Home>Video>Conditions Ripe for More Market Turbulence

Conditions Ripe for More Market Turbulence

Tue, 26 Feb 2013

After a period of relative calm, the Italian elections and fight over the sequester underscore some of the structural problems facing the global economy; investors should be prepared for volatility, says Morningstar's Jeremy Glaser.

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Video Transcript

Jason Stipp: I am Jason Stipp for Morningstar. Monday's sell-off is one of the worst that the market has seen in quite a while. So are we in for another series of storms after a period of relative calm? Here to offer some insights is Morningstar markets editor, Jeremy Glaser. Jeremy, thanks for being here.

Jeremy Glaser: Glad to be here, Jason.

Stipp: On Monday, the market seemed especially upset about the situation in Europe, though that's not the only thing potentially that the market is upset about, but let's start in Europe because that seemed to be in the headlines Monday. What's the situation there? Why did we see a sell-off potentially because of issues that are going on there?

Glaser: The big thing the market was focused on Monday were the Italian elections, and the fact that they had inconclusive results. Despite some early reports that maybe the Center-Left Party had managed to get a majority in both the lower and upper house in the Italian Parliament. When the actual votes start to get counted, it turns out that that was not the case. It looks like there's going to be a three-way tie in the Italian parliament and that will be extremely challenging for these groups to come together and form a coalition government, and it's likely that we are going to hit another election relatively soon.

Stipp: So events in Italy on the political front are definitely still unfolding, but let's talk about Italy with respect to the whole eurozone. How important is Italy and the troubles in Italy to the broader issues that we've been seeing across the region?

Glaser: Italy is really the red line in the eurozone crisis. You look at a country like Greece, which obviously is having substantial problems and even Spain, which is still working through some of its issues, they are relatively small economies both in the context of Europe and in the rest of the world.

But Italy is a much larger, much more important economy and if the kind of crisis that we've seen in Greece and Spain were to spread to Italy, it would be a major problem and would really put an incredible amount of pressure on the euro. There is already a lot of pressure kind of keeping the euro together, as is.

The issue is not that Italy has the kind of spending problems that we are seeing in Greece, where there is a huge primary budget deficit. Right now things are mostly under control. The concern is that will future Italian governments be able to make the reforms, make those pension reforms and work-rule reforms that will allow Italy to remain in that relatively good spending situation and keep their borrowing costs low, so with their already pretty large existing debt stock, they are not paying a huge premium on that and that debt service kind of gets away from them. I think the concern right now is that they are not going to be able to come up with a government that's going to be able to do that.

After Silvio Berlusconi stepped down and Mario Monti came in, Monti was just to be a technocratic leadership, kind of a consensus builder who kind of put Italy on that path. And the financial community was very happy with his performance. But it seems like Italians were less excited. His party received less than 10% of the vote when he ran in this election; they had expected to do much better. There just seems to be a very fluid political environment and people can't seem to really decide exactly what they want the future of the country to look like. I think that concerns the markets. It concerns people who are worried that they're not going to be able to make those reforms. I think that's the big issue in Italy right now and why you see the markets selling off and why people are worried that this doesn't potentially bode well for the rest of Europe.

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Stipp: And Italy isn't the only place that's facing some potential political uncertainty. Elections could be also troubling the market in other areas of the eurozone.

Glaser: Yeah, if you look across Europe, we are focused on Italy right now, but we have German elections coming up. Just more broadly, we have to think about, is there a political will to actually execute the changes that are needed to keep the euro together. We've seen time and time again some very close calls where it looks like an election was going to go to a party that was going to buck the consensus, that was going to try to bring their country either out of the eurozone and try to renegotiate the terms of a bailout. And that's something that the market is very suspicious of and is really looking for almost more of the status quo. But in order for this to get really solved, someone's going to have to take losses somewhere.

I have talked to Morningstar's bond strategist, Dave Sekera, about this a few times. That in order for the process to really come to a reasonable conclusion, we need to decide and Europe needs to decide these are the bondholders that may not get paid back 100% or it could be that its growth is much lower or the public pensions get hit. I mean, there is going to be pain somewhere in Europe, and right now, they are still just kicking the can down the road instead of deciding where these pressure points are going to be. And until you have a political system that has the mandate to actually make these decisions, you won't make them. You keep pushing it down the road, and when you keep doing that, you don't solve the problem. And it can flare up at almost any time.

