The global economy
The primary cause of recent market volatility has been concern over the strength and stability of the Chinese economy. A general trend of weaker economic data and signs of debt distress in pockets of the country’s manufacturing base have given rise to concerns over prospective policy options and a growing recognition that a major currency devaluation may soon be imminent.
For the global economy, China matters. Since 2008 more than 50% of all economic growth has directly emanated from the country, with the secondary benefits of this expansion felt across the globe. However, as we have previously highlighted, much of this growth has been funded by increasingly unproductive debt. As this debt burden grows and economic activity falls, stresses increase within the corporate sector threatening an increase in non-performing loans and rising bad debts. In response the central Government is embarking on a series of fundamental economic reforms to rebalance and stabilise the economy. While these moves are to be welcomed, it would be naïve to believe the country can continue to expand at the same pace while this adjustment takes place.
With China slowing down, pressure increases on the rest of the world to maintain expansion. Here too the picture looks uncertain. Growth across Europe and Japan has picked up but from a very low base, while data from the US remains mixed, clouding the debate over the path of US monetary policy.
As a consequence both the IMF and World Bank have lowered their forecasts for growth in 2016 and 2017, while highlighting the risk of further cuts should the situation in Emerging Markets and Asia continue to deteriorate.
Monetary Policy – lower for longer… and longer
As expectations for growth in 2016 decline, so the prospect of a normalising of the interest rate environment recedes. In the UK, Bank of England Governor Mark Carney has again put back the prospect of any rate rise, while the deteriorating world outlook makes further stimulus from the ECB and the Bank of Japan increasingly likely.
Despite the continuing rhetoric we also believe the current situation will stay the Federal Reserve’s (the Fed’s) hand. The prospect of the predicted four rate rises in 2016 seems unnecessarily hawkish with a further bout of dollar appreciation a particularly unwelcome consequence. Current market expectations are for up to three 0.25% increases this year but we believe that this may prove excessively pessimistic. While further tightening cannot be ruled out, we feel Fed language will change during the first half of this year and that market participants could even be moved to anticipate further stimulus by year end.
Following the market sell-off the valuation argument in support of equities looks more compelling. While not absolutely cheap by historical standards, the removal of excessive market optimism suggests much greater realism over future prospects.
However, with valuations predicated on economic growth rates that will prove challenging to achieve in 2016, a sustained market recovery will require either better-than-expected corporate earnings or a shift in sentiment that drives investors to pay a higher multiple of earnings. Both to our mind seem unlikely.
While investors can take some comfort from aggregate market valuations, looking at the underlying components of market indices paints a different picture. The huge disparity in corporate performance has driven a widening gulf in valuations as investors rotate into the dwindling band of stocks immune to the current issues emanating from China. Increasingly narrow market leadership has pushed valuations to levels which leave little or no margin for error. This is visible in the high valuation of the ‘FANG’ (Facebook, Amazon, Netflix and Google/Alphabet) stocks and their significant impact in driving the performance of the US market.
In contrast to equities the short-term outlook for sovereign bonds seems more positive. Declining growth rates, low interest rates and further deflationary pressure give support to an asset class that has been widely discounted by many other investment managers.
Below sovereign bonds, however, the picture is less clear. Good quality corporates with sound balance sheets and strong operating cashflow should benefit as sovereign yields fall, but for debt issued by companies with high levels of leverage and deteriorating cashflows the situation can be expected to worsen.
This is particularly true within US high yield bonds, where these factors will lead to increased incidences of default. More than 30% of the value of US high yield debt is in some way linked to the mining or oil industries and many of these bonds are now trading at distressed levels.
Much of the weakness across global risk assets has been caused by the continuing decline in commodity prices. Iron ore, copper and coking coal amongst others, have all fallen sharply as Chinese imports have declined at a time when production capacity has been increasing.
However it is the decline in oil that has attracted most comment. From its 2014 peak the price of Brent Crude has fallen by 75% with the pace of decline accelerating in recent months. Much of the blame stems from supply side increases as long-term projects come on stream just as demand declines. However there are other forces also at play. Firstly the growing threat of political instability across the Arabian Gulf is driving a production and pricing policy from Saudi Arabia that is dictated more by domestic internal pressures than macroeconomic considerations. Secondly, with global growth declining it is increasingly clear that even modest economic expansion will not take place with highly priced oil.
While the ‘oil dividend’ will be a benefit to oil-consuming nations across the developed world, the rapid pricing shift is creating significant stresses elsewhere. As we have already discussed, US high yield bonds issued by oil production companies have already fallen significantly, but as more and more capital expenditure projects linked to the industry are shelved or postponed, the ripple effects of contract cancellations and job losses are having a much wider impact.
While much of the press attention has focused on the prospects for oil and industrial metals the defensive quality of precious metals has been generally overlooked. In a market environment where asset-class correlations have risen significantly under three rounds of US Quantitative Easing (QE), the portfolio diversification benefits of gold should not be underestimated. Indeed should we see a more overt shift to aggressive currency manipulation then gold will become highly attractive as a store of value.
Cognisant of the threats posed to the global economy by weaker Chinese growth we moved to de-risk client portfolios through 2015. Reductions in our weightings to equities and high yield bonds were accompanied by increases in sovereign debt exposure and cash. We have also selectively begun to include gold in some portfolios as part of a further move to increase portfolio defensiveness.
Within equities we have retained a preference for the markets of Europe and Japan where monetary policy should remain supportive, while our negative view on China continues to support very underweight positions to Asian and Emerging Markets.
While we have some sympathy with the bearish stance articulated by a number of strategists and have positioned portfolios accordingly, we continue to feel that the more ‘cataclysmic’ predictions current attracting press headlines will ultimately prove unfounded. Global risk assets have experienced an unprecedented period of calm since 2011 as Central bank policy has dampened volatility and supported a ‘buy the dips’ mentality. In our view this excessively benign environment is in itself a problem, fostering excessive risk taking and blinding investors to inherent short-term risk associated with long-term investment. With current market weakness coming as a harsh reminder that all investment decions carry some attendant risk, we would view recent events as helping to purge the system of the excessive optimism that can over time create asset price bubbles and structural instability.
Economic growth will decline during 2016 and this will in turn create challenges for many across the corporate sector, however we would view the risk of a wider recession as unlikely while monetary policy remains highly accommodative. Against this backdrop active asset allocation and highly selective fund and stock selection will be the key to investment returns.
This article was previously published on Tilney prior to the launch of Evelyn Partners.