Market Bulletin (19/01/2016)
As equity markets around the world continue their New Year slide, those already invested or thinking of investing might understandably be concerned about what the near-term future holds. Faced with such uncertainty, it is worth remembering some fundamentals, both in terms of the wider global economic picture and the disciplines of long-term investing.
Confucius said that the superior man acts before he speaks; after last week’s slide on markets, he might choose different advice for the People’s Bank of China.
Global equities have suffered their worst start to the year in decades, last week the price of oil settled below $30 a barrel for the first time in 12 years, and the VIX index (which measures volatility on the S&P 500) has only once closed outside its ‘danger zone’ since the New Year.
The New Year has brought old worries aplenty, whether geopolitical risk in the Middle East or the escalation of the car emissions scandal, or below-par inflation in the developed world. Yet, above all, it is the combination of China’s slowing growth and the collapsing oil price that has driven down markets in 2016.
At the end of last week, the Shanghai Composite and Hang Seng (Hong Kong) stock indices had fallen 18% and 11% since the New Year. Yet that alone should not worry too many investors – the Chinese stock markets (particularly on the mainland) are notoriously volatile and immature, while their exceptionally high share of local investors means emotions trump fundamentals even more than on other major indices.
Of course, once sparks begin to fly, investors and economists alike will tend to look under the bonnet. In China’s case, even a cursory look at the engine of growth shows that the country’s economy is not generating what it once was. Given that China accounts for such a high proportion of global growth, realisation of this fact was always bound to have a major impact on markets.
“There is no doubt the Chinese economy is experiencing a substantial slowdown,” says Chris Ralph, chief investment officer at St. James’s Place. “One reason is the slow transfer from an economy based on manufacturing to one based on services.”
Yet while stocks slip and slide, slowing economic growth is of course very far from adding up to an economic crisis – some of the major consumer indicators remain encouraging. “We think the fears are exaggerated,” says Richard Oldfield of Oldfield Partners. “The latest figures for car sales in China show that the economic rebalancing is not going too badly.”
But even market petulance and a tendency to sensationalise slowing growth may not be enough to explain quite what has gone sour in global markets in 2016. Instead, to return to Confucius, China appears to have a communication deficit when it comes to financial markets. Worse still, that deficit reflects flaws in governance that make the party state ill-equipped to address market fears.
“The Chinese stock market is always volatile and recent weakness has been magnified by some ill thought-out interventions which have had the opposite outcome to that desired,” says George Luckraft of AXA Framlington. “The recent underlying data for the Chinese economy has not been bad.”
Since Xi Jinping took power in 2012, the Chinese government has adopted a more paternalistic approach to both politics and economics. Despite limited economic firepower at the top, the government has even shown a reluctance to de-politicise day-to-day economic and financial decision-making; even China’s central bank has not been accorded proper latitude to make its own decisions.
As a result, monetary and financial policy has become a contributor to fear and confusion on markets. Beijing’s regular currency interventions, while keeping short-term investors happy, prevent the renminbi finding its natural level. The price of such inexpert micromanagement is instability.
The US Federal Reserve’s December rate hike had been so well signalled to markets that it caused only marginal stock ripples. At the People’s Bank of China, external relations are conducted by fax – symptomatic of its distant relationship with market players. Markets can often stomach even bad policy if it is well-signalled.
Without independence or a voice of its own, China’s central bank is unlikely to develop a mature relationship with markets. While this does not yet pose a major threat to growth, it does mean that Chinese stock markets are liable to remain choppier than most.
Major indices around the world fell last week largely on a mix of fears over China and ever-cheapening oil – rate rise expectations globally may yet be hit as a result although some losses were pared back later in the week. The S&P 500 ended the week down 2.69%; the FTSE 100 was down 1.83%; Japan’s Nikkei ended down 3.11%; the FTSEurofirst 300 closed the period down 3.24%.
The most liquid, reliable stock markets are by their nature more international; this makes them more vulnerable to shocks from abroad. But single-digit index dips need to be seen in context. Data from J.P. Morgan shows that, over a 30-year period, the FTSE All-Share Index saw an average intra-year peak to trough decline of 15.8%, yet annual returns were positive in 21 out of 30 years.
But these short-term movements are useful for long-term investors, because they provide opportunities to acquire quality companies at deflated prices. There is not much money to be made when everyone else likes the same stocks.
“The benefit of weak commodity prices is reflected in good increases in consumer disposable income and could explain the better-than-expected experience of the food retailers over the Christmas period,” said George Luckraft of AXA Framlington. “The correction in share prices is bringing the market back to levels where it is becoming much easier to find value.”
“One of the only two technical indicators we follow is the Advisors’ Sentiment Report from Investors Intelligence, which is a marvellous, although of course not flawless, inverse indicator,” says Richard Oldfield of Oldfield Partners. “When newsletters are bullish, it is a danger sign because everyone is invested; when they are bearish, it is a tremendous positive because there will be a lot of uninvested cash about.”
