Isn’t Hurricane Season Fun?
As I sit here awaiting the potential impact of Hurricane Joaquin, less than three years after Sandy made her presence known in a devastating way, I can’t help but believe that investors have felt as though their portfolios have been blindsided by a category 4 hurricane. The feeling of devastation has been primarily fueled by the financial news media that treats any downside volatility in the same manner that the weather news media trumps up the prospects that any given tropical storm will develop into a hurricane only to wreak devastation on the east coast. Having lived in Miami for many years, I became numb to the weather prognosticators and put them in the same category as the financial media—journalists looking for a story not the facts. But to the credit of the meteorologists, the adverse events they predict can actually result in injury or death, unlike the typical result of portfolio volatility.
If you believed the world we experienced year-to-date through June of 2015 was normal from a market perspective, you would be sorely mistaken. In any given year, over each of the past 35 years (since 1980), the S&P 500 Index has averaged an intra-year drop of 14.2% yet has experienced a positive return by year-end in 27 of the 35 years or 77% of the time. So far this year’s peak to trough decline has been 12.4%. It was abnormal that we avoided a 10% decline for nearly 47 consecutive months—the third longest period in history. 
The quarter started innocuously enough with the broad equity and fixed income markets generating low positive returns. Conversely in August, sentiment changed, and set up an inflection point that resulted in a two month rout in asset prices with only the highest quality fixed income markets being spared. As such, most portfolios experienced losses, a rare occurrence since the third quarter of 2011. In fact Q3 2015, marked the worst quarter for the major market indices since then.
During the exceedingly volatile August and September that the markets experienced, Threshold’s Investment Management & Research team was closely monitoring the performance of the risk management tools infused within client portfolios as they had not been truly tested given the recent extended period of benignly low volatility. Thankfully, the strategies were developed to provide some shock absorption during periods of extreme downside equity volatility; we believe the strategies performed well relative to our expectations. Once again, they were not meant to completely inoculate portfolios from losses but rather to mitigate them relative to riskier exposures. Additionally, where appropriate, the other, more basic risk management tools we have deployed, allocations to cash and high quality taxable and tax exempt bonds, provided additional support to portfolios.
THE FED’S INACTION
I am very disappointed that the Federal Reserve did not raise rates at its September meeting. I had hoped the all-too powerful body would have the courage to put a stake in the ground by raising rates 25 basis points (bps) and accompanying that move with the assertion that the U.S. economy is healthy enough not to require life support. Since the Fed's narrative has dominated market sentiment for seven years now, why wasn’t that the right move? Would 25bps on cash really be such a deterrent to those who were thinking of deploying capital? I do believe markets would have reacted positively to a clear demonstration of confidence in U.S. economic growth prospects. Additionally, a positive narrative could have instigated movement in areas of the economy where a “wait and see” attitude seems to persist—buying a home, starting a business, etc. While the prospect of interest rate hikes often scares the markets, what’s more frightening at this point is the uncertainty.
Instead, the Fed lacked courage and leadership (think the 4th “D”, i.e. Dearth of Leadership) by taking the path of least resistance and continued to delay the inevitable. They cited, “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term,” for their inaction. But we believe what they’ve really done is to admit to the world that their monetary policy since the 2008-2009 crisis has not built an economy strong enough to withstand economic volatility from abroad. I wonder if this is the beginning of the end of the “Golden Age of the Central Banker.”? While it will be challenging for markets to adjust to a new era, in the end, in our opinion, investors will be better off in the hands of market dynamics governed by fundamentals as opposed to the utterances emanating from the banking thrones.
At some point we need to rebuild our monetary toolkit to combat the next economic recession. From my perspective, it remains likely that there will be another recession lest you believe the Fed can smooth out the business cycle. For those of you who do not remember, the prevailing thought during the Greenspan era in ’03-’07 was the Fed could mute the business cycle. I hope the 2008-2009 downturn, otherwise known as “The Great Recession”, cured investors of that mental affliction.
