May 16, 5:00 pm EST
We’ve talked about the stock market’s discomfort with the 3% mark in rates. People have been concerned about whether the U.S. economy can withstand higher rates–the impact on credit demand and servicing. That fear seems to be subsiding.
But often the risk to global market stability is found where few are looking. That risk, now, seems to be bubbling up in emerging market currencies. We have a major divergence in global monetary policies (i.e. the Fed has been normalizing interest rates while the rest of the world remains anchored in emergency level interest rates). That widening gap in rates, creates capital flight out of low rate environments and in to the U.S.
That puts upward pressure on the dollar and downward pressure on these foreign currencies. And the worst hit in these cases tend to be emerging markets, where foreign direct investment in these countries isn’t very loyal (i.e. it comes in without much commitment and leaves without much deliberation).
You can see in this chart of the Brazilian real, it has been ugly …
Oil has become the potential breaking point here. At $40-oil maybe these countries hang in there until the global economic recovery heats up to the point where they can begin raising rates without crushing growth (and with a closing rate gap, their currencies begin attracting capital again). But at $70-oil, their weak currencies make their dollar-denominated energy requirements very, very expensive. They’ve had nearly a double in oil over the past ten months, and a 15% drop in their currency since January (in the case of Brazil).
Something to watch, as a lynchpin in this EM currency drama, is the Hong Kong dollar. Hong Kong has maintained a trading band on its currency since 2005 that is now sitting on the top of the band, requiring a fight by the central bank to maintain it. If they find that spending their currency reserves on defending their trading band is a losing proposition, and they let the currency float, then we could have another shock event for global markets, as these EM currencies adjust and their foreign-currency-denominated debt becomes a default risk. This all may force the rest of the global economy to start following the Fed’s lead on interest rates earlier then they would like to (to begin closing that rate gap, and avoid a shock event).
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May 25, 2016, 3:30pm EST
We charted very closely the risks of the oil price bust. We thought central banks would step in and remove the risk. They did. From there, we thought stocks would track the path of oil. As long as oil continued higher, stocks would follow and slowly global sentiment would mend. It’s happened.
When oil sustained above $40, we turned focus to the extremely negative sentiment that was weighing on markets and economies. But given the extreme views on the world, we thought things were set up for positive surprises. We said this surprise element creates opportunities for asymmetric outcomes (bad is priced-in, good … not at all). That sets up for the potential of “good times” ahead for both markets and broader sentiment.
Fast forward: Earnings expectations were ratcheted down and broadly surprised on the positive side. Global economic data has been ratcheted down and is positively surprising. It’s happening in Germany, which is a very important indicator for a bottoming of the euro zone economy. If the threat of further spiral in Europe has lifted, that’s a huge catalyst for global sentiment. When global sentiment has officially moved out of the doom and gloom camp and back to optimism the horse will have already had plenty of steps out of the barn. And we think we are seeing it reflected in stocks, especially small caps.
With this backdrop, we think everyone could benefit by having a healthy dose of “fear of missing out.” Stock returns tend to be lumpy over the long run. When we you wait to buy strength, you miss out on A LOT of the punch that contributes to the long run return for stocks.
Consider what we said on February 11th (stocks bottomed that day and are up 16% since): “We often hear interviews of money managers during periods like this, and the question is asked “are you getting defensive?”
That’s the exact opposite of what they should be asking. When stocks are up 15–20%, and acknowledging that the long–run average return for stocks is 8%, that’s the time to play Defense. When stocks are down 15–20%, that’s the time to play Offense.
The reality is most investors should see declines in the U.S. stock market as an exciting opportunity. The best investors in the world do. The same can be said for average investors.
Here’s why: Most average investors in stocks are NOT leveraged. And with that, they should have no concern about stock market declines, other than saying to themselves, “what a gift,” and asking themselves these questions: “Do I have cash I can put to work at these cheaper prices?” And, “where should I put that cash to work?”
As Warren Buffett says, bad news is an investor’s best friend. And as his billionaire counterpart says, and head of the biggest hedge fund in the world, ‘stocks go up over time.’ With these two basic, plain-spoken, tenets you should buy dips and look for value.
Broader stocks have just gone positive for the year. Small caps are still down small. Remember, when the macro fog cleared in 2010, small caps went on a tear, from down 6% through the first seven months of the year, to finish UP 27%. Don’t miss out!
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