“This indicator is now at an extreme,” says Oldfield. “Well over 30% of newsletters are bearish and under 30% are bullish – that’s usually the precursor to a strong rally in markets.”
Oil and water
Source: Bloomberg. Data correct as at 18 January 2016
Among the greatest ripple effects of slowing growth in China is the fall in the price of oil, which was last week below $30 for the first time in 12 years – China has accounted for almost half of the growth in demand for oil over the past decade, largely due to manufacturing needs. In India, a bottle of mineral water is now more expensive than the same amount of oil. Given that several major banks said last week that oil may dip to $20 a barrel, India’s experience may yet become much more common.
Unlike last week’s market falls, the declining oil price may be a much longer-term phenomenon. It has already claimed some important victims – last week came confirmation that all government departments in Russia would need to make immediate budget cuts of 10%; the country has been hit especially hard by cheap oil. Subdued metal prices may be similarly fundamental – sparked by slowing manufacturing in China together with increased supply and global inventory hitting capacity ceilings.
The oil price drop has had a major impact on both equities and bonds – and thrown up new opportunities. “The slowdown in China, leading to weakness in commodities, has caused bond prices to decline,” said Scott Service of Loomis Sayles. “China’s growth is moving from the 8–10% range down to a 4–6% range. They have overcapacity in property and industrials but they have $3.3 trillion in reserves. It will be a bumpy road but they have levers to pull to transition the economy from manufacturing to services. I just see it as an opportunity to invest in credits currently being negatively impacted by this environment.”
Given the preoccupation of markets with these factors, it is also easy to forget the continued primacy of the US economy. US retail figures came in down a marginal 0.1% for December, but the previous week’s payrolls data continues to offer a major reason for optimism – as, of course, does headline growth. Moreover, US consumers have received a helping hand in the form of cheap oil.
It is also important to note that, in the midst of such equity turmoil, corporate and government bonds have held up relatively well, emphasising the value of a diversified portfolio strategy.
“We do not expect a recession in the US or globally,” says Richard Oldfield of Oldfield Partners. “And we think that the idea of recession is embedded in the valuations of very many companies in Europe and Japan and some, albeit a lot fewer, in the US, which is indeed in aggregate rather expensive. We feel there is plenty of opportunity.”
Stuart Mitchell of S. W. Mitchell Capital echoes Oldfield’s view. Against the backdrop of steady economic recovery in Europe, and as austerity eases and consumer confidence improves, he sees the nervousness in markets as providing plenty of scope for discerning stock-pickers.
“Our meetings with domestically orientated companies have generally been very encouraging,” says Mitchell. “We should also remember that China only makes up 4% of eurozone exports. The current turmoil is throwing up some extraordinary opportunities for us, particularly in the more cyclical areas of the domestic economy.”
Moreover, when fear drives markets down together, it often ignores sectors where fundamentals remain unchanged.
“Fear is back and exactly on cue: investors are herding into the same four safety sectors – consumer staples, utilities, healthcare and telecoms – on the premise that, no matter how bad things get, people will still buy toothpaste, pay their electricity bill, get their prescriptions and use a phone,” says Tye Bousada of EdgePoint.
Bousada’s particular focus is finding companies well-positioned to grow in the future – but ensuring he is not having to pay for that growth. “We’re finding lots of opportunities because of the fear,” he says. “Our cash in the global portfolio peaked last year around 15%. In November it was 9% and today it’s around 5%. We’ve said this many times in the past, but it’s worth repeating: volatility is the friend of the investor who knows the value of a business and the enemy of the investor who doesn’t.”
Nick Purves of RWC has built up cash over the last year as some valuations became extended. “Should market weakness continue then it may offer the potential to put that cash to work at much more attractive valuation levels in quality companies, underpinning long-term equity returns,” he says.
George Luckraft of AXA Investment Managers takes a similar line. “As Warren Buffett says: ‘Be fearful when others are greedy and greedy when others are fearful’,” says Luckraft. “There is certainly plenty of fear around at present.”
- In the immediate future, China’s slowdown and falling commodity prices are likely to continue to steal the headlines and unsettle markets. But other major economies, such as in the US, UK, eurozone and Japan, are generally improving, with data suggesting that there is little to support the case for a significant global economic downturn. “The decline in the oil price, though obviously creating problems for energy companies, is basically stimulative,” says Richard Oldfield.
- Recent years have been characterised by low market volatility. The current return to more normal levels can be unsettling. But, whilst painful, it should not be feared; long-term investors can take advantage of the opportunities to buy quality companies at attractive valuations when share prices overreact to short-term noise.
- Whilst it can be tempting, timing the market is impossible to get consistently right. A recent study of US retail investors showed that, over a period of 30 years, those who attempted to time the equity market by buying at the bottom and selling at the top achieved an average annual return of less than half that of the benchmark S&P 500 index.
- Current markets demonstrate once again the value of diversification across a range of asset classes to help cushion your portfolio from short-term fluctuations.
AXA Investment Managers, EdgePoint, Loomis Sayles, Oldfield Partners, RWC and S. W. Mitchell Capital are fund managers for St. James’s Place.
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