Legg Mason: Investors should take a ‘deep breath’

Listen to this article

Investors turning on their TVs after U.S. equity markets opened Aug. 24 were greeted with news that was anything but good: a market correction, the first in years. The S&P 500 closed down close to 11 percent that day since its July 20 high. Just four stocks drove 10 percent of that drop, with 20 percent coming from 11 names. The 10-year treasury yield reached a low of 1.9015 percent, an intra-day level not seen since April 26, 2015.

Legg Mason gathered some of the senior investment professionals at its affiliates to sound out their views on what happened. What is driving the surge in market volatility: sentiment, valuations or something else? How does this market move fit from a historical vantage point? What signs might suggest markets are in oversold territory? And where do the investment professionals see opportunities?

“It is important to have perspective,” advised James Norman, President of QS Investors. “We’re suggesting people take a deep breath, relax and think strategically about what they should do.”

Norman focused on the market’s higher volatility, which caught some investors off guard.

“Though the volatility feels horrendous, if you look back, we were in a period of low volatility. Over the last 10 years, [the VIX] has been at the 10 to 13 range. That’s unusually low. Historically, on average it’s 20 or higher. People got used to it and under-reacted to the risks in the market.”

He added, “These rubber bands around the world in terms of asset prices, having gone up quite a bit, means they’re more vulnerable. Investors are afraid they’ve under-reacted to these things – that maybe some of these rubber bands are going to snap, and they’re going to get hurt.

“I think this is a healthy return to volatility, to make sure people are properly pricing risk assets in the market. People generally tend to under-react at first, then they overreact. They realize they’ve overreacted, and you see a shift back. That’s what we’ve seen this week.”

Equity valuations

To Scott Glasser, Co-CIO of ClearBridge Investments, the emphasis was on equity valuations.

“Before this correction we didn’t think valuations were extreme, but we thought they were at the upper end,” Glasser said. “Relative to interest rates, that meant that to get additional stock performance, it really had to come from earnings growth. But over the last several years, stock valuations have risen as performance has been much better than underlying earnings growth.

“That potentially makes stocks vulnerable: the higher valuations go, the higher the risk. Our belief is after several good years, this would be a moderate year with very modest returns. S&P profit growth will probably be between 0 and 2 percent. Stock returns would be low single digits. We have no change. That’s absorbing as much as a 50 percent reduction in energy estimates.

“Markets don’t go up year after year. To grow into earnings would be a much healthier way to adjust valuations than a significant correction, but it is normal to have 10 percent corrections periodically. We haven’t had one for over three years. It actually creates opportunities, puts risk back in the system and ultimately is a healthy thing, although painful while going through it.”

Fixed income markets were also impacted. Concern immediately focused on whether the U.S. Federal Reserve indeed will begin the process of raising interest rates, as expected.

“The Fed clearly wants to get off zero,” said Western Asset Management Deputy CIO Michael Buchanan. “We had been in the camp that September is more likely than December. The market is telling us there’s virtually no chance of a September move, right now, but I’m not sure it matters. What matters more is the trajectory of rates once they do the first hike.

“We think that’s going to be very different than previous Fed hike cycles: much slower. We believe Janet Yellenwhen she says that the pace of rates will be gradual and prudent. Any rate rise will be accompanied with very dovish language from the Fed. Although they are removing accommodation, they’re going to do everything they can to make sure the markets know they are still accommodative and watching the fundamentals. The Fed won’t hurt you in this rate rise.”

Buchanan also sees several areas of opportunity stemming from the market turmoil.

“We have always looked at the contrast between fundamentals and valuations,” he said. “Looking at those dynamics right now, we see opportunity in spread sectors. Free cash flow generation is strong, leverage is low, interest rate coverage is high, and the fear of defaults is way overblown. Even factoring in the stress in the energy space, we still believe defaults are going to remain abnormally low for at least the next year or two. Energy companies definitely have the financial flexibility and wherewithal to navigate through a period of depressed oil prices.

“So we look at the fundamentals, then contrast with valuations in the high yield market of 7.5 to 8 percent. It’s difficult to time the bottom and we don’t agonize over that, but if you wait for the day things turn, it will be very difficult to buy paper anywhere close to where you could have picked up paper Monday. There’s a real opportunity we are reflecting in our portfolio strategies.”

