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Rude Awakening for Investors

Michael Staines

Commenting on how conditions are in place to support the US consumer, but there are still concerns over the impact of external disinflationary forces in the Eurozone and Japan on US growth, Michael Stanes, Investment Director at Heartwood Investment Management said:

“Violent intra-day swings in financial markets have given investors a rude-awakening. Looking beyond the market noise, it is important to focus on the fundamentals before reacting. We are in a period of waiting – waiting for financial market volatility to settle, waiting for corporate earnings season to report, waiting for the oil price to find its floor and, at the margin, waiting for some positive headline news on Ebola.

“Developed markets have been gradually rising for some time, with volatility falling to unusually low levels. Very low volatility tends to spike suddenly and, in this case, several factors conspired to magnify the move.

“However, compared with previous market dislocations the current risk-off environment is not based on overt systemic risk. Funding costs are lower for governments, banks are in a stronger position, companies are less leveraged and the US economy is making gradual improvements, despite the latest data disappointments. The implied volatility level of the S&P500 is back to mid-2012 levels, still below the level at the height of the euro sovereign debt crisis in 2011.

“Importantly, we believe that the conditions are in place to support the US consumer – low interest rates on mortgages, significantly lower energy prices and the wealth effects of higher stock prices and a recovering housing market. So while there are persistent worries about deflation globally, there are good reasons to believe that longer-term US inflation expectations will move higher.

“The prevailing worry is the impact of external disinflationary forces in the Eurozone and Japan on US growth. It is worth noting that the US economy relies less on exports as a contributor to GDP growth than other major developed economies. Exports contribute 13.5% to GDP, while personal consumption expenditures are a much larger contributor at nearly 70% according to US Bureau of Economic Analysis. In addition, a weaker euro should start to help European exporters, while we expect the ECB to implement further stimulus measures to support growth.

“The bigger question is whether US growth will be sufficient to offset renewed concerns about European financing risks, which damages confidence more generally. Financial conditions are tightening in periphery-euro sovereign debt markets, which potentially impact debt sustainability for the most vulnerable countries. Euro sovereign credit spreads are not back at 2011 levels yet, and any move higher should be contained. We expect central banks in developed economies to continue with growth supportive policies to restore calm and stability to financial markets.”

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