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August 8, 2011

Market volatility reflecting a crisis of confidence among investors

We have witnessed dramatic global stock market volatility recently, following a string of weaker than expected economic reports and what President Obama termed "dysfunctional" behaviour by U.S. politicians related to the U.S. debt ceiling vote. The market drop reflects heightened investor uncertainty about global economic growth prospects, and concern about the ability of policy-makers to take appropriate action to reduce the uncertainty in the world's economies. We see this more as a soft patch, however, than a meltdown.

This is not a repeat of the 2008 financial crisis

While market volatility can be worrying, it is important to remember that we are not in the midst of a financial system crisis, an economic crisis or a debt ceiling crisis; it is a crisis of confidence. Our fragile global economy is still reliant on prudent policy-makers making the right decisions. When this is not the case, stock markets will respond quickly and show a lack of confidence. In 2008, by contrast, stock markets responded when the world's financial-system was immobilized as a result of the failure of Lehman Brothers and subsequent liquidity problems.

We are following several indicators that show we are experiencing a crisis of confidence, including the following:

Standard & Poor's downgrades U.S. long-term rating

After the markets closed on Friday, August 5, 2011, the rating agency Standard and Poor's announced that it had downgraded the long-term rating on U.S. sovereign credit from AAA (highest rating) to AA+ (one step lower, but still "investment grade"). The other two major ratings agencies, Moody's and Fitch, did not downgrade U.S. debt. It is possible that equity markets have already built this into prices, however, we will continue to monitor the markets. The Wall Street Journal noted in a weekend article: "Experience also shows that a downgrade doesn't have to be catastrophic for government debt. When S&P downgraded Japan early last decade, yields on Japanese government bonds had a muted reaction and 10-year government bonds remain around 1% today."

Our belief that growth in the global economy is highly dependent on policy-makers taking appropriate action was echoed by Standard and Poor's in their announcement: "The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed." This emphasizes that the current investment market situation is a crisis of confidence.

Still seeing positive signs

Today, despite the economic uncertainty, many companies in Canada and around the world continue to deliver strong growth in earnings. Economic indicators may be weak, but they are not in recession territory. The banking system is relatively healthy and bond investors still consider United States Treasury Bills to be a safe haven.

Downside protection built into our portfolios

In times like this, well-diversified portfolios tend to perform well. We have constructed our MD funds with a downside protection bias, enabling them to respond to market downturns more effectively. We have also consulted directly with our investment managers, who tell us they remain true to their investment philosophy and believe in staying the course. They continue to focus on the characteristics that drive returns over the long term, and even anticipate taking opportunities to selectively rotate into investments that offer long-term value. This approach, combined with our diversified portfolio approach to investing, provides a strong strategy during turbulent market conditions.