Investment View January/February 2016
The start of 2016 has been very uncomfortable and unsettling. Investors should not fret but come to the realisation that it is very likely 2016 will be a low growth, low return world, with corporate margins under pressure.
“Widespread fears over ongoing stock market and currency weakness in China, the falling oil price, geopolitical tensions, overvalued assets and an end to fiscal stimuli have led to stock markets plunging around the world. The bear appears to have his claws out and investors with shorter memories may well be spooked” said the Chief Investment officer of a major Fund House.
Bear markets are typically defined by a broad range of indices falling by 20% or more from their most recent peaks. At one point in January the FTSE 100 index was 20.3% off its April 2015 peak, while the Dow and the MSCI AC World indices were not far behind. If a bear market is also defined as one where investors should expect further sell-offs, then we may well be in the bear’s claws. Ironically, the drivers of this bear market may be found in economic policies aimed at stabilising global economies. Volatility has been artificially subdued in recent years due largely to quantitative easing (QE), with markets settling into a pattern of reassurance that modest earnings growth would continue all the while asset prices were being boosted by QE.
The era of asset price reflation, fuelled by both post-crisis undervaluation and aggressive central bank easing, is over and we cannot rely on our returns being flattered by QE or other valuation recovery dynamics. At a global level, expected earnings are lower than they have been for five years while prices are much higher even if, while volatility is high and rising, it is not in territory that typically marks capitulation and is some way off the levels of volatility we saw in 2008.
China, of course, remains a key driver of volatility. Its economy is slowing, but not at a rate many feared, as it desperately tries to rebalance.( Indeed, one fund house chief economist believes China will surprise on the upside as 2016 progresses and has presented a compelling paper in support of his view). This slowdown has already resulted in currency depreciation and stock market woes, which have spilled over into other Asian markets and across the world. Yet fears over China are not new. Oil prices have once again played a key part in market anxiety, with Brent crude down 75% from its June 2014 high of $112/barrel and 39% off the $45/barrel price we saw as recently as last November. Is this a clear sign of global weakness or just maybe a power struggle for control of the oil market?
Dollar strength, liquidity, credit spreads and Brexit also remain key concerns. Yet this is not the time for investors to throw in the towel, as some bank bond analysts and doom-mongers have suggested. The outlook for Emerging Markets remains challenging, particularly for those countries that have built their economies to serve Chinese demand for commodities. The outlook for these countries is downbeat, and weaker currencies may not help to lift demand for EM exports where consumer and corporate demand is subdued. A world where the US tightens policy but other central banks retain an accommodative stance should mean a stronger dollar. That is likely to be a further headwind for EMs, as there is a strong inverse correlation between the dollar and emerging markets. Further FED rate rises would exacerbate this position.
We believe that a well-diversified portfolio of asset classes using predominantly active managers is well-placed to ride out short-term shocks in markets. In this world, a focus on valuations and fundamentals should be more important than it has been in recent years, when markets were backstopped by abundant and growing liquidity. As can be seen in the chart diversification is vital. Both property and global bonds, for many the latter a reluctant component of retirement portfolios, provide gains during this turbulent period. Equities will lick their wounds and take their place once again and the lower risk assets will plod on.
Longer-term investors know that what can feel like a crisis in the short-term may not hold as much significance some years down the line, so a focus on old school investing values makes particular sense in such a volatile world. Former Treasury secretary Robert Rubin was right when he would regularly reassure anxious politicos in the Clinton White House that “markets go up, markets go down” on days when a market move created either joy or anxiety. The best executives manage their companies with an eye to long-run profitability, not the daily stock price. And policymakers do best when they concentrate on strengthening economic fundamentals rather than on daily market fluctuations. We have spoken to many Fund Houses and individual managers since the New Year and all are adamant that nothing fundamental has changed with any of the companies they invest in other than the recent turbulence provides a good opportunity to top up and also brings previously expensive companies onto their radar.
Markets need to see some markers of stability to defeat the bear. If China and its investors could accept the country’s need to rebalance its economy, we might see a smoother stock market ride. Oil price stability would also help, but the situation in the Middle East is difficult to fathom. Saudi Arabia’s continues to pump oil even at current prices and seems in no mood to change. With demand falling, partly as a result of US shale oil flooding the market, oversupply remains a key issue and it remains to be seen how the geopolitical factors in play will pan out.
Even if the prospect of further interest rate rises have been pushed a little further down the road, they arguably remain one of the key threats. The recent macro and company indicators suggest that they are not what one would expect to see when the world’s most important central bank, the US Federal Reserve, is starting an interest-rate tightening cycle. It is clear that the Fed is very keen to start normalising interest rates, but if one simply looked at the data in isolation, it is hard to come to the conclusion that the Fed needs to raise rates quickly or aggressively. Last year the FED was heavily criticised for acting too slowly in raising rates but now the critics suggest they shouldn’t have moved them at all. “It is reasonable for investors to wonder whether Fed’s December rate hike was a policy error,” admits Bob Michele, chief investment officer of JPMorgan Asset Management. “Historically the Fed has raised rates because either growth or inflation was uncomfortably high. This time is different — growth is slow; wage growth is limited; deflation is being imported.”
Although equities have taken the brunt of the turmoil it is worth remembering that income generated from an equity holding is a major component of growth. Whilst values have been impacted since the New Year their ability to generate profits and pay dividends has not.
Markets are often more volatile than the fundamentals they seek to assess. Economist Paul Samuelson quipped 50 years ago, “the stock market has predicted nine of the last five recessions”
Douglas Kearney C.A. Investment Director