The first month of 2014 was a rocky one for the equity markets. As volatility returned to the global equity markets with a vengeance, emerging markets were the first to hit bumps, and now, it seemingly has spread to the U.S. equity markets.
The flight of capital is leaving the equity markets and stoking up the bond markets as U.S. Treasury yields have dropped to levels not seen since mid-2013. We have seen tepid economic reports posted out of China, India and other emerging markets in general. Even the U.S. economic data has cooled as December's non-farm payrolls grew only 74,000 against estimates topping 200,000. We have seen weakness in durable goods, the Institute for Supply Management factory index and existing home sales.
It always amazes us how the emotions of the media talking heads will shift directions, going from a love fest in the equity markets to running for the door in fear once the selling starts. As if perfectly choreographed, the bullish analysts have taken their seats with the orchestra and the bearish pundits have taken the stage for a chorus of “highway to hell.” We see folks criticize China's growth when they are still humming along at a 6%-7% GDP rate. Even the United States posted an above-average revision to 4Q GDP, settling at 3.1%. And cries supporting the shelter of long-dated bonds have again emerged.
We would like to consider this market choppiness as merely a correction, which we know is very healthy for the life of a bull market, but could it be something else? Let's examine the pertinent data to better determine the probabilities of a mere soft patch or if this is a turn in the economy and markets.
Bearish Case: The bears point out that the global data has turned negative at the same time the Federal Reserve has begun to wind down its asset-purchase program, more commonly known as quantitative easing. The taper is causing money to leave emerging markets, thus causing currency problems in countries such as Turkey, South Africa and India. The potential contagion could cause a meltdown not seen since the Russian ruble crisis of 1998. Bears note that the the holiday season was lackluster, indicating U.S. consumers appear to be pulling in their purse strings.
On top of that, we now have a down market print for January and thus that points to a down year. If that is not bad enough, this is the second year of a presidential cycle, which historically has meant volatility and challenges for the markets. Finally, we have a new Fed chairman and historically the global markets always test the new chairman with a crisis in the first year of his or her tenure.
Now, how can you argue with this “wall of worry?” Often we see the greatest amount of fear at the bottom of the markets. We would remind readers that great buying opportunities rarely come without elevated anxiety. In fact, as selling accelerates, we often find the bottom within sight. Let's try to look at the bull case to see if the story still bears listening to.
Bullish Case: Although we have had weaker data out of the U.S. over the past couple of weeks, we need to understand that the weather in the U.S. has been brutally cold for most of the country. As one wonders where “global warming” is really taking place, we see the prices of natural gas moving up sharply, even as the known recoverable reserves of natural gas have grown and America becomes energy self-sufficient. Could it be that things got a bit softer in December and January as the polar vortex hovered over many of our cities?
Quarterly earnings for the fourth quarter of 2013 are coming in nicely. We don't see any discussion of slowing. In fact, we hear discussion of expanding capital expenditures, which has not been on the corporate plate for quite some time. The expansion of spending on capital programs is an indicator of an economy that is expanding and not contracting. We note that new loan demand is beginning to grow and consumer delinquencies continue to dry up. Corporate access to liquidity is more than ample and we see no uptick in corporate defaults.
The “all telling” yield curve is still very positive, sporting around 325 basis points of positive pitch. The Fed is winding down its QE purchases; remember, however, that over $3 trillion of reserves have been injected into the economy that is not being removed. The zero interest rate policy is here for a very long time. In short, this is the most monetary stimulus that has ever been released upon any U.S. economy in our history. Finally, the Fed has stated that they will continue to be very supportive of U.S. economic growth with an eye to raise inflation expectations and continue jobs growth in the United States.
After carefully looking at both sides of the argument we find ourselves looking at the current market weakness as a buying opportunity in what we believe is an ongoing secular bull market. We have often said that we will not “fight the Fed” and we will not start now. We think that these corrections are sharp and inflict a fair amount of pain and fear. They would not be effective corrections if they didn't. Typical corrections start off slight and crescendo on sharp price declines. We believe we are entering that stage now. Will it be over in a day, a week, or a month? We don't know for sure, but we think that a normal correction would amount to around 8% and last 60 to 90 days. We have corrected to date around 5% and only burned up 30 days with the decline.
Specifically, we would be buyers of growth at a discount. We know fear is in the emerging markets, but that is where the growth has been and should be again. You can buy the BRICKs (K = South Korea) at a very cheap multiple, for which we believe you will be rewarded. China should be fine with their GDP basing at around 6%-7%. We would also be buyers of Japan, Europe and the U.S. equity markets.
Finally, the “January” indicator is just that. If one looks closely, the data on losing Januarys is rather thin. Losing Januarys with losing years is even thinner. We don't put much stock in such indicators whether positive or negative.
All in all, we think we are in just a bit of a soft patch in the data set with the real economic evidence continuing to support an expansion in the global economy in general and the U.S. economy in particular. Earnings should grow in the United States this year from an expansion in business and not just from refinancing debt or share buybacks. We believe the future is still intact. Sometimes you just have to hold your nose and buy.
Scott Colyer is chief executive officer and chief investment officer of Advisors Asset Management.