Prepare for volatility and surprises (audio available)
With the conclusion of the Memorial Day holiday, we are officially entering the summer period where history would suggest that investors should be prepared for volatility and the potential for surprises.
From a seasonality perspective, the S&P 500 sees its weakest returns of the year in the months from May to August and history shows that lounging at the beach and ignoring economic and market developments is a naïve way to spend the summer. Over the past 20 years, the average maximum drawdown for the S&P 500 has been 10% and seven of those years saw drawdowns in excess of 10%.
We looked at a history of major market moving events that have occurred during the summer months over the past ~30 years. In addition, we highlighted some upcoming risks for investors to be aware of this summer.
- Asia currency crisis: The collapse of the Thai baht spurred a credit and currency crisis across Asia beginning in July 1997. It spread to Russia with the Russia financial crisis in August 1998 and ultimately led to a bank-led rescue of a major hedge fund in the U.S. (Long term capital management). In 1998, the S&P 500 saw a 19.3% drawdown as a result of the global turmoil.
- Worldcom bankruptcy: In July 2002, Worldcom, the second largest telephone company filed for bankruptcy after a series of accounting scandals. The S&P 500 lost 25% from May 31-Jul 23 that year.
- Start of Great Recession: Some pinpoint the start of the Great Recession to Lehman Brothers bankruptcy (Sept. 2008). However, we believe it can be drawn back to June 2006 when the Federal Reserve tightened rates to their cyclical high. Then in June 2007 when Bear Stearns halted redemptions in two CDO hedge funds.
- Grexit: The European debt crisis spanned multiple time periods but it was the summer of 2010 and 2011 where the EU had to bail out Greece and the acronym PIIGS was developed (Portugal, Italy, Ireland, Greece, and Spain). The S&P 500 saw drawdowns of 16% and 19%, respectively in those summers.
- U.S. credit rating downgraded: Aside from the troubles in Europe, in August 2011 U.S. politicians drove the debt ceiling debate to the final hours and nearly threw the U.S. in default. S&P responded by downgrading our credit rating below AAA for the first time in history.
- China devalues CNY: The summers were relatively quiet in the following years until the People’s Bank of China devalued their currency to boost exports and fuel growth in August 2015. This surprised investors and sent the S&P 500 down 12%.
- Brexit: We also can not forget that the shocking Brexit vote took place in June 2016. The S&P 500 saw a quick 5% pullback only to rally into year end.
Will 2019 deliver us another volatile summer? Most likely, especially if you look at the list of items that could fuel volatility this summer.
- Debt ceiling…again! The debt ceiling will need to be raised by Sept/October 2019 in order for the U.S. not to default on its debt. Current political commentary suggests this will get done along with numerous government funding bills. However, we do not rule out politicians dragging it to the last hour and debates heating up this summer, especially given the divisive political environment.
- Brexit…again! The official extension of Brexit was pushed from March 2019 to October 2019. However, after Theresa May’s decision to resign, it looks likely that June will be a vital month for the Brexit process. The UK will need to find a replacement for May after she steps down on June 7.
- Trade war: The chance of a comprehensive trade deal between the U.S. and China is dwindling and the probability of raising tariffs on another $325 billion worth of goods is rising. However, some are still hoping for a more conciliatory tone at the G-20 summit at the end of June. If talks are suspended further risk sentiment could be challenged.
In addition to the above risks, the geopolitical environment is unstable especially between the U.S./Iran/North Korea. Investors should expect volatility this summer, be patient, hold cash as a hedge and we will make allocation changes if they deem warranted.