Global equity markets have endured steep declines in recent days, culminating with a broad-based, 5%-plus decline yesterday. This market correction has been driven by fears of a renewed U.S. economic recession, as well as continued turmoil in European credit markets. How should investors react to the market losses and increased volatility?
First, we would advise against participating in the panic-driven selling that is occurring at the moment, especially if you can afford to take a longer term view. The selloff has spared very few stocks , and the prices of many companies with strong fundamentals have been overly punished in our view. This kind of market action is an indication of sudden fear, and as that fear dissipates, we should expect a rally. In addition, it remains possible that this is simply a stiff correction within the bull market that began in March 2009.
However, there are plenty of reasons to be concerned. The U.S. economy is barely growing, and while this morning's release of July employment figures was better than most expected, we clearly need to see much improved data to remove the increasing risk of another recession. In addition, the European debt crisis continues to worsen, threatening the banking system and prospects for global growth. Finally, the upward trend of the markets has been broken, and declines of this magnitude should be taken as a warning of further declines to come.
So what is our investment strategy? First, the key to long term wealth preservation and growth is risk management. Protection against market turmoil should be built into portfolios prior to the storm. As such, we have taken actions in recent months to get more defensive, including reducing positions in small cap stocks, emerging markets and commodities. We have also shifted equity exposure more in favor of large, high dividend paying companies. We would recommend taking advantage of a market rally to further reduce risk and move into defensive sectors.
Second, it appears to us that interest rates will remain very low for quite some time. Global economic concerns, lack of pro-growth policies in much of the developed world, and the widely-held view that U.S. Treasuries are a safe haven will create downward pressure on interest rates, despite threats of a U.S. credit rating downgrade (which would normally cause rates to rise). High unemployment and the need to reduce high levels of debt around the globe should keep inflation at bay. A a result, we advise against betting on higher inflation and interest rates over the near term. Investors should avoid high yield corporate debt and focus on higher credit quality fixed income.