Sailing Through the Storm

"I'm not afraid of storms,
for I'm learning how to sail my ship."
- Louisa May Alcott

Executive Summary

  • Recent volatility in equity markets is being caused by global equity markets adjusting expectations for lower economic growth and an increased risk of recession, primarily due to disappointing growth in the US and the ongoing European debt crisis.
  • The macro economy remains resilient. While we don't expect a return to recession, economic growth will likely continue to ebb and flow as economies work off the overhangs from the housing bubble.
  • Increased volatility is normal during an economic recovery as equity markets attempt to anticipate future growth and respond to often conflicting information. Equity investors should expect substantial volatility for the foreseeable future, but not at the level exhibited in recent weeks.
  • While as investors we cannot control volatility, we can control our reaction to it. When the urge to do something strikes, long-range planning puts the current investment environment into the appropriate long-term perspective.

Just when you thought it was getting safe to go back in the water, another storm has engulfed the global financial markets. As with all financial crises, this one is marked with grim milestones: US sovereign debt downgraded for the first time in history; our elected officials flirt with a catastrophic default; and Europe's largest economies appear increasingly shaky, causing concern that the Euro-zone might split apart.

When has it ever been so bad? Pretty recently, as it turns out. One doesn't have to look back very far to see headlines like today's. The blue box below compares headlines from mid-2010 with those we've seen recently.

Last Year's Headlines

"Europe Crisis Deepens as Chaos Grips Greece" Sebastian Moffett and Alkman Granitsas. Wall Street Journal, May 6, 2010

"Fearful Investors Are Pulling Out" Adam Shell. USA Today, May 20, 2010

"Housing Prices Remain Weak" Sara Murray. Wall Street Journal, May 26, 2010

"Fear Returns—How to Avoid a Double-Dip Recession" Cover story. Economist, May 29, 2010

"Spill Tops Valdez Disaster—Deep Trouble: There Was 'Nobody in Charge'" J. Weisman, G. Chazan and S. Power. Wall Street Journal, May 28, 2010

"Discouraging Job Growth Batters Stocks" Don Lee. Los Angeles Times, June 5, 2010

"Economic Outlook Darkens" Jonathan Cheng and Justin Lahart. Wall Street Journal, June 2, 2010

"Bond Fund Managers See Signs of a Bubble" Sam Mamudi. Wall Street Journal, June 8, 2010

"Rapid Declines Rattle Even Optimists" E.S. Browning. Wall Street Journal, June 14, 2010

This Year's Headlines

"Greek Woes Fuel Fresh Fears" Marcus Walker and Hannah Benjamin. Wall Street Journal, May 10, 2011

"Fear Wins: Stocks Resume Long Slide" Adam Shell. USA Today, June 16, 2011

"Home Market Takes a Tumble" Nick Timiraos and Dawn Wotapka. Wall Street Journal, May 9, 2011

"The World Economy—Sticky Patch or Meltdown?" Cover story. Economist, June 18, 2011

"Japanese Nuclear Crisis Is Ranked at the Level of Chernobyl" Mitsuru Obe. Wall Street Journal, April 12, 2011

"Jobs Data Stoke US Recovery Fears" Robin Harding, S. Bond and M. Mackenzie. Financial Times, June 4, 2011

"Stocks Plunge Amid Fears That Global Economy is Slowing" Christina Hauser. New York Times, June 11, 2011

"Why Are Investors Still Lining Up for Bonds?" Jeff Sommer. New York Times, May 29, 2011

"Investors Shaken by the Fear Factor" James Mackintosh. Financial Times, June 18, 2011

Headlines assembled by Wellington, Weston of Dimensional Fund Advisors. "The Best of Times, the Worst of Times", Down to the Wire, June 23, 2011.

Despite the scary headlines in mid-2010, global equity markets surged in the following year, several indices by more than 30%. Economic headlines are a poor indicator of future stock performance. Experienced investors cannot help but be appropriately humble about their ability to predict future events and how markets will respond to them.