We shall see how the markets react to this latest round of inaction. While the crystal ball is in the shop, I suspect the Fed’s uncertainty around raising rates will continue to paralyze markets much like we have been experiencing in the short term.
As you have seen me state in a recent blog, I welcome this downside volatility as it appears investors had become far too complacent, ignoring capital market, macroeconomic and geopolitical risks and, as a result, not factoring them accurately into asset pricing. Now it appears that a little downside volatility has caused investors to recalibrate (appropriately so) their assessment of the many risks inherent across the macroeconomic as well as geopolitical landscape.
While the wake-up call was recent for most investors, we have been watching a number of potential market and economic headwinds and tailwinds. There are plenty of the former to choose from, including the deceleration of growth in global growth, a possible known unknown catalyst causing a European recession in the form of Volkswagen’s transgressions, a European migrant crisis, the perennial U.S. budget battles, the spike in high yields and the list goes on.
While our hackles are raised by the omnipresence of risks, many if not most of these risks are not new. Along with these risks, we apply a balance sheet approach by making a comparable list of prospective tailwinds including a U.S. expansion that continues marked by low unemployment claims, strong global merger and acquisition activity to support the capital markets, near term wins in the battle with deflation in Europe, the prospect of China deploying its sizable seems $3.5T foreign reserves balance they have a lot of room to try and accelerate growth, and finally the signing of the 12-member Trans Pacific Partnership agreement last week could be a defining event, i.e. a catalyst for global growth over the next few years.
As always, we ask ourselves many questions and attempt to assess the effects on the capital markets of the questions themselves and their potential outcomes. The end goal is to evaluate how portfolios are positioned relative to the risks and opportunities across the global markets as well as how they are positioned relative to our clients’ goals, risk tolerance, liquidity needs and other considerations.
Thankfully, for the part of the east coast that was devastated by Hurricane Sandy just three years ago, Joaquin was a bust. Unlike Sandy, however, we were perhaps a bit better prepared this time. In many respects Sandy’s devastation caught us by surprise, and perhaps the meteorologists went overboard with the warnings, just in case. Or perhaps it was for ratings.
Some investors, on the other hand, may have been surprised by the recent volatility storm. The talking heads perhaps made things worse, by constantly trumpeting its effects on the markets, and potential for future damage.
At Threshold, we were not at all surprised by the volatility. In fact, we’ve alluded to it frequently in several blog posts over the preceding months. We’ve also built portfolios that reflect our convictions. What we haven’t done is to overreact. Equity market volatility is a fact of life, much the same way that fall hurricane season is a fact of life. We need to be prepared, but not overreact; to state our predictions, but not sensationalize them.
It is in our clients’ best interests that we prepare for periods of volatility. It is imperative, however, that we look beyond the one-dimensional doom and gloom, or rosy forecasts of the moment in order to determine not only what’s currently driving the markets, but also what underlying factors, seen or unseen, will be the catalysts moving forward.
In conclusion, while the volatility red storm has impacted returns and investor mood year-to-date for most of the major indices, the fourth quarter can tend to be a quarter of renewed optimism and correspondingly positive investment performance. Today, we see a U.S. economy that continues to show signs of strength especially in the service sector (many times larger than the manufacturing base), low interest rates, and consumers starting to show signs of life. Internationally, we see easy monetary policy around the world which has provided life support to European and Japanese stocks (and may continue to do so). If we are fortunate, the headwinds, of which there are many, may only send a mild breeze through markets from time to time.
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 "Guide to the Markets,” JP Morgan Asset Management, As of September 30, 2015
 “Guide to the Markets,” JP Morgan Asset Management, As of September 30, 2015
 “Fourth Quarter Comeback?”, Charles Schwab, October 10, 2015, Advisor Perspectives.
 Dr. Ben Hunt, Salient Partners
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