced markets, ex-North America, lost 21.6%. And the MSCI EEM Index for Emerging markets dropped 21.3%. In the latter trading days of last week, equity markets reversed course. Does this signal that the bear market has reached a definitive bottom, or will the recent lows be revisited and possibly be surpassed?
The global bear market has resulted from a number of negative factors coming together and interacting. To summarize these very briefly, the collapse of the US housing market led to the subprime crisis, which later morphed into much broader problems for financial institutions, with a sharp drop in confidence affecting counterparty funding relationships. Financial institutions in Europe were affected directly through their relationships with the US. These negative developments are being compounded by developing serous problems in a number of European housing markets, particularly in Ireland, Spain, the UK, and France. The second factor has been the dramatic rise in the price of oil and surging prices for other commodities, particularly for agriculture. These have had growing negative effects on consumer attitudes and the business climate and have contributed to rising inflation and inflation expectations. The direct impact of these higher prices has been greatest in emerging markets, where energy and food constitute a large proportion of the budgets of most citizens. Of course, the high energy and commodity prices have been a boon to those countries that are net exporters of these products, such as Brazil, Russia, Australia, Canada, Norway, and the Middle East oil exporters.
To what extent have these factors, or their expected future course, changed recently? We have yet to see the US housing market carve out a clear bottom. Mortgage delinquency curves have not flattened out. The process of deleveraging by banks certainly does not appear to have been completed, and many banks still need to raise additional capital. While we may well have heard most of the bad news to come from the largest financial institutions, there is probably more to come from smaller banks. And we have yet to see the impact of tightened lending standards on business investment.
On the energy front, the sharp drop in the oil price last week was certainly welcome, but a further sustained drop is needed to have a lasting impact. The increase in output from Saudi Arabia’s oil fields is a positive development. Efforts to tap the oil reserves of the US Continental Shelf, if carried forward, will not affect oil supplies for a number of years. We continue to be concerned about the effect on consumers of what appear likely to be very high home heating costs for the coming winter. It is evident that oil prices at the current levels are finally having the positive effect of destroying demand for gasoline and for many other elements of energy demand. But it is difficult for families to economize on heating requirements.
Other commodity and materials prices have come off their highs, reflecting both slower global growth and growth expectations, along with some positive supply responses. This is a plus for oil- and commodity-importing countries and for the outlook for global inflation. Taiwan’s prospects, for example, should improve, both due to these factors and because of improved commercial relations with China. But we doubt that the long-term boom in commodities has come to an end. China’s economy, while it has also slowed somewhat, is still the most rapidly growing large economy in the world. It is likely to continue to register growth in the 9-10% range for the foreseeable future and be a major consumer of raw materials and commodities. India, while confronting greater near-term problems than China, is still advancing at a 7% pace, as also is Russia.
The future course of inflation is a critical and uncertain factor for the US economic outlook. If energy and commodity prices do ease in a convincing way and the pace of economic activity remains modest, the Federal Reserve Board’s concerns about inflation and inflationary expectations will moderate. Under those conditions, the Fed would be expected to hold off any interest rate increases for some time. On the other hand, should inflation start to ramp up further, the Fed would be forced to step in with higher interest rates, despite the risk of tipping a slow economy into a significant recession.
Among the advanced markets, despite the negative factors listed earlier, the US economy has proved to be surprisingly resilient in the first half of this year, avoiding any quarterly decline in GDP. In fact, the lowest growth rate was registered in the final quarter of 2007, +0.6% at an annual rate. First quarter 2008 growth was +1.0% and it looks like the second quarter’s growth was in excess of 2%. The latter was beefed up by Congress’s fiscal stimulus package and very strong exports, thanks to the weak US dollar. These two factors should help the current third quarter as well, but we are less confident about the closing months of this year and early 2009, which could be rather weak.
Economies in Europe were surprisingly strong early in 2008, but more recently there are growing and widespread indications of deceleration. The continued very expensive euro, high energy prices and high interest rates, along with rising inflation are biting into economic performance in Euro land. Even Germany, the strongest performer among the major European economies, is signaling that its economy slowed sharply in the second quarter. In France, real wage growth has turned negative despite French President Sarkozy’s pledge to strengthen the purchasing power of consumers. The UK economy, while not tied to the euro, is looking particularly weak. The Bank of England’s leeway to stimulate the economy is severely limited by the fact that the UK’s inflation rate is the highest it has been for 16 years. We expect that European equity markets will underperform in comparison to the US equity market in the coming months.
In Asia, Japan appears to be experiencing a mild recession, but its equity market has outperformed the Euro land markets this year. Japan has largely avoided the banking crisis that hit Europe along with the US, Japan’s inflation remains subdued (indeed, there is still a risk of slipping back into deflation), and the Bank of Japan is not expected to raise Japan’s very low interest rates for the foreseeable future.
Putting these and other pieces of a complex and uncertain outlook for global equity markets together suggests to us that, while there are some promising developments, the downside risks going forward remain significant. In order to preserve investors’ capital and to be ready to take advantage of a more convincing upswing in markets, Cumberland has been raising cash levels in our Exchange-Traded Fund (ETF) accounts. In doing this, it is important to seek to identify those markets that are most likely to underperform going forward and to target the most likely outperformers for the time when the cash that has been raised is to be put to work.
Finally we should note the value of a diversified, multi-asset class investment strategy in such markets. Diversification across equity markets, sectors, industries, and countries is likely to reduce the overall risk in a portfolio. Adding other asset classes that are not closely correlated with equities, such as commodities, currencies, fixed income, and real estate, can significantly add to the diversification of a portfolio, and the benefits that come from diversification. (Correlation is a statistical term that defines the strength of a linear relationship between two markets.) This approach has been followed by major institutional investors, particularly university endowment funds and pension funds. The development of an ever-growing number of ETFs covering all of these asset classes provides an efficient, low-cost way to create such a portfolio.
At Cumberland Advisors, we now have accumulated two and a half years of experience with such an all-ETF investment style, our Global Multi-Asset Class Portfolio. This portfolio style uses ETFs that represent major markets in multiple asset classes. These markets may have varying degrees of correlation with each other. It is the goal of this portfolio style to take advantage of low or negative correlations between asset classes, represented by the ETFs. This way, when some markets are down, others should be steady or up, if they conform to historical patterns of behavior.
Kotok comment: readers must note that this approach only has 2 ½ years of live account experience. These instruments (ETFs) did not exist a few years ago. We can provide details on the composition and structure to those who email a request.