Market Bulletin (28/09/2015)
Shakes not quakes
As the volatility typical of the height of summer extended to September, investors could understandably be unnerved by the series of small tremors that has continued to rattle markets. Yet the factors driving market uncertainty – rising US interest rates and lower Chinese growth – represent normalisation of the global economy, rather than precursors to a more significant seismic event.
The measure of volatility in the S&P 500 index, the VIX, remained at elevated levels last week; but is way down from its peak at the end of August, and has tracked lower over the course of September generally. Nerves clearly remain high, and nothing brings out the bears like a spell of volatility.
It is notable, however, that in every year but one of the last 35 years, the S&P 500 index has seen a decline of at least 5% at some point in the year. Some years saw double-digit intra-year drops, but still ended with positive double-digit returns. Yet despite average intra-year declines of 14%, 27 out of those 35 years saw positive returns.
As Geoff MacDonald of EdgePoint says, “You can’t invest in the stock market and think for a minute that you’re going to go straight up. Volatility is not an ‘if’ but a ‘when’, and it’s what we do when it happens that really matters.”
Source: Bloomberg. VIX index data from 01/01/2015 to 28/09/2015.
Past performance refers to the past and is not a reliable indicator of future results.
Two uncertainties remain paramount. The Federal Reserve’s decision to leave rates unchanged on 17 September has left the question of rate rise timing unanswered – and the Federal Open Market Committee (FOMC) report did not provide as many clues as the market had hoped for. But in a speech delivered on 24 September, Janet Yellen expressed her expectation that rates would start to rise this year: “Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter.”
There is plenty of US data to support the case for a rate rise, from unemployment figures to headline growth. Whether it occurs in October, December or even January, the rise itself will come as no surprise. “The case for staying at zero is weakening,” according to Mark Stanley of Payden & Rygel. Yet until that rise is formally announced, investors can expect more volatility. Such is the short-term sensitivity of markets to headline events.
Yellen’s words on 24 September are a reminder – as if one was needed – that the eventual return to higher rates will only be achieved at “a gradual pace”. Tightening of monetary policy has not tended to have much of an adverse effect on equity markets in the past when, as now, it is based on an improved economic outlook and not on fear of overheating.
The second uncertainty causing tremors in markets is the pace of economic growth in China. In her press conference on 17 September, Janet Yellen pointed to slowing growth in China (and poor policy responses by the Chinese government) as a major cause of the Fed’s decision to hold rates. A volley of disappointing economic figures, together with slowing headline growth, has contributed to a sense that China is on the slide, which could have major implications for global growth.
In September, Chinese manufacturing activity reached its lowest ebb for more than five years. The Shanghai Composite Index has lost two fifths of its value since its record high in June (although it had clearly overreached itself and is now at the same level as it was in February). Headline growth in China has slowed from the double-digits of the 2000s to 7.4% in 2014. This year the IMF expects the country’s economy to grow at 6.3%, below Beijing’s 7% target, although recent weeks have also seen a number of economists arguing that the true growth figures are lower still.
The reality is that double-digit growth in China always had a time limit. From the time of Deng Xiaoping’s market reforms in the 1980s, China has been making a fast-paced transition from an agricultural to an industrial economy and, in the process, became the factory for the world.
Today, however, the country is entering a new phase of development, with greater focus on skills, technology and services. As Hugh Young of Aberdeen Asset Management observes, “The days of fixed investment and exports driving China’s growth are coming to an end.” The country is also beginning to feel the effects of its population policy since 1949. Both of these trends imply a lower rate of headline growth – not a crisis.
For these reasons it is important to look beyond manufacturing output and to consider the outlook for consumer retail, which must now pick up some of the growth slack. Here, the figures are more encouraging. Retail sales were up 11% in August versus August 2014. There were also positive figures for air passenger numbers, house prices, cinema receipts, and mobile phone contracts.
Moreover, analysis from Capital Economics showed that, while GDP growth is lower than the official 7%, it has actually stabilised in recent months. Likewise, in a recent interview, Mark Schwartz, the chairman of Goldman Sachs Asia Pacific, said he was not expecting a ‘hard landing’ for China. Instead, he said, the market had overreacted to ill-advised short-term policy decisions over the summer, and some disappointing data. More broadly, it is important to remember that in recent years the services sector in China has been accounting for a growing share of GDP growth.
Dropping a gear
The Shanghai Composite Index ended slightly down at the end of last week, having spiked midweek as funds flowed out of US- and European-listed stocks on news of Volkswagen’s misdemeanours. It also received a boost from news of a potential tie-in with London’s stock exchange.
The S&P 500 ended the week down 0.57%, while the FTSE 100 Index was unchanged over the week after surging nearly 2.5% on Friday as Yellen’s words helped reassure investors about the strength of the US economy. The FTSEurofirst 300 Index also recovered ground on Friday, but was down 1.5% over the week.
Although worries over global growth continued to tell on markets, the headline news of the week was that Volkswagen had fitted its diesel vehicles in the US with illegal “defeat device” software that ensured artificially low emissions readings. It quickly became clear these devices had been fitted on European cars too. There had already been concerns over the outlook for car manufacturers, given falling demand in emerging markets, but the Volkswagen case raised worries that other car companies are likely to be at fault too.
Stuart Mitchell of S. W. Mitchell Capital had halved his position in Volkswagen several weeks ago on concerns over China’s slowdown. Whilst the outlook is undeniably uncertain, he observed that, “On the basis of the sum of the parts, the business is worth around €250 per share, after allowing for likely fines, against a current share price of €105. However, its industrial stakes in Porsche, Scania, Man and financial services are worth €111 per share on their own.”
More broadly, concerns persisted over the marginal level of inflation in Europe. On Wednesday, ECB chairman Mario Draghi said that it is still too early to make a decision on a further round of quantitative easing, noting that price growth will take longer to materialise than previously expected.
The recent asset shifts from equities to bonds reflect a nervous market with low expectations, and underline once again the importance of maintaining a diversified investment strategy. For all the current volatility, it is important to remember that global GDP growth looks healthy; the IMF predicts global growth of 3.3% for 2015.
A marginal Fed hike should not spook long-term investors. In fact, after six years without change, a rate rise will be a step on the path towards recovery after the financial crisis, and a sign that emergency-level interest rates are no longer needed. Similarly, although perhaps of less global significance, an eventual rate rise by the Bank of England will be confirmation that the economy is getting back to normal.
As for the world’s second-largest economy, growth has undoubtedly slowed, but that is no reason to expect it to keep sliding ad infinitum. Moreover, China’s contribution to global GDP growth has barely diminished since the 2000s – its growth rate has declined but remains significantly higher than the global average.
Short-term tremors will continue to worry the markets on a day-to-day basis, but investors should continue to look beyond this ‘noise’ to the calmer days that should follow a Fed rate rise and a stabilising in Chinese growth figures. In the meantime, it’s important to remember that a few tremors do not an earthquake make.
Aberdeen, EdgePoint, Payden & Rygel and S. W. Mitchell Capital are fund managers for St. James’s Place.
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