After a prolonged slumber, market volatility returned to the financial markets with a vengeance in late August. Many concluded that a slowing Chinese economy combined with the then-still-imminent prospect of a Federal Reserve rate hike had sent stocks on their wild ride.
My Uncommon Sense view—where I challenge a prevailing consensus driving the market—is that there is something much bigger wreaking havoc on the capital markets than worries over China’s economic growth and a Federal Reserve (Fed) rate hike.
While there have been about 700 rate cuts by global central banks since the last Fed rate hike in 2006, investors are now starting to concede that monetary policy alone isn’t enough to stoke inflation, solve the world’s debt problems and return economic growth to historical norms.1
There is a growing realization that public and private sector reforms are needed in conjunction with sound monetary policy to boost inflation and get back to more normal rates of growth, and investors are starting to grasp that this path to economic recovery will be a long, bumpy one. I believe this is the true cause of those August squalls.
The real story in China
China was the scapegoat for the August sell-off and subsequent market volatility, yet I would argue that the situation is more nuanced.
Source: Bloomberg, State Street Global Advisors. Period: 9/18/2012 to 9/18/2015. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss, and the reinvestment of dividends and other income.
The measures taken by the Chinese government during the last year couldn’t have been more aggressive, and yet they have failed to slow declining economic growth. Now China is spending huge sums to prop up the stock market and influence the value of the renminbi.2At this point, China will likely have to spend even more, but that doesn’t alleviate the fact that there’s less and less evidence it will actually work.
It’s widely believed that the current challenge for the Chinese government is to build an economy that relies less on exports and more on consumer demand and services. This shift from an investment-driven export economy to a consumption-driven service economy may take years, and investors are waking up to the fact that China’s transition will be rocky.
We have also seen that there is growing concern about China’s inability to manufacture domestic inflation and economic growth. If China is challenged, with its vast policy tools and committed government, then how can other central banks possibly succeed?
It worked. It really, really worked.
This isn’t to say that quantitative easing and other extraordinary monetary policies haven’t worked. On the contrary, they have helped global economies avoid deflation, repair unemployment and restore confidence in financial markets.
However, these policies were meant to be temporary and governments around the globe were supposed to use the breathing room of low interest rates to revamp their economies. Governments have failed to enact longer-lasting policy overhauls as they try to combat an array of demographic and other challenges, such as falling labor participation rates.3
It’s now time for public and private sector solutions to broaden the economic recovery from just holders of financial assets to include a much larger group of stakeholders, and restore inflation and growth to historical norms.
What does this mean for investors?
Generally speaking, investors with long time horizons and a disciplined, diversified investment approach have been rewarded with returns that enable them to grow wealth and preserve capital faster than the rate of inflation, even after the deduction of taxes, fees and transaction costs. I believe once investors adjust to the new environment that this time will be no different.
The markets are realizing that full recovery from the 2008 economic downturn, the greatest since the Great Depression, will be even harder and take longer than they thought. As a result, stock market volatility may be elevated in the coming months and quarters while this adjustment occurs.
On the bright side, it also means we’ve entered the next phase of recuperation. US economic growth continues to show signs of life and underlying company fundamentals remain compelling. This may enable stock prices to recoup recent losses and grind higher into next year.
You can read more about my contrarian view on market volatility in my full Uncommon Sense article.
Definitions
Shanghai Stock Exchange Composite Index
An index that tracks the performance of all A and B shares listed on the Shanghai stock exchange.
1Bank of America Merrill Lynch
2Financial Times, “Renminbi outlook a puzzle for investors,”as of 10/8/2015
3The Wall Street Journal, “Central Banks’ Lesson: Easy Money Alone Isn’t a Growth Salve,” as of 9/17/2015