We noted in a recent Weekly Economic Update that we expected market volatility to increase. It has certainly done so. Some of the primary factors we believe are behind the increased volatility are growing uncertainty about US monetary policy, somewhat dimmer economic prospects for Europe and China, and the possible spread of the Ebola virus internationally. We believe these events are serving as catalysts for a market correction. However, US economic data remains positive, which contributes to our belief that the market correction will not morph into a bear market.
While the Federal Reserve is expected to end its Quantitative Easing (QE) program later this month, there is considerable disagreement about the future path of interest rates, even within the Fed itself. Forecasts for the first interest rate hike range from early 2015 to 2017. Uncertainty is something that markets generally do not like. As uncertainty rises, market volatility also tends to increase. When the QE program was ongoing and there were no expectations that it would end any time soon, there were expectations that interest rates would remain low. These expectations have been replaced by concerns about when and how fast interest rates will rise.
The economic outlook for both Europe and China has recently turned negative. Based on gross domestic product (GDP), the European Union and China are the world’s largest and third largest economies respectively. Their weakening prospects are also impacting the emerging world. Countries that supply commodities and/or goods and services to the EU and/or China will most likely experience economic slowdowns as well. In contrast, economic trends in the US, while modest, appear to support the case for growth. However, this divergence has caused the US dollar to appreciate materially over the last few months. A stronger dollar weighs on commodity prices and by extension foreign investments.
This year the headlines have been dominated by geopolitical uncertainty in Ukraine and the Middle East. A new threat that is not so much political but rather viral has emerged. We cannot say with any degree of confidence what Ebola’s long-term impact will be. It does, however, give us pause. Hopefully, it will end in a very similar way to the way concerns related to the SARS virus did back in 2002 and 2003. While the long-term impact of SARS from an economic point of view was negligible, it did create fear and angst in the financial markets for a period of time. We will monitor this situation closely, as it develops.
It is impossible to forecast the next stock market correction or even bear market with any accuracy. Similarly, as we saw in 2008-2009, the market can fall much more than anyone expects. However, the market’s precipitous decline from that period was the result of a credit crisis that we had not seen since the Great Depression. We do not feel that current economic conditions are similar in this respect (i.e., a lack of extreme levels of debt for consumers, firms and financial institutions).
Despite this uncertainty, we remain constructive about long-term prospects for the markets. Over the long haul, we expect the global economy to grow rather than contract. Global economic growth should translate into positive stock market returns. Any market dislocations along the way should present the opportunity to acquire well-managed businesses at even more attractive prices. We can assure you that we are paying close attention to market-related developments and will react accordingly. We encourage you to contact your advisor if you have concerns.