Investors, and Bulls, and Bears, Oh My!

Market volatility returned over the last month and, during the last two weeks, stocks suffered a modest correction. China kicked it off and, while the ripple effect started in emerging markets, it soon spread to the developed world, including the United States. While some investors shifted assets into investment-grade bonds and treasuries, there was a significant movement toward cash. In a correction or crash, this is a typical response.

In finance, “correction” is a technical term. It refers to price decline of at least 10%, and it is usually short-lived. Corrections happen to individual securities, but stock markets may also suffer corrections as a whole. Generally, corrections are a healthy response to new information, overly optimistic investors, or overvalued assets. Corrections bring prices back in line with the fundamentals of investing and allow more confident investing going forward. This is why analysts and financial professionals do not tend to get too worried about these events, unless they are concerned about an unresolved issue in the market that indicates a larger price adjustment is overdue. In 2008, the shaky credit market was just such an issue and its resolution required a restructuring of the lending and credit rating industries.

After that brief explanation, it is important to recognize that this correction does not look like 2008. There does not seem to be a lurking structural problem that would undermine confidence in the markets, at least not in the United States or Europe. We may easily see markets fall further, but we do not expect a prolonged recovery. In fact, periods of volatility create opportunities to purchase assets at a discount. We already have experienced this during the recent market pullback – equities have experienced sizeable rebounds following large declines.

The outlook in China is not so optimistic. You may remember that it suffered through a miniature credit crisis, last year, but it bounced back relatively quickly. It appears that it failed to cure the structural problems that allowed that credit crisis to develop. Over the past couple of months, China’s stock market struggled to find its footing, despite significant intervention from the People’s Bank of China (PBoC). With loose regulations on margin investing— investing with borrowed money—it was difficult to stop the slide as investors were forced to sell their holdings to pay their margin debts.

Unfortunately, it is unavoidable that China’s woes will impact the global economy. As the world’s second largest economy, China’s demand for raw materials and energy drives the global prices for those resources and it has become a valuable trading partner for western nations. Until recently, China’s appetite has been insatiable and the rest of the world scrambled to feed its tremendous hunger. Now that China’s economy seems to be slowing down, we can expect that its demand for goods and resources will fall accordingly. Resource-rich countries, like those with oil, and emerging markets will be especially hard hit by this slow-down, but developed countries will need to adapt too.

In September, we will be looking to the US Federal Reserve (“the Fed”) and China to set the tone for the rest of the world. If China is able to stabilize its stock markets and post some positive economic numbers, then that should give its trading partners a confidence boost. That would also reassure investors that this was just a hiccup and not a symptom of a more serious economic issue.

On the other side of the globe, investors are awaiting the Fed’s September meeting for news of an interest rate increase. Analysts’ opinions are split on whether the inevitable rate hike will come in September or December. By making the decision in September, the Fed would signal the US economy is healthy and no longer needs the assistance of these low interest rates to spur growth. Waiting until December would indicate that the Fed needs more data, in light of the recent volatility, and would rather not take action too soon.