Global Asset Allocation Perspective
Greece, China, and Interest Rates: Three Heads of the Volatility Hydra
Third Quarter 2015
Senior Vice President and Senior Portfolio Manager
Asset Allocation Strategies
There are three major clouds on the financial horizon: Greece, China, and U.S. monetary policy. Of the three, the ramifications of higher U.S. interest rates and further weakness in the Chinese financial system are potentially more detrimental to investment portfolios than the exit of Greece from the European Union. We believe that the best way to address these risks is in the context of a carefully constructed saving and investing plan developed in conjunction with a financial professional.
Financial markets face significant potential volatility in the form of questions about Greece’s ability to remain in the European common currency, economic and financial market difficulties in China, and the likely reversal of years of extraordinarily easy monetary policy by the Federal Reserve (Fed). While we face uncertainty on many fronts, we encourage investors to focus on what they do know— their saving and investing goals, and the balanced financial plan necessary to achieve those financial targets.
- We view the latest Greek debt deal as just another “kick the can down the road” step. A possible Greek exit from the euro is not out of the question. However, markets appear to have priced in the possibility of “Grexit,” as the response to each successive crisis is more muted. And because so much of the outstanding Greek debt is held by the European Central Bank (ECB) itself, there is little likelihood of contagion from a default.
- Arguably, the biggest risk at present is China, where there are real questions about economic growth and health of financial markets. Poor growth in China also has important implications for commodity prices, which are suffering from slumping demand. It is difficult to see a rapid recovery, despite extensive government efforts to stimulate growth and support asset prices.
- In the U.S., marginal improvements in economic growth, employment, housing, and consumer metrics leave the Fed on the brink of raising interest rates. But as we have been writing for some time now, higher rates in the U.S. argue for greater volatility in financial markets, which has already manifested itself in both stock and bond markets.
- In our asset allocation portfolios, we are beginning to reduce our long-running overweight to stocks and REITs relative to bonds and cash. Within our equity allocation, we prefer Europe and Japan over the U.S. at the margin. In our fixed-income allocation, we continue to underweight U.S. Treasury and government agency bonds in favor of higher-yielding corporate- and mortgage-backed securities, and hold select European investment-grade corporate bonds.
- You can view a more in-depth discussion about opportunities our investment teams see at present in global financial markets in the Fixed Income Macro Outlook and Global Equity Outlook on our website.
Fragility, Robustness, and Efficiency
Author Nassim Nicholas Taleb wrote of financial markets: “Fragility is the quality of things that are vulnerable to volatility.” He also famously said that you should never take advice from anyone wearing a tie. So you should probably read the following with the appropriate degree of skepticism.
Fragility and robustness are terms that we should define briefly before using here. Having the characteristic of robustness means that an entity or system is well adapted to withstand internal or external shocks. An organism or system that can be undone by a single shock or event could be said to be fragile. Often, though, the reality is far more complex—a system can be optimized for a specific kind of challenge, but remain vulnerable to unanticipated shocks. In addition, there are often tradeoffs involved in achieving any degree of robustness.
It should be obvious the application of these concepts to investing. If fragility is the quality of things that are vulnerable to volatility, then our goal is to build robust portfolios capable of withstanding unanticipated shocks, expressed as market volatility. But we must be mindful of the tradeoffs involved—it is possible to reduce risk, but often at the expense of return potential. Rather, a robust portfolio is an efficient portfolio—one that maximizes return for the risk taken, or minimizes risk for a given level of expected return. It is our belief that portfolios diversified by asset class, geographic region, currency, and other factor are best able to meet the definition of efficiency and robustness over the long term. That is, they are likely to be better able than less diversified portfolios to withstand shocks to the financial system. At present, there are three issues that threaten to cause an increase in volatility—Greece, China, and changing Fed monetary policy.
It’s also worth remembering that even in the face of mounting risks, an investor’s financial goals remain. Funding retirement or a child’s education, for example, are long-term goals that expose investors to the vagaries of financial markets over many years. Consider that just since 2000, we have experienced the bursting of the Internet stock and housing bubbles, wars in Afghanistan and Iraq, September 11, the 2008 Financial Crisis and Great Recession, government shutdowns and budget crises, and the rolling European credit crisis, among other challenges. Volatility looks more the norm than the exception in financial markets over time. As a result, we feel strongly that investor portfolios should account for this reality. The best way we know to do this is to adopt a balanced approach using a broadly diversified portfolio consistent with your financial goals, risk tolerances, and time horizon, among other considerations.
