Amid the resurgence of significant market volatility, many investors wonder whether risk management techniques have evolved since September, 2008. The events which brought giants such as Lehman Brothers and AIG to their knees raised questions of whether a misunderstanding of risk and risk management practices was at least partially to blame. Some even pointed the finger at risk models which they believe failed to properly account for “black swan” events – rare, unexpected events which in hindsight would have been predictable, such as the mortgage meltdown. Wylie Tollette, Franklin Templeton’s SVP and Director of Performance Analysis and Investment Risk, says avoiding over-reliance on models is important to mitigating risk:
“Models are just another tool in an investor’s arsenal. I think any management approach that’s solely dependent on one particular model or tool is always going to be vulnerable to the flaws and inconsistencies that exist in all models…Having a great risk model does not mean that you’ve really incorporated and integrated risk management into your practices. It needs to be supported at each step and really built up both from the top down, with support from the top of the organization, as well as from the bottom-up. For each of the investment decisions that are made, you’ve got to have risk management at every step.” Read more…
If you’re feeling a little motion sickness from the recent market volatility, you’re probably not alone. Investors have been on a wild roller coaster ride in recent days, as markets have careened through extreme highs and lows. But Chris Molumphy, CIO of the Franklin Templeton Fixed Income Group®, notes that these large market swings may not perfectly reflect the underlying market fundamentals:
“We certainly have witnessed significant volatility, and in many cases, changes in levels and valuations in the financial markets over the past several weeks. However, it’s important to recognize that relative to just three weeks ago, the world in economic fundamentals has really not changed that dramatically. It’s really been the financial markets – and in particular investor sentiment- that has changed.”
Mounting sovereign debt crises combined with a slowing U.S. and European recoveries have created the potential for a perfect economic storm. As policymakers scramble to act, many investors are seeking shelter. But, are we on the brink of another recession? Michael Hasenstab, Co-Director of the International Bond Department at the Franklin Templeton Fixed Income Group, doesn’t believe so:
“We continue to believe the recovery remains on track in most economies and expect that emerging markets should continue leading an uneven global recovery…Importantly, we do not currently anticipate a new recession in the U.S. The subpar growth we do expect could be sufficient to continue supporting economic activity in Asia and other emerging markets. We expect some moderation in the growth trajectory of these economies but would view that as a welcome development, since it could allow growth to be sustained over a longer period, reducing the potential for overheating.”
This continued growth in emerging markets can not only help sustain the global economic recovery, but also provide opportunities for some investors, says Dr. Mark Mobius, Executive Chairman of the Templeton Emerging Markets Group:
“In particular, we believe certain currencies and stocks of emerging countries look relatively attractive given that (1) emerging markets generally have more foreign reserves than developed countries, and (2) the debt-to-GDP (gross domestic product) levels of several emerging countries currently tend to be lower than those of many developed countries. Emerging markets’ overall improved fiscal health is one of the reasons we believe emerging-market currencies have been so strong recently, and they may continue to appreciate going forward.”
Still, some investors examining the global investment marketplace may be tempted to seek solid shores rather than ride out the rough water. Deep plunges in recent equity trading sessions can make for investing nausea. Yet, during the broad market selloffs, some stocks with solid underlying fundamentals actually present a better buying opportunity. Gary Motyl, C.I.O. of the Templeton Global Equity Group, reminds us that as market conditions whip-saw in the days to come, it’s more important than ever to remember the fundamentals of value investing for the long-term:
“To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.”
You might be forgiven for thinking that you’ve just woken from a three-year coma: To many investors, the steep market declines of recent days have echoes of September, 2008. But today’s volatility has different roots – and presents different challenges. Friday’s S&P downgrade of the long-term U.S. sovereign credit rating only added to a growing list of concerns. In the excerpted conversations with Franklin Templeton investment professionals below, we’ll explore the current market environment, where there are challenges, and where there may be potential opportunities for savvy investors.
On the causes of the downgrade:
Few attentive investors doubted a U.S. credit downgrade was possible. Anyone following the U.S. debt ceiling debacle saw American politics hit an ugly new low – even as S&P warned that policymakers needed a viable consensus for significantly reducing the national deficit. As Roger Bayston, Director of Fixed Income for the Franklin Templeton Fixed Income Group®notes,
“News of the U.S. long-term sovereign credit downgrade by Standard & Poor’s (S&P) to AA+ from AAA on August 5, 2011, was not entirely unexpected. On April 18, 2011, S&P changed its outlook on U.S. debt to “negative” from “stable.” Furthermore, on July 14, 2011, S&P placed the U.S. on a Credit/Watch Negative warning. According to S&P, these actions were prompted by the U.S. government’s lack of ability to agree on a viable plan to reduce the country’s deficit over the long term.”
