Expect Continued Uncertainty And Volatility in 2014

volatilityIf the rest of 2014 is like the first 37 days or so, the word that will be used to describe the financial markets will be “volatile.”

The disruptions coming this past two weeks centering especially in the currencies of several emerging countries is just the latest upheaval to cause market to move in a direction opposite the one that was forecast a month or so ago.
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But, bond markets and stock markets in developed countries have been impacted as well.

The volatility measures used to capture the movement in the financial markets jumped up this week, some of them approaching 52-week highs.

It is easy to argue that financial markets will remain “jumpy” for at least the rest of the year.

There are several reasons for this.

It looks as if the American economy and the economy of the United Kingdom are continuing to grow and it even looks as if the growth rates of each are becoming stronger.

However, in the European Union the situation does not appear to be as rosy. There has been more talk about actual price deflation in the EU than I have ever heard in my professional career. Growth rates in most countries in Europe are tepid accompanied by high rates of unemployment. Inflation is running so low that the economists are afraid that it could tip over into an actual decline in prices. This, the economists feel, could have a cumulative effect on the economy because Europe still has so much debt outstanding that falling prices would actually make the real burden of the debt greater…and, this could result in an even greater slowdown in spending.

Furthermore, the emerging nations are also not experiencing very exuberant markets. A lot of concern is expressed about a real slowdown in the Chinese economy. But, other developing countries are right on the edge of much slower growth.

The economic picture for 2014 is not clear and this tends to blur the thinking of investors.

Second, many of the central banks in the world seem to be on different pages. Perhaps the most important central bank in the world, the Federal Reserve System, has started to change its policy stance. For most of 2013, the Federal Reserve added roughly $85 billion in securities to its balance sheet each month. In December 2013 it intentionally added only about $75 billion to its portfolio of securities. At its latest meeting, the Fed’s Open Market Committee voted to add only $65 billion to the portfolio in February.

The expectation is that every month this year…unless something else happens…the Federal Reserve will reduce its monthly purchase amount by another $10 billion. This would mean that the Fed would not be purchasing securities on a regular schedule by the end of the year.

The Federal Reserve is the biggest supplier of liquidity to the world…not only just the United States.

After beginning this “tapering” of purchases, others within the world started to complain. Not only does this policy action put the Federal Reserve on a different page than other central banks in the developed world. It also threatens the financial markets in emerging market countries.

Just last week, Raghuram Rajan, the Governor of the Reserve Bank of India, and formerly a professor of finance at the University of Chicago, accused the United States of being selfish because of the actions of the Federal Reserve because it was not taking into consideration the fact that withdrawing liquidity from the financial markets seriously impacted world financial markets, particularly the Indian financial markets.

What the Federal Reserve does this year may be especially disruptive of financial markets because the Federal Reserve…in fact, no central bank…has never done something like it is trying to do this year. There are no roadmaps…there is no certainty.

We just don’t know what the Federal Reserve is going to do…we just don’t know how the Federal Reserve is going to respond to market movements…and, we just don’t know how the brand new Chairman of the Board of Governors of the Federal Reserve System who was just sworn into her new position Monday is going to act or react during the year.

In fact, one could argue that what the Federal Reserve does this year is perhaps the biggest uncertainty world markets face!

In addition, we have no idea how the President and Congress are going to work together this year. We know that the Republican members of Congress, especially in the House of Representatives, are going be combative with President Obama. But, now we even see the Senate Democrats are opposing several parts of the President’s program. We just don’t know what will get done and what shape anything will take if it does get done.

Finally, given all these uncertainties, households and businesses have to plan and go forward. In can be strongly argued that the spending of the private sector has been constrained over the past four and one half years of the current economic recovery because of all the uncertainty they have been faced with. Although I believe that economic growth will improve slightly in 2014, that the improvement will continue to be constrained by the uncertainties, like the ones mentioned above, facing everyone.

With all this uncertainty we are going to see volatility in financial markets. In the last two weeks it looked as if everything were falling apart in the emerging markets. The value of some currencies dropped precipitously. Some central banks raised short-term interest rates dramatically to protect their currencies. Risk averse money left riskier investments in emerging countries and riskier securities like stocks in the United States and elsewhere in the world and went into “safer” investments like United States Treasury securities. The prices of financial assets changed.

It is highly likely that we will see other situations similar to these throughout the year. It is just a part of the current economic environment in the world.

The investor needs to be prepared for this kind of behavior and position her/his portfolio in a way that it can be lived with during the year. The price of financial assets are going to vary this year and sometimes unexpectedly and rather dramatically. What can you live with?

In recent years, investors have been stretching for yield because interest rates have been so low. To get more yield they have either extended maturities and taken on more interest rate risk or have purchased riskier investments and taken on more credit risk. Volatile times just exacerbate the market swings and make it tougher to live with these additional risks.

Perhaps it is a good time for you to review your portfolio and determine whether or not you can live through this next year or so with your current portfolio given that the road ahead might be a little bumpier. Or, maybe you need to adjust where you are to make this year a little more livable.

About John Mason

John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.

 

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