Call it the beginning of the Great Unwind. Just as successive rollouts of the Federal Reserve’s multi-billion-dollar bond purchases inflated asset prices and caused money to flow into risky investments, the Fed’s stimulus withdrawal is causing disruptions across asset classes globally.
As the Fed scales back its stimulus, money is flowing out of U.S. stocks and emerging-market securities and currencies and into U.S. Treasuries, the dollar and gold.
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As 2014 gets underway, the Standard & Poor’s 500 is down 5.8%, while bonds -- as measured by Barclays U.S. Aggregate Bond index -- are up 1.85%. Contrast that with last year when stocks soared 30% and bonds fell more than 2%. Meanwhile, gold, which plunged 28% in 2013, is up 4.5% for the year and the dollar has rallied materially against all the major currencies except the yen.
Investors are unwinding risky investments in emerging markets and the U.S., jettisoning anything that can be sold to raise cash since security markets in developing economies aren’t as liquid as the U.S. Over the past five years, the Fed has kept overnight interest rates near zero and initiated a multi-billion-dollar monthly bond-buying program to lower longer-term interest rates and encourage people to borrow, invest and spend.
The Fed’s policies created the added effect of sending investors overseas in search of riskier, higher-yielding investments for juicier returns they couldn’t find domestically. Investors borrowed money at low interest rates in U.S. dollars and took that money to emerging markets to exchange for local currencies to invest in those countries’ stocks and bonds. Now that the Fed is cutting back on the amount of bonds it buys each month, investors are stampeding out of emerging markets and risky assets in favor of safer assets with higher expected yields in the U.S., causing ripple effects across global markets.
The selloff is leading investors to question whether the domino effect across world markets is reflective of underlying financial risks in emerging economies that could spread to the U.S. Bob Doll, chief equity strategist for Nuveen Asset Management, says the selloff is solely psychological.
“There’s no evidence of economic problems, nor is there evidence that financial fissures and credit problems are emerging in the developed world as a result of this,” he said. “But if this goes on long enough and fast enough then you can get those dislocations.”
Aside from unwinding trades in developing countries, some are pinning the pullback on profit taking after a 30% run-up in 2013. “We’re seeing a rotation into more defensive asset classes,” says Sam Stovall, chief equities strategist for S&P Capital IQ. “The worry about a correction was not far from people’s minds. Like impatient first graders playing musical chairs they keep trying to sit down anticipating when the music will stop.”
Indeed, the market experienced its worst January since 2010. And for folks who worry about the old market adage ‘as goes January so goes the year,’ heed this: Whenever the market fell in January the odds for a down year were no better than a coin toss.
Instead, whether the market rout continues depends more heavily on Fed policy and the strength of economies globally. So long as the economy continues to improve, the central bank plans to cut its monthly bond purchases by $10 billion at each meeting, fully winding down its program near the end of the year. If the U.S. economy continues to strengthen and emerging markets are able to weather major capital outflows, then stocks should perform well.
The selloff in emerging markets shouldn’t inflict much pain directly on the U.S. economy. Exports to emerging markets including Argentina and Turkey -- two of the economies under the most pressure -- account for just 1.5% of U.S. gross domestic product. Perhaps that’s why the Fed didn’t mention the emerging market rout in its statement from its January meeting.
“I’m not overly concerned that this will bleed into some sort of economic recession, triggering a bear market,” says Doll. That said, he thinks there’s more selling pressure to come before moving sideways and eventually back up. Doll forecasts the S&P 500 will end the year around 1950, which would be a 12% return from current levels.
One gage to keep an eye on is the dollar. In the post-financial crisis era, when the dollar rallies, stocks sell off, and vise versa. Whether this relationship holds this year will be contingent on how much the economy strengthens. If the dollar is strengthening because the U.S. economy is improving and interest rates increase as a result, it makes the dollar more attractive. In that case, stocks could climb higher because growth is picking up. But if the dollar is strengthening because people are bailing on stocks to look for safe havens in Treasuries, gold and the U.S. dollar -- as they are now -- then that’s a negative.
“Early on people are gravitating toward the dollar in a fear trade, but we still believe global economic growth will pick up and that by the end of this year we could still see the S&P (500) up about 5% for the full year,” says Stovall.
And while Treasuries are catching a bid now that investors are stampeding out of risky assets for safer investments on the back of the Fed taper, both Doll and Stovall think Treasuries will end the year lower. Stovall expects the yield on the benchmark 10-year Treasury to rise to 3.5% from 2.58% thanks to his outlook for near-3% GDP growth this year. (Yields move in the opposite direction of prices, and tend to rise with economic growth.) Indeed, after a relatively strong first read of fourth-quarter GDP, bond yields rose before falling down on market turmoil.
Thus, as the Fed peels back its stimulus and if the economy picks up as most expect, investors could finally see a return to more normalized markets that trade on the strength of economic data and corporate earnings as opposed to central banks stimulus.
What should investors do now?
While markets are in a tailspin and individuals might be fretting about their holdings, Stovall says stay the course -- though he’s not advocating adding to holdings until things settle down.
Doll is betting on an improving economy and using the market selloff to dollar-cost average into stocks that are tied to improving growth. He’s overweight industrials, selective technology and consumer discretionary; while he’s underweight utilities.
Investors who are thinking of bailing might keep the following words of wisdom from Stovall in mind: Since World War II, the market fell 5-10% 57 times and took only two months to return to breakeven. There have been 19 times that the market fell by 10-20% and it took only four months to get back to breakeven.
“So if roughly 85% of all declines of 5% or more have been recovered in four months or fewer, then you’re better off forcing yourself to buy at each 5% pullback,” says Stovall.