An Excerpt from the Mid-Month Update

Given the market volatility, we provided a mid-month update to our investors.  The following is a brief commentary on the markets:

For purposes of this update, we’ll highlight some ways in which the situation today is very different from 2008:

  • On the positive side, while the Great Financial Crisis nearly pulled down the US financial system, which choked off the real economy, today US banks are less leveraged and have double ($1 trillion) the capital base relative to 2007.  US household leverage is lower as well.
  • Likewise, there likely isn’t systemic risk from trouble in the high yield market, where so far the damage is in energy related investments.  Large banks have limited exposure to energy (Wells Fargo estimated 2% of its loan book yesterday) so losses are more likely to be spread out to mutual funds and other holders.
  • A big negative is that while emerging markets weathered 2008-09 much better than the developed world, they potentially are in much worse shape today.  Growth post-crisis was fueled by debt (some estimate $5 trillion in new USD denominated debt), and much of that debt may need to be written off.
  • A related issue is that commodity producers — both companies and countries — will be in serious jeopardy if prices remain this low.  Sovereign defaults are a real possibility, so 1997-98 might be a better analogy (with much larger numbers, unfortunately).
  • Finally, most central bankers, some would argue, are out of bullets.

It’s the latter three issues that concern sophisticated investors.  The narrative goes something like this:  low commodity prices cause widespread corporate defaults, especially among emerging markets producers, which destabilizes local banks and financial systems.  Countries have to step in to support the financial system after having already depleted sovereign funds accumulated during the commodity bull run.  Social services and employment get cut, causing a decline in demand and a downward spiral in activity.

The crude oil game of chicken will end at some point, and in the interim we should see an “oil tax cut” flow through the rest of the economy.

The flip side is that no one wants to see this happen, so if things deteriorate we should expect a big policy response.  China has stumbled recently, but still has plenty of arrows in its quiver.  The crude oil game of chicken will end at some point, and in the interim we should see an “oil tax cut” flow through the rest of the economy.  The Fed can telegraph slower tightening and the ECB can ramp up asset purchases.  Corporate profit margins in the US are remarkably high by historical standards and the job market remains robust.

Information flows in waves, and the past few weeks have been resounding negative.  This is not to say that the current problems won’t escalate or, for that matter, that the equity market wasn’t due for a repricing (see our video on the Hidden Risks in 60/40 Portfolios), but drawdowns like this tend to occur as the market digests sudden, new information.  When the new information is cloaked in opacity (China’s real growth rate) or nearly impossible to predict with accuracy (crude prices over the next five years), people sell first and ask questions later.

January 15, 2016