You may think the sky is falling if you’ve paid much attention to financial news this month. That is an exaggeration, but world markets certainly look weak despite occasional relief rallies. Our Republic managed accounts are still in defensive positions, waiting for this storm to pass.
How long must we wait? Markets didn’t reach this position overnight, and won’t escape from it overnight, either. The major economic trends that created the situation take time to adjust.
Let’s take a step back and review the big picture.
Two years ago the world economy was in a mild but steady “Plow Horse” recovery. Crude oil was over $100, reflecting both strong demand and tight supplies. In the background, U.S. and Canadian shale production was ramping up quickly.
By mid-2014 this new production and slowing growth in China were having a noticeable impact on the energy market. Prices weakened and then began falling quickly. The OPEC countries, led by Saudi Arabia, chose to maintain high production levels and let prices fall.
With lower energy prices raising the threat of deflation, European and Japanese central banks reacted by loosening interest rates, in some cases into negative territory.
At the same time, low oil prices put energy companies in a tough spot. The logical move would have been to reduce production at sites the low prices had rendered uneconomic. Yet those operating on borrowed money needed cash flow to make their debt payments. So production remained high, which helped push prices even lower.
We have now reached a new stage in which banks and bond holders fear defaults on their loans to energy companies. They are right to be nervous, too; leverage will increase the severity of their losses.
The downturn that began in energy has evolved into a banking crisis. Traders are openly questioning the stability of major European institutions like Deutsche Bank (DB). The European Central Bank’s negative interest rates and bond-buying stimulus program aren’t helping very much.
On this side of the Atlantic, the Federal Reserve under Janet Yellen appears to have raised interest rates at exactly the wrong time. The disconnect between the Fed and other central banks is aggravating currency differences. Yet after agonizing for months, the Fed seems reluctant to change course now.
In the midst of all this, corporate earnings weakened faster than stock prices, meaning we now have a stock market whose value is out of sync with its profit level. Prices must fall to restore balance – and they are.
Unfortunately, excess works both ways. Irrationally high markets often correct themselves by going irrationally low. Eventually they find a happy medium, but the process can take months or even years.
Again, we don’t know how long the current weakness will last. We have little confidence that governments and central banks will respond correctly. That is one reason we have shifted our managed accounts to cash and other less-volatile assets. We believe it is possible to achieve positive returns even in environments like this one.
What we will not do is simply ignore risks and expose your hard-earned assets to potentially major bear market losses. Staying in the right position amid fast-changing conditions is difficult. We don’t expect to always buy at the bottom and sell at the top – nor do we need to. We believe a balanced, risk-managed strategy can deliver superior results over time, and that is what we always strive to deliver.
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