Where is the economy headed?

The downgrade by Standard & Poor's of US long-term debt was widely expected and, while contributing to some fear-based selling, doesn't seem to have had any direct near-term impact on interest rates or the economy, for now. A "systemic risk event," such as the collapse of Lehman Brothers in 2008, appears unlikely, as do materially higher interest rates on Treasuries for now. (That could change if US policy-makers fail to adequately address long-term structural deficits, possibly resulting in further downgrades.)

For now, the market's main concerns seem to be the slow-motion debt crisis unfolding in Europe and slowing economic growth, particularly in the developed market economies.

US economic growth has slowed considerably from the pace of late 2010, and equity markets responded negatively in recent weeks as data showed that growth had slowed even more dramatically than expected. The concern, of course, is that the economy might be falling back into recession. In a "typical" recession, policymakers would apply a range of fiscal (increased government spending) and monetary (reduced interest rates) tools to boost growth. However, fiscal stimulus is politically unfeasible and the Federal Reserve has few monetary options remaining, boosting the risk of recession.

Still, there are reasons to be hopeful. The Federal Reserve has announced it will maintain the current, very easy monetary policy for at least the next two years. Corporations are very profitable and flush with cash, and the financial sector is in much better shape than in 2008. Productivity growth is slowing, possibly a sign that companies have squeezed as much out of their current employees as possible and will need to hire again soon. Slowing growth has also led to a recent decline in commodity prices, contributing to a reduction in the price of gas and putting more money into consumers' pockets. All of these factors support growth.

In our view, the debt situation in Europe is a more serious concern. There is the potential for contagion to the major European economies and banks. While European leaders haven't inspired confidence thus far by embracing a holistic solution to the crisis, the European Central Bank recently began outright purchases of Italian and Spanish government bonds, which halted the negative spiral. Negotiations within the Eurozone leadership continue.

Overall, we believe that the global economy remains resilient, and that the recovery will continue to unfold. However, the recovery is likely to continue to ebb and flow for some time to come as the economy works through some considerable headwinds, primarily the debt, housing and employment issues left in the wake of the burst housing bubble and subsequent recession

Longer term, deleveraging among consumers and fiscal restraint in Western economies will likely weigh on growth, but over time should result in more sustainable levels of debt that support healthy economic growth.

Amid this backdrop, Aspiriant has updated our long-range capital market expectations, which guide our investment portfolio recommendations and long-range financial planning models. In two articles, Aspiriant's Chief Investment Officer, Dr. Jason Thomas, summarizes our 20-year global economic outlook and delves into one of the key growth-drivers going forward—developing markets.

What might lie ahead for equity markets?

While the current economic challenges are serious, we don't see the current environment as being fundamentally that different from the dynamic that we saw last summer. Then, after 14 months of nearly unabated growth in equity values, equities plunged 17% as the market realized that the hoped-for "V-shaped" recovery would not occur. This current period of adjustment is an entirely normal dynamic for financial markets emerging from recession.

Markets much prefer clarity and show their distaste for conflicting information with an increase in volatility. Consistent with our view of an uneven recovery, we expect equity market volatility will continue, though not at the current level as the path becomes clearer and the market finds a new equilibrium. It's important to remember that even when the markets begin marching upward again in anticipation of further recovery, that upward march will be punctuated by occasional periods of severe stress such as we've seen in recent weeks.

Being a successful long-term investor requires perseverance, restraint and optimism. The market severely tests all three qualities from time-to-time. We also find that context is critical to making wise investment decisions. Most clients, when faced with the occasional steep losses that the markets deliver, find solace in revisiting their long-range plans. Going through this exercise satisfies the craving to do something, highlights those decisions you can control, and puts investment choices into long-term perspective. And, happily, the exercise usually reassures clients that, despite passing investment losses, they can chart a very acceptable course forward. Your Aspiriant team is eager to give you this clarity and help you navigate these stormy seas.

Greg Schick, CFP®
Director - Wealth Management, Principal

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