Market Volatility Intensifies Amid Negative Rates in Some Countries | American Funds

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Investment Insights

February 2016

Market Volatility Intensifies Amid Bank Stocks Selloff and Negative Rates in Some Countries

  • Volatility likely to persist amid global slowdown and uncertainty about central bank policies
  • Risk of a recession in the U.S. has increased due to a tightening of financial conditions
  • Fed likely to eschew any further rate increases in 2016
  • Negative interest rates and deflation pose a real threat in Japan and Europe
  • 2008 repeat still an unlikely scenario
  • Holding a broadly diversified portfolio with exposure to multiple asset classes is still likely the best approach

China’s slowing economy and falling oil prices topped the list of investor worries heading into 2016 but, in recent weeks, concern has rapidly spread to other areas of the market. The growing list now includes negative interest rates in Europe and Japan, a global selloff in bank stocks, further devaluation of emerging markets currencies and the fear that all of this turmoil may derail the U.S. economic recovery.

“The big question is whether the U.S. economy gets overwhelmed by problems overseas; we’ll have to wait and see,” said Jim Lovelace, a portfolio manager who has seen many market selloffs in his 33 years with Capital Group. “At the very least, I expect the environment for U.S. corporate profits to be challenging in 2016.”

Indeed, for companies in Standard & Poor’s 500 Composite Index, earnings have declined three quarters in a row, partly due to weakness in non-U.S. markets. These companies get about 40% of their revenue from outside the United States.

U.S. Economy Trudging Ahead

Nevertheless, Lovelace said he does not expect the U.S. to fall into recession this year, nor does he see a repeat of the 2008 financial crisis any time in the near future. “While there is no doubt that we are experiencing weakness overseas, it is my view that the U.S. economy will muddle through.”

Bond manager Wesley Phoa says, “The risk of a recession in the U.S. has risen substantially in recent weeks as a result of tightening financial conditions.”

A relief rally on Friday and Tuesday offered some solace for battered investors. Oil prices moved higher on word that the world’s largest oil exporters, particularly in the Middle East, may consider reducing production. The news also sent U.S. stocks higher overall, but they remained in negative territory for the full week and for the year-to-date period. Oil prices are down about 70% since the summer of 2014.

“Oil prices fell primarily because we had a supply surge,” explained Mike Kerr, a portfolio manager who has spent most of his 30 years at Capital Group following the energy industry. “So it’s a very good sign if some of the biggest oil-exporting countries are seriously talking about production cuts. If you’re an oil investor, you are really hoping the Saudis call a meeting and make an agreement. Most likely, that is how the cycle will turn.” Stability in oil prices could help calm investor nerves.

Market Declines Accelerate

Meanwhile, central banks are using all the tools in their arsenal to prevent a sharp global economic slowdown, but whether they will succeed is wide open. Investor worries have deepened as to whether the slowdown and the sharp slide in asset prices creates a negative feedback loop.

A mere six weeks into 2016, market volatility has surged across the board — from stocks and bonds to currencies and commodities. The MSCI World Index and the S&P 500 are both down about 9%. Energy and materials stocks — the hardest hit sectors last year — continue to struggle. But it’s the financial sector that has suffered the biggest declines so far this year. Financial stocks have tumbled 14% amid worries about slowing global economic growth, bad loans in the energy sector and negative interest rates in some countries. Persistently low or negative rates make it difficult for banks to profit from lending activities.

On January 29, the Bank of Japan surprised markets by moving into negative territory on a key interest rate. Japan joined Denmark, Sweden, Switzerland and the European Central Bank in this unorthodox shift to negative-rate policy, which, in theory, is supposed to encourage lending and boost economic growth.

Danger of Negative Rates

“Central banks across the globe seem to be more open to the possibility of moving interest rates deeper into negative territory,” said Jens Søndergaard, Capital’s economist specializing in Europe. “The economies of Denmark, Sweden and Switzerland have, in many ways, been helped by negative rates, even though it’s creating a headwind for the banks. However, adopting significantly negative rates could have many unintended consequences, from triggering cash hoarding among individuals to undermining the traditional business model for banks. Neither outcome would be good for long-term growth prospects.”

On the other hand, U.S. and European banks are better positioned now to deal with turbulent economic times than they were prior to the financial crisis. Bank reserves are significantly higher, due primarily to strict new regulatory requirements. Leverage in the banking system also is drastically lower. “We’ve paid for it in terms of economic growth and flexibility,” said Phoa, “but systemic risk in the financial system has gone down a lot from pre-crisis levels.”

“One and Done” at the Fed?

The recent global market turmoil calls into question the Fed’s plan to continue raising short-term interest rates this year. In December, the Fed signaled four potential rate increases in 2016, depending on the tenor of economic data. However, market participants are growing increasingly skeptical of that plan. The Fed’s December rate hike could be its last for a while.

“Given the moves in risk markets so far this year, it looks more and more likely that the Fed is going to be one and done,” said Ritchie Tuazon, a fixed-income portfolio manager. “The bond market is already pricing in no rate hike for March, and I agree with that view. Financial conditions have tightened considerably since the Fed last hiked in December. While the U.S. labor market continues to look strong with a 4.9% unemployment rate, the tightening of financial conditions will likely make the Fed more cautious.”

“There is a big disconnect right now between the market and the Fed,” Tuazon added. “Financial conditions have tightened enough that I think it will actually impact U.S. economic growth towards the latter half of 2016 and, in turn, the Fed may not end up hiking rates again this year.”

Where Do We Go From Here?

With such a difficult start to the year, many investors are asking: How long will the selloff continue? And what should be done in the meantime?

“The truth is, no one can predict with any degree of certainty what will happen to the market over the next week, month or even year. Short-term swings are driven by investor emotions and often get exaggerated in both directions before rational thinking wins out,” said portfolio manager Will Robbins. “Day-to-day market moves are something no investor can control. It’s important not to let such ‘noise’ steer you off course from a well-reasoned and disciplined investment plan.”

One step investors can take now is to review their asset allocation decisions and make sure they have a broadly diversified investment portfolio — with an appropriate mix of fixed-income securities, in addition to stocks. “This approach has, once again, proven its value,” Robbins said. “Although many pundits recommended lowering or eliminating exposure to bonds last year given potential rate increases by the Fed, high-grade bonds have done well in 2016, providing a degree of shelter from the storm.”

“It is unnerving to see the stock market decline as vigorously as it has since year-end,” Robbins added. “But I always remind myself, and our clients, that a long-term perspective is an investor’s best friend.”

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Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and not to be comprehensive or to provide advice. 

Terms and Definitions
A market capitalization-weighted index based on the results of approximately 500 widely held common stocks.
MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure results of more than 20 developed equity markets. Results reflect dividends net of withholding taxes.