“Greece” Is the Word
First, some context—the Greek economy accounts for less than 2% of eurozone gross domestic product (GDP) and only about 0.3% of global GDP. Because Greece is such a small fraction of the European economy, the issue is not so much about problems with Greece directly, but with any contagion or collateral effects for economies, risk assets, and currencies that might result from a Greek debt default and exit from the European common currency. However, the risk of contagion is mitigated by the fact that Greek debt is not widely held among private investors. Instead, Greek bonds are concentrated in the hands of a number of multinational agencies, and the ECB has said publicly that it will act swiftly to counter any potential contagion.
Moreover, the latest debt deal takes a Greek exit from the euro off the front pages and puts it on the backburner. This is important because European growth has actually been better than expected, so removing uncertainty around Greece and the common currency should help economic conditions. Indeed, we are seeing a great many statistics on consumers and businesses show clear improvement across Europe. In addition, there is massive ongoing stimulus, so we believe near term economic prospects remain decent for the eurozone.
Finally, we are encouraged to see the ECB playing a much more active, stronger role in regulatory terms. Generally speaking, banks across the eurozone are much stronger than in the past, while many smaller, weaker financial players have simply gone away. Evidence for the efficacy of these measures can be seen in how muted the market response to the latest round of debt negotiations has been—the euro remained in the same tight trading range it has occupied for some time, even as a potential Greek exit loomed.
China in Focus
We believe the biggest underlying risk to markets at present is poor growth in China, where the central bank is trying step after step to support the economy and having little success. To put the problem in perspective, China accounts for more 16% of global GDP, and is more than 50 times the size of the Greek economy, for example. When China sneezes, global commodity markets catch cold—it is the slump in China’s economy that is wreaking havoc with commodity prices. What’s more, now the Chinese stock market is falling sharply. In response, the government has taken a series of steps to support the market, ranging from regulatory changes to direct investment, but all to little avail.
Instead, the economy continues to struggle with significant challenges with respect to overinvestment and a massive buildup in inventories. China’s GDP growth has so far managed to stay around the 7% level—thought to be an important threshold for China’s ongoing industrialization and development—but evidence at the company level continues to suggest that challenges are deepening. Earnings reports from industrial firms to fast-food operators, and from makers of infant formula to luxury goods, all continue to point toward softer growth. These struggles are taking a toll on consumers, with measures of consumer confidence approaching all-time lows. These confidence readings also do not fully reflect the recent decline in stock prices, so we would expect confidence to dip even further. Indeed, the first signs of trouble go back a year or more to the sharp slowdown in Chinese visits to the gambling island of Macau. That was the proverbial canary in the coal mine on the Chinese consumer.
So while we believe the Chinese government will continue to take aggressive steps to support the economy and financial markets there, we see little likelihood of a reacceleration of growth until China unwinds its excesses and consumers begin to feel on solid footing once again.
Rates Are the Thing
We close with a brief discussion of U.S. interest rates. We have covered this topic extensively in past editions of the Global Asset Allocation Perspective, as well as in recent CIO Insights and other publications available from American Century Investments. Here let us simply reiterate that we see an increasing likelihood that the Fed will raise short-term interest rates before 2015 is out, reflecting the evident improvement in employment, wages, consumer confidence, and financial markets in recent years. Higher rates also connote higher volatility—members of the Federal Reserve Board are on record as saying that they welcome a return of volatility to financial markets and do not target a given level of asset prices. This is a clear signal that investors should not expect the Fed to ride to their rescue if markets sell off while underlying economic conditions continue to improve.
On the other hand, the dollar is gaining momentum again, commodity prices are held down by trouble in China, inflation is essentially flat, and enough uncertainty remains in the global economic and financial system that longer-term U.S. bond yields are unlikely to rise significantly. Will these challenges be sufficient to stay the Federal Reserve’s hand on rates? We think not, but it should be clear that the path ahead is not one of uniformly higher rates and smooth economic sailing. Rather, uncertainty and volatility are likely to remain concerns going forward, even if the economy continues to strengthen. In that sort of environment, we argue for a more robust portfolio, an efficient portfolio built on the proven principles of diversification, and disciplined investing over time.
Our latest detailed economic analysis and fixed-income outlook is available on our websites in the form of the Fixed Income Macro Outlook.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.
For detailed descriptions of indices or investing terms referenced above, refer to our glossary.
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