Investment View September/October 2015
September is a busy month for fund houses reviewing the year to date performance and considering what the outlook for the remainder of the year and beyond might offer for each asset class. This year has been very interesting as right now we are in the midst of a challenging economic climate that has seen global markets become hugely volatile driven by weak economic data coming out of China. The consensus, almost without exception, is that Europe and Japan offer significant opportunities, UK mid cap is a better place than the FTSE 100 and active funds in the US should perform satisfactorily, whilst passives both in the UK and US might be hindered as energy, mining and commodity stocks struggle in the current global environment. Property remains a good and steady performer but the sector could overheat, albeit no evidence of that yet, but needs to be continually under scrutiny. Income remains the key component for almost all investors and their portfolios and the fund houses are very aware of that requirement. The other key message, of which we totally agree, is that the sell-off has been indiscriminate across the good, the bad and the ugly and that creates opportunities.
Equity markets have ridden a wave of QE-driven liquidity in recent years but investors are now facing the reality that developed world economic growth, seven years on from the crisis, remains unimpressive. Policy makers in the US and the UK who would like to raise interest rates are currently unable to do so. Markets had been hoping that the developed world would return to some sort of economic ‘normality’ this year, and in that context a Chinese slowdown could be managed or contained.
Unfortunately, the only developed economy of any significance to have registered strong growth post-crisis, the US, has been challenged by a stronger dollar and a tightening labour market, and capital expenditure has been hit by the global slump in oil prices. If the US begins to slow, and China slows quickly or worse, which is unlikely but does remain a possibility, the scenario for global growth is uninspiring; there are no other economies waiting in the wings to take the economic growth baton despite all the policy initiatives to boost growth, such as QE and 0% interest rates. In that sense, while China has been the catalyst for the recent slump in equity markets, it is not solely responsible for the economic growth malaise that the world now finds itself in, and neither is it responsible for the fact that the policy toolbox in the developed world is empty.
If the recent stock market falls are merely a correction, there will be good opportunities for long-term investors, and fund managers have been adding to their favoured holdings at attractive valuation levels. This has to be done with care, however, as some of the intra-day moves have been large. While these intra- day movements remain abnormally high, we are currently only carrying out essential portfolio changes to avoid this unnecessary risk.
In bond markets, core government bonds continue to offer little protection from the storm and only property has offered some negative correlation over the last few weeks. We have avoided core government bonds for some time now and we are not inclined to change that positioning given how they have performed.
On the policy front, we think it is now unlikely that the Bank of England will raise interest rates this year. There was even a suggestion put forward that further rate cuts could be considered, but our view is that this is not likely to gain support. In the US, market pricing suggests that the odds of a Fed rate rise this year are evenly balanced, but we think that the likelihood of a Fed rate rise in 2015 is fading rapidly. Indeed, irrespective of what happens in China, a ‘lower for longer’ interest rate environment now looks more likely.
We share the view is that this is a correction rather than the beginning of something bigger, although a great deal depends on what happens in China over the remainder of this year and into 2016. If authorities there can achieve a ‘muddle through’ scenario, then there is a good chance that the developed world will be able to do the same, and in that event the current slump could turn out to be a buying opportunity.
However, if the Chinese authorities cannot steady the ship, the outlook for global growth is lacklustre and that is the huge cloud over markets. In the short term delayed interest rate rises would be positive for equities (and emerging markets) and would help to support bond markets. However, in the longer term, the inability of central banks to raise rates modestly would be indicative of a very weak growth environment, which ultimately would be bad for equities. A world in which China exports deflation would be very challenging for corporate profits globally as pricing power is likely to be eroded.
The temptation at times like these is to avoid the markets and hold cash. The chart recently produced by BlackRock demonstrates comparative returns for equities, bonds and cash. Whilst the road for both equities and bonds is far from smooth it can easily be seen that the journey is well worth some of the very uncomfortable bumps on the way. This is undoubtedly a turbulent and uncomfortable time on the journey but it may well turn out to be a time to take advantage of the markets’ indiscriminate cull of all stock prices and support the opportunities that the fund managers are increasingly seeing. As we have written many times this year, it is looking as though 2015 will not be a vintage year, but equally this is not a re-run of the global financial crisis