Stipp: Those flare-ups could also cause volatility in the market obviously. So, Europe is going to continue to be an issue [and cause] potential turbulence for us. But here at home, we are also facing some issues with our government--the sequester that's coming up and all the wrangling that's going on about debt and deficits. Still, what's the situation recently? What's the conventional wisdom on those automatic spending cuts that are set to go into effect very soon?

Glaser: Sure. First off, the situation in the United States isn't nearly as dire as that in Europe in terms of a systemic risk. I think that's important to point out. But it seems like the conventional wisdom right now is that the sequester is going to go into place March 1. The Congress is not going to be able to get together and repeal some of these mandatory spending cuts before then.

However, March 27 is another important date, which is when Congress used to come up with a budget or a continuing resolution, and if they don't do that, we'll see a government shutdown. I think it's likely that as we look into the end of March with those negotiations around the budget that the sequester cuts will probably get lumped into those negotiations, as well. There will be talk of when we fund the government for the rest of the year, that might restore some of those cuts or change where those cuts are made.

So, there is tremendous amount of uncertainty about how long the sequester would really be in place and exactly what would happen when the sequester gets hit. The Executive branch has kept their cards pretty close at about exactly how the cuts would be made or where we would feel the pain. We've had a few announcements, things like the Transportation secretary, say that there are going to be big airline delays. But we don't know how much of that is political rhetoric, and how much of that is really going to come into fruition if the sequester hits. It's going to be certainly an impact in the short term even if it's only there for a couple weeks as the budget gets negotiated.

Stipp: So, you said, there are short-term issues; there might be short-term fixes on a few things. But this also a very long-term problem that we may be dealing with in fits and starts again for potentially years to come.

Glaser: I think that's the important part here. Beyond whatever the short-term impact of the sequester is or if it gets repealed, if it doesn't get repealed, whatever happens there, I think this points to what's going to be kind of the new normal political negotiations. We've been seeing this go on for a couple of years now. I think the pattern has become reasonably clear. The truth is that this grand bargain just doesn't seem to be in the offing. This idea that everyone is going to come together and pass one piece of legislation that's going to put us on the sustainable fiscal path for the next decade, next 15 years, and that we can just kind of set it and forget it after we've done that; that it's going to have entitlement reform, it's going to have tax reform, it's going to have spending cuts and other areas that this is just going to happen.

And I think even if there were--and I think there may be--a majority of congressmen and a majority of senators who are willing to actually come together and agree to a plan like this, the way that the politics are so polarized right now, it just doesn't seem like either side is willing to actually do that at the moment. And because of that we're going to see, I think, a lot more of just these mini deals, that we make very little small amounts of progress, which is real progress--which I think should be pointed out that we are kind of making progress down that road. But it's never going to be kind of this grand idea. We're going to do it in fits and starts, we're going to set up these deadlines, we're going to blow through some of them, we're going to have last-minute deals, and then everything is going to be kind of small ball instead of kind of these grander deals.

I think investors are going to have to get used to that because it's a much more volatile way of doing things. As we get to each deadline, there's always going to be a chance that Congress isn't going to do what they said they are going to do, or things aren't going to play out exactly as people expect. That could create some volatility, and I think that's something that's going to be on everyone's radar for years. These are difficult problems and ones that we're going to be solving for quite a long time.

Stipp: So, it sounds like we won't be able to breathe one big sigh of relief and the problems aren't going to all get resolved at once. We will have, as you say, fits and starts and a lot of volatility potentially because of that. So, if I'm an investor, I've got a portfolio, and I know we might see some turbulence as these deadlines come and go and small patches are made. How should I be thinking about how to invest in such an environment of uncertainty and volatility?

Glaser: I think there are a few important points. The first is asset allocation. It's really important that you've thought about what your mix of kind of more liquid cash assets, fixed income, and equities are, and that you kind of stick to that general framework. With the amount of volatility that we could see in equities, volatility we could see in fixed income, it's important that money that you need in the relative short term for your living expenses, for any college expenses that might be coming out, that they're in pretty liquid assets, and that you're able to pull that out, that you're not going to be worried about selling into a falling market and not being able to take advantage of that.

