Failure to Launch
Stock market volatility returned in August, as a slowdown in the Chinese economy (and a steep selloff in Chinese stocks) reverberated around the globe. Investors were also on edge as to the timing and magnitude of an eventual “liftoff” in interest rates by the Federal Reserve. For more than a year now, the Fed has telegraphed its intent to raise rates in the near future (for context, the last such increase occurred in 2006). Consequently, the U.S. dollar strengthened vs. most major currencies, a trend which has accelerated in the last 12 months:
Earlier this year, a consensus emerged that the Fed would likely begin raising rates by the time of their September meeting (held earlier this week). However, a subsequent market correction (the S&P 500 declined 10% within the month of August), along with signs of weakness abroad, clouded that consensus. Ultimately, the Fed elected not to raise rates just yet, postponing action until either their October or December meetings.
The Fed’s wavering over a 25 basis point increase may appear melodramatic, but in fairness they have a difficult task. The Fed’s “dual mandate” in setting monetary policy is to promote both full employment and price stability. This is a delicate and imprecise balancing act, particularly when relevant economic indicators deliver mixed signals. Currently, the unemployment rate is 5.1%, down from a peak of about 10% during the financial crisis, and just above the low (4.4%) reached during the last business cycle. Based on this data point, it would seem that the U.S. labor market is close to full employment.
Normally, a tight labor market increases inflationary pressure, since employers are forced to raise wages to compete for workers. Additionally, the Fed’s apprehension about possible deflation has led officials to err on the side of caution by explicitly targeting a positive (albeit modest) inflation rate of about 2%. But even amidst a seemingly tight labor market and very accommodative monetary policy, inflation has stayed well below the Fed’s target, thanks in large part to a collapse in energy prices.
Meanwhile, a strong U.S. dollar–combined with slumping demand for many commodities–has been especially rough on emerging markets. Developing economies are commonly oriented towards commodity and raw materials exports, so a drop in commodity prices lowers GDP growth (and tax revenues), thereby increasing fiscal stress. Compounding this, many emerging market countries have financed part of their sovereign debt with dollar-denominated bonds (ironically, in an effort to attract foreign investors). Of course, as the dollar strengthens vs. the local currency, servicing this debt becomes ever more difficult. And presuming interest rates rise in the U.S., formerly attractive bond yields in emerging markets appear relatively less so.
While August’s selloff was brief (the S&P 500 quickly retraced about half of its initial correction by the time of the September Fed meeting), it led to a spike in volatility and some associated trading anomalies which should give pause to efficient markets enthusiasts. On Monday, August 24th, a flood of sell orders at the U.S. market open (China’s stock market had declined over 8% the previous day) quickly overwhelmed stock exchange “circuit breakers” which were implemented following a similar “Flash Crash” in 2010. Trading in certain stocks was temporarily halted, and market-makers for some exchange traded funds (ETFs), unable to confidently price the underlying holdings of those ETFs, backed away from the market. Bid/Ask spreads widened, and some shares temporarily traded at ludicrous prices (ex: the Vanguard Consumer Staples ETF dropped 32% in the opening minutes of trading).
Another asset class impacted by recent trading volatility is closed end funds (CEFs). As we discussed in our Q1 2014 commentary, the structure of CEFs is attractive for long-term investors such as ourselves, since they potentially have two layers of discounts (both the securities in the CEF portfolio, and the CEF itself, which periodically trades at a discount to its net asset value, or NAV). As Morningstar recently noted, certain types of CEFs are trading at discounts to NAV not seen since 2008. An example from our own portfolio is the Templeton Global Income Fund (GIM). We originally purchased this fund at 5% discount to NAV; currently, the discount stands at more than 14%:
While there is no guarantee that this discount will narrow in the future, it seems likely to us that it will. Moreover, this source of return would be additive to the income from the underlying bonds in the portfolio (GIM has a current distribution yield of 4.8%). What would it take? History teaches us that an actual improvement in fundamentals is not necessary. Discounts, or premiums for such funds, are mostly a product of investors’ psychology. Our expectations are that, eventually, investors will feel positive again about emerging markets.