The month of August revealed the speed and magnitude a downward move in stock markets can have. August will resonate with investors for a long time, especially because other asset classes did not offer much protection or diversification benefits. Searching for similar market environments, the parallels with the summer of 1998 are striking.
Globally, virtually all risk asset classes lost value in August. Even government bonds did not offer the protection that investors got used to and relied on for the last few years. In a blog post from last summer, we mentioned that this assumed protection feature of bonds in a portfolio cannot be taken for granted. (see „No Hiding: Market Timing in Wealth Management“).
The US dollar, typically viewed as a safe haven currency, lost significant value against the Euro. Just before the intense move our EUR/USD model switched from its long held USD positioning into a neutral (small) EUR position that was of benefit in the second half of the month.
An exception among risk assets was gold. The metal increased slightly in August. These small gains did not compensate for losses from the equity side and certainly not for the last four years during which gold has been on a continuous downward trend. Gold does not play a role in our strategies.
What happened
No single event was responsible for the strong sell-off in August. Chinese stocks had been on the way down for quite a few weeks. The devaluation of the yuan by China’s central bank was another component to increase investor’s concerns of slower growth in China.
In addition, profit taking in Europe or reluctance to allocate to the region on doubts of further gains and a standby mood before FED’s interest rate decision occurred during summer vacations. Such a combination can turn a rather small market downward trend into a crash. Monday, August 24 might be classified as such a crash day. The most liquid, widely held, and fundamentally sound companies as well as those that focus only on the US domestic market fell by double digits on that Monday. This happens in a market environment with a lack of liquidity. No buyers are available or buyers are only willing to buy at fire sale prices. This illiquidity is remarkable and raises more essential questions when assuming that the market environment will not change in the foreseeable future.
Summer 1998
If you search for historical parallels or patterns that appear from time to time in the financial markets, you will certainly find those. More often than not the explanatory power of such historical comparisons is low. Predictions of future market developments from these observations are difficult because only a few factors from the occurrences in the past overlap with those in current environment. Looking at the current market developments, the parallels with the summer of 1998 are quite numerous and noteworthy.
Back then as well as today, global equities lost significant value. Equities in Europe and the US were no exception although a recession was not in sight in either region. Emerging markets triggered the downturn. Asia’s financial crisis started in 1997 and together with the Russian crisis was already past its peak by mid-1998 when the US stock market lost 20% in July and August of that year. In 2015, for months we had already observed a major slide in Emerging Market stocks in Brazil, Russia, and China just before the developed nation’s markets got hit in August.
More parallels with 1998 exist. The oil price had been falling since the end of 1997 amid high production and reserves. In addition, the US dollar appreciated until that upward move reversed during the equity market drawdown in the summer of 1998. These exact same movements can be identified from Mid-2014 onwards.
What happened in the aftermath might lift the mood. The significant losses in the US equity market from summer 1998 were easily recovered before the end of that year. Company valuations, measured by Shiller CAPE for example, were much higher than they are today. The M&A boom was also in full swing. The stock market rally of the 90s continued for another two years until the dotcom area ended.
The US dollar regained its strength and moved higher in tandem with oil until the recession began.
Outlook
It is still open if the US central bank will raise interest rates in September. The question seems to determine the behavior of market participants. From our point of view, the timing of the rate hike is secondary. All potential scenarios – there are only two – are on the table and can be weighted by probabilities. The central bankers specified that the hike will happen this year and not automatically trigger a round of further rate hikes. With very high certainty we know that rates will be insignificantly higher this year and remain on similarly low levels for 2016. At the same time, for continental Europe and Japan a more restrictive monetary policy is not in sight.
As mentioned above, Emerging Market equities and the corresponding currencies have been in a downward trend for months. The rating downgrade of Brazil to junk, the steep decline in oil prices, and probably a too pessimistic outlook for Chinese growth might take steam out of the downward trend in risk assets.
For the longer term, we are convinced that these fast and intense sell-offs in stocks and in other asset classes can pop-up from time to time. The reasons are the market infrastructure, a lack of liquidity, and the behavior of fast-acting market participants. We see three measures as crucial to prevent long-term damage stemming from these sell-offs. First, we do not rely on so called safe havens or on assumed protection benefits of certain asset classes. Secondly, all strategies are designed to be able to recover from significant drawdowns in a reasonable time period. Last but not least, diversification across strategies and implicitly across risk-return drivers serves the objective to weather these unavoidable negative market periods over the long-term.