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By the end of the third quarter of 2008, equity markets around the globe had registered declines well in excess of 20%, the magnitude commonly considered to indicate a bear market. The convergence in market performance is striking. Over the first three quarters of this year, global markets as measured by the MSCI World Index declined by 25.5%, on a total return basis. Over the same period, the MSCI EAFE Index, widely used as the benchmark for the advanced markets, excluding North America, lost 28.9%. And the MSCI EEM Index for emerging markets dropped 35.4%. Few are talking about a “decoupling” of emerging markets from the advanced economies. In the following 20 days, as credit markets seized up and the reality of a global recession set in, investors fled to safety and equity markets swooned another 10%-12% or more.
This global bear market has resulted from several factors coming together and interacting. One was the dramatic rise in the price of oil and surging prices for other commodities, particularly for agriculture, earlier in the year. These had substantial adverse effects on consumer attitudes and the business climate, and contributed to rising inflation and inflation expectations. Central banks became concerned; a number of them, the U.S. being an exception, adopted tighter monetary policies despite indications economic momentum was declining. The direct impact of higher prices was greatest in emerging markets, where energy and food constitute a large proportion of the budgets of most citizens. Of course, high energy and commodity prices were 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. This factor has now reversed.
The more serious developments occurred in financial markets. A collapse of the U.S. housing market led to the sub-prime mortgage crisis, which later morphed into broader problems for financial institutions. As losses mounted, confidence affecting counterparty funding relationships dropped sharply. When several of the largest financial institutions were forced to close or be bought, culminating with the bankruptcy of Lehman Bros., credit markets around the globe became essentially frozen. Financial institutions in Europe were affected directly through their relationships with the U.S. and their requirements for dollar funding.
With the worst financial crisis since the Depression at hand and economies veering into a recession of unknown depth and duration, it became unavoidable that monetary and financial policy officials would come to the rescue. The cavalry finally did arrive. On Oct. 10, the finance ministers and central bank governors of the G-7 countries met in Washington, D.C., and released a statement outlining an “urgent and exceptional” plan for co-ordinated action to support liquidity, bank recapitalization, deposit guarantees and restarting the credit markets. Together with internationally co-ordinated interest rate cuts earlier that week, the plan demonstrated a remarkable degree of commitment to take effective and internationally coherent action.
Major moves to provide additional liquidity to the financial system have been taken. The most pressing problem, however, was not a shortage of liquidity in the global system. Rather, it was the fact that many of the leading financial institutions had experienced steep declines in value of significant portions of the assets on their balance sheets. Recapitalization of the U.S. and European financial systems was needed to re-establish the confidence necessary for banks to resume lending to firms, households and one another. Massive government steps to fill this need have since been announced.
Other important parts of the G-7 rescue plan involve expanded government guarantees for bank deposits and other liabilities, including, importantly, inter-bank loans. This step was expected to help unfreeze the crucial inter-bank lending markets. The Federal Reserve is also backstopping the commercial paper market. In effect, governments are inserting themselves as the counterparty in a broad range of financial transactions, which should offset the great concerns about counterparty risk that have shut down credit markets.
It appears that these efforts are beginning to have the desired effects on financial markets, but the process of restoring confidence is likely to be slow. With counterparty risks and credit availability becoming less of a concern, equity investors are turning their attention to the state of the economy, and they are not happy with what they see. While economies in the first half of the year, particularly the U.S. economy, proved to be surprisingly resilient in the face of gathering economic headwinds, growth appears to have slowed markedly in the second half. Indeed, most advanced economies may register declines in the current quarter. Growth in emerging markets has also slowed, although it remains considerably faster than in the advanced economies. Reported earnings have fallen substantially below earlier expectations, and earnings forecasts are being revised downward.
Looking forward, we believe prospects may be somewhat brighter than is currently priced into the markets. Oil prices are currently more than 50% below their highs earlier in the year, which is equivalent to a substantial reduction in taxes. The drop in the prices of other commodities has a similar effect. The actions to rescue the financial system have involved major additions to global liquidity. And further economic stimulus actions seem increasingly likely in the U.S., China, Japan and some other economies.
We therefore question projections of a severe and sustained recession in the United States. More likely, in our view, is a relatively mild recession, with a gradual recovery beginning by late spring of 2009. A similar pattern is expected for the eurozone, with an even more gradual recovery. A sharper recession is underway in the United Kingdom. The Japanese economy is one of the few economies projected to register stronger growth next year than in the current year. Another is Canada.
With the equity markets in a highly volatile mode as this is written, it is particularly difficult to judge whether a bottom has now been reached. But looking at all the indicators that in the past have signalled bear market bottoms, the case for a bottom having been reached, or being very near, is strong. For example, we have been seeing the kind of panic selling in which fear feeds on itself. Valuations have become very attractive. At Cumberland Advisors, we have begun to invest the cash we had built up in our equity accounts. Going forward, we expect the U.S. market to outperform those in Europe where the economies are less flexible and interest rates have been held too high for too long. Among the advanced economies, we also favour Japan and Canada.
The emerging markets as a group are expected to return to outperforming the markets of the advanced economies. While they have been affected by the slowdown in the advanced economies, domestic demand — both consumption and infrastructure — and trade between emerging-market economies have become important drivers of growth. Relatively low sovereign debt burdens and improved government fiscal burdens are other positives for many of these economies. Equity markets in Asia ex-Japan (China, Hong Kong, Singapore, Malaysia and Taiwan, in particular) are expected to be stronger than those in Latin America. The Chinese economy is slowing from 10%–11% growth rates to perhaps 8%–9% rates, which would still be well ahead of other economies and remain an important factor for the region. The situation of central and eastern European economies is less bright, with external financial strains becoming severe. Russia, despite the strength of its natural-resource-based economy, has lost the confidence of international investors in its markets and currency. The South African market also is likely to experience a bumpy road ahead until its new government gets inflation under better control. On the other hand, the Israel market is expected to continue to outperform.
All this being said, the global outlook is particularly uncertain, and downside risks going forward remain significant. A well-diversified, multi-asset-class investment strategy should show its value 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 not closely correlated with equities, such as commodities, currencies, fixed income and real estate, can significantly add to the diversification of a portfolio, and to the benefits that come from diversification. This approach has been followed by major institutional investors, particularly university endowment funds and pension funds. At Cumberland Advisors, we have found that the arrival of an ever-growing number of exchange-traded funds covering all of these asset classes provides an efficient, low-cost way to create such a portfolio. The goal is 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 behaviour.
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