After being unusually calm so far this year, the markets have been roiled over the last few days, driven largely by news from China. The question on everybody's mind: What does this mean for my investments, and what impact does it have on my strategy? Whether the volatility seen in the equity market is an over-reaction or not, it certainly has the potential to negatively impact consumer confidence.
Look for Opportunities in Putting Capital to Work
In really volatile environments like the one we're experiencing, liquidity can be challenging. The flip side of the low liquidity is that, if you have a target position in mind and there are sellers of that position, then often times you may be able to purchase fixed income assets at levels that a week or two ago would not have been possible.
I recently wrote about keeping "dry powder" for potential opportunities. I think this is definitely one of those times where you can find selective opportunities. As an investor, particularly in bonds, you're dependent on other investors needing to sell positions -- there have to be sellers before there can be buyers. It pays to be nimble in an environment like this, especially today when broker/dealers have limited capacity to position bonds on their balance sheets.
The Impact of China on the Fed Rate Increase
The big debate in the markets has been the potential for a Fed rate increase. I have been calling for a Fed rate move in September. The Fed has been on a mission to telegraph their activity, to be more transparent with regards to how they will be shifting interest rates. The events of the past few weeks present a real challenge for the Fed, as it seems that the deflationary pressures emanating from China promise to outweigh any positive momentum that may be coming from the U.S. economy. The U.S. dollar is the world's reserve currency and, even though I think the Fed's primary focus has to be the U.S. economy, when there are so many weak spots popping up across the globe, it really becomes difficult to begin a tightening process in the midst of a decline in global growth.
Like it or not, the U.S. economy is linked to the Chinese economy. Over the past few years, China has accounted for more than 1/3 of the world's economic growth. China's devaluation of their currency is going to have an impact on inflationary prospects in the United States. My sense is that deflation is the Fed's biggest fear. China's economic struggles have already had a large impact on commodity prices. There's been a lot of investment in the United States over the past few years in the commodity space, all premised on higher commodity prices. For example, if you look at the amount of capital expenditure occurring in the energy space today, it's a fraction of what people were anticipating a year ago. That is a direct impact of events in China on what happens here in the United States.
One of the more interesting things occurring here is China's recent decision to move towards a freely floating currency. For years, the Chinese currency was in a position where it was likely to appreciate against other currencies, but the Chinese government managed their currency on exchange rates throughout that timeframe to keep it low. To me, it's interesting that they're shifting towards more of a free-floating type of currency exchange rate policy, but doing so at the exact time when their currency has weakened relative to the U.S. dollar. There's been a lot made of this policy shift by the Chinese, but certainly this is an example of a country's government, doing what's best for its domestic economy, likely taking growth away from other parts of the world. It's the same challenge the Fed faces.
Top Takeaways
Here are the top three issues that bear watching:
First, expect more market volatility. I sense more fragility in the financial systems as a result of what's been happening, more so around the globe. The impact on commodity-producing countries, especially in the emerging world, is going to surface more negative stories that are in turn going to drive volatility.
Second, there will be more bumps from China. Whenever you're dealing with a government that is trying to manage its way through a crisis as the Chinese government is today, the government is apt to make some mistakes. Eventually, the free markets are going to come to grips with what is happening in China, but understand that, as the government tries to manage things, it just seems like its ability to manage will be diminished as it finds it has fewer levers at its disposal.
Third, the U.S. consumer is going to benefit greatly from the decline in oil prices, which is a good thing for consumer confidence. However, given the volatility in the oil markets and the steepness of decline, I'm worried about potential bankruptcies for some of the more highly levered companies in the energy space. There could be some serious short-term destruction to the economy, which would outweigh some of the longer term benefits of lower oil prices. If the price of oil gets down into the 30s for a sustained period, that may have a significant impact on some of the marginal companies in the energy space.
So, while there is no need to panic, we should be prepared for a volatile ride. More importantly, I believe now is an opportune time to buy quality securities that may have been unfairly punished during the most recent downturn, especially if they align with your long-term investment thesis.
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