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 AUGUST 2015 INVESTMENT JOURNAL:  CURRENCY CONFUSION
  • IMF nixes further loans to Greece
  • China devalues its currency
  • Stock markets swoon globally
     
There is no way around the fact that August was an ugly month for equities. Looking at the chart below, US stocks lost 6%, while international markets were even weaker with developed markets down 7.4% and emerging markets losing 8.9% for the month. This was the worst one month performance for US stocks since May of 2012. Gold was the strongest performer during August, even as other commodities were flat to down for the month. US bonds were also flat during August, and have shown little return this year as market participants await the Federal Reserve's decision on whether or not to begin raising short term interest rates.    
     
 
    
Last month's sell off in emerging markets stocks brought them back to a negative return over the last 5 years, joining commodities and gold. The idea of diversifying into countries with higher growth rates and younger populations hasn't been rewarded in recent years, as older, more indebted economies have shown stronger stock performance. Mean reversion is a powerful force in investing, however, and these long periods of underperformance will eventually end and overtake the former leaders:
       
      
August was a tumultuous month for investors. Driven mostly by overseas developments (especially in China), sellers came out and overwhelmed buyers, leading to larger than normal declines in many markets. Volatility picked up, but, when viewed over a longer term time period, is well within normal ranges:
        
  
     Source: Charles Schwab & Co.
    
August began with a decision by the IMF not to extend any more loans to Greece, effectively pushing the problem squarely onto the lap of Germany. Chancellor Merkel has pledged to do "whatever it takes" to hold the Eurozone together. This new schism in the Troika will likely prove to be the "put up or shut up" moment for each of the major Eurozone players, and we suspect voters in all of the upcoming federal elections are going to reject further propping up of an unworkable fiscal union. The countdown to the end of the Euro has begun.
       
In mid-August, China unexpectedly devalued their currency, sending markets into a tizzy. Commodities were especially hard hit. Data showed Chinese exports dropping 8.3 percent in July from the same period last year - far more than the 1.5 percent that had been expected. While hoping to revive a flagging export sector, many investors focused instead on its current wilting state, and extrapolated that to envision further slowdowns across the globe. It was truly a case of seeing the glass half empty but, nonetheless, that sentiment is now the prevailing view among many investors.
  
The bigger take-away from the devaluation is that China has now joined the currency wars, and is willing to risk a political clash with Washington, Berlin, London etc. Their devaluation comes less than a month after the IMF rejected the idea that the renminbi was ready to join a basket of other major international currencies to form a new global reserve currency called Special Drawing Rights, or SDR's. It should not be surprising then that China, after being told they were not ready for prime time, took bold action (the devaluation was the largest since 1993).
  
Their sizeable and ongoing domestic stock market decline was not helping matters either, sending out a string of bad headlines that made conditions ripe for a "panic moment", which culminated in a "flash crash" in the U.S. on August 24. The price action was chaotic, especially at the open, with many securities halted from trading.
  
Normal market functioning resumed quickly, however and, by the end of the day, it was clear that a lot of panicked sellers had let their emotions get the better of them. They paid a steep price by turning temporary, steep losses into permanent losses. Overall for the month of August, investors sold stocks in droves, resulting in one the largest monthly outflows from equities since 2007:
            
  
     Source: BofAML Global Investment Strategy                
                                 
While the good news is that this type of panic selling is rarely repeated, the bad news is that much technical damage has been done, i.e., price trends have been weakened significantly. So, while markets recovered somewhat to end August off the lows, U.S. stocks have now entered "correction" mode, meaning they are off their highs by 10% or more.
    
Corrections can be healthy developments, though, as they clear out the weak hands and help to build a base from which new highs can reached.  That does not mean that we are "out of the woods" yet, or that new lows in stocks cannot occur. However, stocks must regain their footing first for the bull market to resume. That will take some time. We expect a more volatile period ahead as investors decide whether to put on their bull or bear hat.
    
The U.S. bond market, meanwhile, has caught a bid, as it remains the destination of choice for scared capital ("flight to safety"). Market pundits are busy opining on whether recent stock market wobbles will keep the Fed from raising rates later this month. If short term interest rates are raised, the US Dollar, already in a strong uptrend, will get an added boost as higher cash yields come into play. Another complicating factor is that China has been selling enormous quantities of US Treasuries to fund their domestic imbalances, so the question also arises of "who will pick up the slack" if the flight to quality bid disappears.
            
In short, investors are being tested. August was a reminder that markets can react quite quickly when participants are all heading in the same direction (selling). We're expecting more volatility in the coming weeks and months, but eventually the selling pressure will subside, and markets will consolidate as they always do, emerging on the other side in a more healthy state. Now is a time to be very properly British: keep calm and carry on!
    
 
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