Small cap space

By contrast, the U.S. small cap space “has been getting a little bit out of joint over the past several years,” according to Francis Gannon, Co-CIO of Royce & Associates.

“That was most noticeable in the first half of this year, with the performance of non-earning companies,” Gannon said. “That’s where the majority of the market’s outperformance has been coming from. A third of the Russell 2000 is actually comprised of non-earning companies, the highest level it’s ever been in non-recessionary periods. Concentration is towards growth. You see it in the outperformance of the growth industries this year versus the value indexes.

“This most recent correction seems normal from our perspective. Small cap markets have corrections periodically. In fact we had a 13 percent correction from July last year to the middle of October. The triggers might be different this time, but it allows us to be more selective in our portfolios in terms of stocks and price, which we think is really important in today’s world.

“The corrections we’ve seen over the past several weeks, just to show how it’s been going on for a period of time now: if you equal weight the Russell 2000, the average stock is down 27 percent from its 52-week high. So it’s been quite painful for small cap stocks for a period of time now.”

Brandywine Global believes the keys for stabilization are for the Fed to delay hiking interest rates – previously expected in September – and China must reflate its domestic economy.

“Multiple factors converged to drive the correction, but it all boils down to global deflationary forces weighing on U.S. corporate pricing power enough to affect future profitability,” Portfolio Manager Jack McIntyre said. “These wild swings may have been exacerbated by weak liquidity, since August and September have historically been challenging months for risk assets.

“Markets are finally catching up with the subpar global growth environment, resetting equity multiples in anticipation of very low nominal GDP growth – or slow deflationary expansion.” “Markets are also concerned that tighter U.S. monetary policy could become counterproductive for the current U.S. business cycle expansion. The Fed has three mandates: two are official, the other implied. Price stability and full employment are official, but financial market stability is implied. Of those three, employment is the only reason for the Fed to tighten.

“Moreover, the U.S. dollar’s valuation, credit spreads and financial markets – through the recent wealth destruction – have already tightened financial conditions for the Fed. As such, we believe the Fed will have to back away from its tightening bias and might be on hold into 2016.”

China’s stabilization

Those thoughts were largely echoed and expanded upon by the team at Permal.

“How this plays out is entirely dependent on whether you think China can stabilize and the U.S. and other developed economies can grow,” said Isaac Souede, chief investment strategist at Permal. “If you are negative on either, then the bearish state continues. We are not. Why?

“The U.S. is in good shape, evidenced by the yield curve, consumer confidence, housing and household formation. Europe and Japan are softer due to structural factors and greater dependency on exports to China, but can still grow thanks to the tailwind of lower oil prices.

“The Chinese government needs to avoid a hard landing, especially a rise in unemployment. The pressure is on to use all their policy tools, just like the U.S. had to do in 2008: reduce reserve requirements, reduce interest rates, channel public pension fund assets into the stock market, more fiscal spending for infrastructure. There is a political imperative and the means to succeed.

“We should have reasonable entry points for Asian and other emerging markets following this correction. Shanghai still needs to stabilize. U.S. equities are likely to be earnings-driven, dependent on wages and productivity. We like Japan but are a little less bullish than before, while Europe is a mixed picture. What we saw earlier this week means we are less likely to see Fed action in September. As for oil, it appears oversold and should find its way back above $50.”

Scotland-based Martin Currie believes the ongoing volatility in global equity markets presents short-term investment opportunities, as they believe the market to be oversold. With both U.S. and European markets selling off by 10 percent during August, the valuation gap has yet to close.

“On an earnings and price to book basis, the European market is now trading below long-term averages again,” said Michael Browne, portfolio manager of Martin Curries’ European Long/Short Strategy. “The current situation should be seen as an opportunity for investors.”

To the Martin Currie team, the selloff in global equities resulted from: the industrial/economic negative of oil prices; the banking impact of the oil price, as the high yield energy debt selloff augurs sharply higher loan losses; the Chinese slowdown; and the prospect of a U.S. rate rise.

“Although the market has been pricing in an Asian slowdown it may have to do more, especially if the Yuan continues to depreciate,” Browne said. “The market has also been pricing in a major oil, gas and materials earnings slowdown, and will have to do more. However, continued deflation in commodities and import goods have not yet been priced in. Opportunity exists here.”