In what may have been the biggest nail-biter in recent legislative memory, a divided U.S. Congress finally ended a bitter stalemate on increasing the U.S. debt limit on Tuesday. The compromise reached between Republican and Democratic lawmakers enables the U.S.to raise its debt ceiling conditioned upon up to $2.4 trillion in spending cuts over the next 10 years. In so doing, America has avoided a possible default and its potentially dangerous economic consequences.
Dr. Michael Hasenstab, Co-Director of the Franklin Templeton Fixed Income Group, thinks that while the plan avoids default in the near term, it doesn’t go far enough in addressing the nation’s long-term debt problem. In his words,
“In some sense, yes, we avoided the worst-case scenario, which would have been a missed payment or a default. However, I don’t think the solution—or what was passed —really addresses the issue of the long-term finances of this country.”
In particular, Hasenstab believes significant entitlement reform is needed to curtail America’s long-term debt trajectory. Although the deal cuts more than $2 trillion over a decade, the yearly deficit alone is about a trillion dollars. And if the economy slows further, that deficit may even grow, especially if tax receipts decrease or additional stimulus spending is implemented. This concerns Hasenstab, because despite the cuts, the deal’s inability to cope with the larger, structural debt issue may still give credit rating agencies a reason to downgrade the U.S.
“… I think a potential downgrade certainly is in the cards. They [credit rating agencies] had asked for serious entitlement reform, and we didn’t get that – we got a little bit, but not really a lot.”
Roger Bayston, Director of Fixed Income for the Franklin Templeton Fixed Income Group, thinks while the U.S. AAA credit rating is likely still valid, in the longer-term, issues may arise:
“In our assessment, the U.S.’s debt servicing ability as a percentage of tax revenues currently reaffirms the country’s AAA rating. However, if we look out several years, say to 2015, that ratio potentially becomes much less supportive of the top credit rating, and we believe that the longer-term picture is what has been driving the credit ratings agencies to review the U.S. sovereign credit rating. For the ratings agencies, this latest controversy about raising the debt ceiling appears to have been less about the near-term issues—how does the federal government continue to function and finance itself—and more about the long-term challenges, namely the mismatch between expenditures…and the revenue needed to back those obligations.”
Congress’ agreement includes a first tranche of approximately $900 billion in cuts from discretionary spending (including some from entitlement programs), with an additional $1.2 to $1.5 trillion in some combination of cuts and increased revenue that are dependent upon a special bipartisan joint committee’s recommendations. The committee needs to agree upon at least $1.2 trillion by November 23; if it cannot reach an agreement, a backup provision will automatically cut the $1.2 trillion from a combination of defense and discretionary programs. This back-up plan is designed to serve as a motivator for compromise to committee members, since many Republicans shiver at the thought of large defense cuts, while Democrats typically cringe at the thought of massive entitlement cuts.
Still, Hasenstab cautions that it’s not just cutting for cutting’s sake. Ill-timed cuts or those which do not address larger, structural issues, such as entitlement reform, may not deal effectively with the debt:
“Certainly, you want to be careful [with] how you manage your expenditures in a period when the economy is weak – you want to stage that out. But I think what the markets were really looking for was not necessarily a $2 trillion cut in government spending today, but really addressing the longer-term entitlement issues…it’s not saying you have to cut all that spending in year one, but just have a tangible plan that has hard components that politicians have to hold to.”
While the debate over the debt ceiling has been dominating airwaves, negative economic news has still been filtering through, contributing to aU.S.sell-off in equities Tuesday and growing pessimism over the recovery. However, Hasenstab seems less concerned about the possibility of a “double-dip” recession, in part due to the strength of the U.S. corporate sector:
“Well, you’re still growing, but there will be a period where it looks like it might be turning, but it’s just a temporary soft patch. And I think that’s very common, but especially in this recovery where there’s a lot of deleveraging that has to work through the system, it’s not surprising…but the global economy still seems fairly robust. The U.S. corporate sector is still incredibly strong and robust, and while the labor market hasn’t rebounded as we would like to have seen, it’s somewhat offset by the strength in the corporate sector. So, I think it’s possible for the U.S. recovery to continue and the market negativity on that is a little exaggerated and overstated.”
So, while all may not yet be rosy on the economic front, the picture isn’t entirely one of doom and gloom. And in dealing with the debt —or at least part of it —the U.S. has likely taken another step toward recovery.
If you’d like to watch the entirety of the interview with Dr. Hasenstab, please click here.
Until next week, Beyond Bulls & Bears leaves you with a quote from the late Sir John Templeton,
“ The only certainty about the future is that it will be different from the past.”