I think the biggest important point is that you're kind of within that range that you've set for yourself that makes sense for where you are, on your way to retirement or to your other goals, and I think that's the single biggest thing that you need to think about.

Stipp: So it's important for investors to make sure that their shorter-term needs are covered with safer assets, shorter-term assets. But it doesn't mean that you want to abandon stocks altogether, you probably still have a certain time horizon, even if you're in retirement, for the later years of your retirement. So you're still going to probably hold stocks for most portfolios. What should you think about the stock holdings, the ones that are going to be most sensitive to all those movements in the market?

Glaser: For stock investors, wide moats just make a ton of sense. These companies that have sustainable competitive advantages, that our analysts think are going to be able to fend off their competitors and be able to create economic profits for decades to come, I think are the kind of businesses you want to own when we're having a lot of volatility, when there's lot of uncertainty of what the world is going to look like.

If you look at a company like Coca-Cola, you can imagine that people are going to still be buying Coke no matter what's happening to sequester cuts and the defense budget. I think those are the kind of the really solid businesses that make sense for a lot of investors in this type of environment.

Also, low-uncertainty stocks and even some medium-uncertainty stocks are ones that our analysts think that there's a much smaller cone of uncertainty around what's going to happen with those names, either because they have a lot of lock-in in their contracts or they have other features that make their businesses more predictable. They're going to be certainly hurt by an economic downturn or could be hurt by gyrations, but they're going to be able to come through that and we think we have a pretty good idea of where they'll be afterward. So, I think that those are stocks that could make a lot of sense.

Stipp: What about your regional or your geographic diversification? As different areas of the world face pain points, pressure points, and issues flare up, how should you think about how you're diversified across the globe?

Glaser: That's another important one for stock and fund investors to think about their diversification. And I think you need to do that across a bunch of different metrics. You mentioned geographic diversification. I think that's a great one. Just because there are problems in Europe, you probably shouldn't abandon Europe with stocks. A lot of those multinational companies there are selling a lot in emerging markets, are selling a lot elsewhere. Those are companies that you still want to own. You want to have exposure to those emerging markets. You want to have exposure to other parts of the geographies that you can invest in.

So, I think that's certainly an important point. And also [you should have exposure] across sectors. We could see definitely the sectors be impacted by some of these changes in spending cuts, some of the changes in government policy in different ways, and it probably makes sense to have decent diversification across different types of businesses.

Stipp: How should I think about the economic performance of these different areas of the globe? Should I avoid an area when it looks like they're going to be in recession for a little while?

Glaser: That's a lot trickier. A lot of research has shown that there's just not a huge correlation between what's happening with economic growth and what happens with stock returns. What really matters is valuation. So, if stocks look inexpensive based on the cash flows you're getting from those companies, you're probably going to see a good return, and if they look expensive, you're not going to get that good of a return. And sometimes that just isn't necessarily correlated with what's happening with gross domestic product as a measure. When the market sees GDP falling, it could hit valuations much harder than they should be, and it means you have an opportunity to pick things up very inexpensively. So I think investors who are thinking tactically like that should really think more about valuation levels across geographies and less about what's happening with growth.

Stipp: As all these things are happening at the political level, you feel very out of control. You can't control the deadlines that are blown through, you can't control the wrangling and all of the rancor that's going on, but there are some things that investors can control, and they can actually have a big impact on your bottom line?

Glaser: Yeah, absolutely. Low-cost investments; I think is one of the big ones. That's something that we sometimes we harp on a little bit, but it's important to not overpay for your managed products and overpay elsewhere. That's a cost that you absolutely can control. You know what you're going to be paying, and if you can reduce that cost, that's going to help boost your return. And then from a behavioral standpoint, it's important not to try to trade too much, not to try to kind of front-run some of these changes, or not to try to really be too aggressive in your turnover. That buy-and-hold strategy, buy-and-hold mentality, should help you ride out some of these waves and produce decent returns over the long run.

Stipp: Jeremy, some great insights on the political situation in Europe, the situation in the U.S., and some great tips for investors. Thanks for joining me today.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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