Would you be surprised if I told you stocks had another slow patch this quarter? Not likely. For the third year in a row, the middle part of the year has meant most stocks have been hit by a recurring set of concerns.
Some have called this occurrence the “new normal”, referring to the new economic growth rates, interest rates, correlations of stock returns to each other and limitations on total investment returns. While there is no shortage of economists willing to foretell what will happen next, we believe it is far easier to understand where you are today and where we could go from here (and what will be necessary as a catalyst of change). The most significant contributors to this new normal are:
Economic Malaise & Excess Capacity
If the recent recession were more “normal”, we would have likely seen a sharper upturn following such a sharp downturn. Instead, despite significant monetary policy stimulus throughout the world, we continue to see below-trend GDP growth, under-utilization of our capital resources (think plants and other commercial infrastructure) and under-employment.
These are all deflationary factors, which explains the attempted monetary response to date and implies the challenge we have in trying to break the trend. Structurally, the longer this continues the more difficult it will be for us to escape the cycle.
European Financial/Debt/Economic Crisis
The crisis that has developed over the past three years was a natural side-effect of the medicine of the financial crisis. Efforts by governments to intervene and slow the economic decline, combined with previously high debt levels spelled trouble for nations without an autonomous central bank and reserve-currency status.
Once a government attempts to intervene through deficit-financed stimulus, it must have a sufficient multiplier effect, along with low enough debt levels and a strong tax-collection policy for such a deficit stimulus to be effective. Unfortunately, most Euro-zone nations did not meet one or more of these requirements, and the financial markets have responded negatively. The impact on us? Despite economic slowdown, aggregate U.S. exports to Europe have held steady, and it is estimated that less than 10% of S&P 500 companies’ profits are earned in Europe. So it is not an economic concern for us today, instead it is the risk that a financial crisis, originated in Europe, that would turn into another global economic recession. Meanwhile, stock and bond prices in Europe and much of the developed world reflect expectations for recession.
Secular Global Deleveraging
Deleveraging is closely related to the low interest rates and low growth rates mentioned. But the cause and effect relationship is cloudier, and this is where the economists start to divide.
Leverage problems can originate from two sources in a financial system. Leading up to and during the financial crisis, leverage issues related to both the quantity (using the same amount of capital to create more loans) and quality (modifying underwriting standards) of leverage in the financial system. Much of this damage later spread to the non-financial economy, as is expected following a financial crisis.
The resulting excess capacity, significant influence from central bankers and cumulative deflationary expectations can create a negative economic cycle. A catalyst event must occur to break the negative cycle and help reverse the trend.
Until then, countries will be faced with a dilemma- where they draw the line between the stimulus benefits of running a deficit and maintaining the faith of their creditors by not exceeding some debt-to-GDP level drawn in the sand by the marketplace. This is difficult, because once you remove the deficit stimulus to attempt to balance a budget, it continues moving further away due to reduced tax receipts (a problem most European policy makers are well aware of at this point). This will, over time, have a great influence on our investments, stocks, bonds and their related derivatives.
The markets today are indicating a likelihood of a global recession (or near recession), as are economic trend lines. Bond prices are implying, today, years of economic malaise, and stock prices imply the same, or at least distrust in the feasibility of corporate profits to continue growing at the same rate. If this expectation does not prove to be true, the most probable outcome is an increase in the value of stocks and higher interest rates on bonds.
Because we do not pretend to know any more about our economic future than the aggregate marketplace, we instead invest based on a variety of potential outcomes and their relationship to our economic analysis. By assigning probabilities, and what is most likely to occur in each scenario, we can build guidelines for overall portfolio decisions. An economic slowdown will undoubtedly be negative for investor returns, but such an outcome is not guaranteed. However, when it comes to investing, “you can chase a butterfly all over the field and never catch it. But if you sit quietly in the grass it will come and sit on your shoulder.”
William A. Callahan, CFP®
President and Chief Investment OfficerThe financial market summary above includes historical data and Callahan Financial Planning Company’s internal proprietary analysis and is designed for information purposes only. Scenarios described do not encompass all possible or probable outcomes and are not an indication of future results. Financial probability modeling is not a guarantee of future investment returns, and investing in stocks or bonds carries risks. Any investment decisions are recommended to be made in conjunction with your Financial Planner, comprehensive financial plan and all other components that make up your financial situation today.