Given the dramatic market volatility we have seen over the past few months, we thought it wise to provide our take on what is driving the turbulence, especially in light of the short-term surge in the U.S. dollar and the declines in commodity-related investments.
The trend downward since June has been primarily driven by slower expectations for worldwide economic growth and growing skepticism that monetary and fiscal stimulus will be able to address the problem. Adding to the volatility have been key events such as the Japanese earthquake, the U.S. debt ceiling debate, the U.S. debt rating downgrade, fear over inflationary pressures in Asia and ongoing concerns that China will crash after a period of rapid credit expansion. But perhaps the most significant event is the ongoing debt crisis in Europe, which has stoked widespread fears of a European banking crisis that may even threaten the existence of the euro itself.
The market has long concluded that Greece will default. However, larger nations such as Italy and Spain have been an uncertainty. While policymakers suggest one plan, the market grows increasingly impatient. When economic growth slows, the market grows even more concerned. A solvency crisis for large nations in the eurozone would have significant negative implications for the global economy: first, for the banking sector, then spreading to other sectors of the economy as global liquidity tightens. The impacts would be felt worldwide, and the difficulty in seeing past the crisis is reflected by current global stock valuations. Sentiment is extremely low, and cumulative short interest on major U.S. exchanges has recently hit 2009 highs.
Despite the fear, Euro Pacific Capital has not abandoned our long-term, value-oriented approach to global markets. We continue to maintain our exposure to high-quality, dividend-paying companies with solid balance sheets and minimal exposure to Europe, Japan, the United Kingdom and the United States. In our managed accounts, we are currently taking opportunities to add to these positions. We also increased our precious metal exposure early in the year. We have maintained our overweight allocation to non-cyclical sectors such as consumer staples and utilities.
Clearly over the past few months, our global strategy has underperformed the broad U.S. markets. This is largely due to the correction in precious metals, a breakdown in some of our key currencies and a lack of liquidity in some of our key markets such as Norway and Singapore. Moving forward, we look for liquidity pressures to abate and precious metals and currencies to rally, which would be a tailwind for our strategy. We feel the lack of liquidity in some markets was a key differentiator in September, but will have less influence moving forward. Additionally, we think a lot of the selling in our markets has been flushed out and that there’s still some distance on the downside to cover in developed markets.
In our opinion, the recent strength in the U.S. dollar and U.S. Treasury bonds is unwarranted. While many explain the rally as an understandably defensive “flight to quality” in the face of what many believe to be increasingly likely deflation, we find this scenario to be extremely unlikely. From the Federal Reserve’s perspective, deflation is public-enemy No. 1, and it will do anything to prevent such an outcome. As a result, we believe additional stimulus will follow before austerity. Each day that the market ticks down increases the likelihood of Fed action. Even if the Fed were to resist its instincts, we believe that a deflationary scenario could place politically unbearable pressure on public finances.
We think a more likely scenario is a two- to three-year game of “monetary whack-a-mole” where markets trend sideways with increased volatility as policymakers whack away at crises created by a market that is trying to correct the excesses of the past decade. But the long-term implications of our view appear to be clear: Developed deficit nations will continue to stimulate, devaluing their currencies and increasing the value of commodities over the long run. In contrast, we continue to believe that the countries we focus on are in fairly good shape and have more conventional policy tools at their disposal.
Market valuations at their recent lows make little sense. The 10-year Treasury note has dipped to a low of 1.7% and is currently holding at the lowest levels in more than 60 years. This comes at a time when CPI is increasing 3.9% annually. In contrast, equities in some world markets are now trading near seven times earnings with 5% dividend yields. Many equities and market sectors are now approaching 2008 lows, even though corporate balance sheets are much stronger than they were at that time.
These conditions suggest that markets will correct to reflect these underlying realities over the long run. While we can’t predict what might happen over the short term, it makes sense for investors to maintain some exposure to equities and foreign currencies in order to stay diversified.