The Nobel Prize-winning economist Paul Samuelson famously joked that “Wall Street indexes predicted nine out of the last five recessions.” We think this is apt wisdom given the signals that financial markets are sending investors. Indeed, this January was one of the toughest on record as various parts of the market are pricing in a high probability of recession. According to Bloomberg, at least forty equity indices are in bear market territory (defined as a 20% decline from their recent peak), including the Eurostoxx50, Germany’s DAX, and Japan’s Nikkei 225. That said, we believe the current market weakness has more to do with idiosyncratic issues stemming from China and oil and their second-order effects than a sudden fall-off in global growth. As expressed in our 2016 Outlook “Finding Opportunities in a Changing World,” we believe this year will see a continuation of the business cycle, led by developed markets, amid still-friendly monetary policy conditions which will support risk assets going forward
The principal drivers of the most recent market weakness have been China and oil markets. Regarding China, investor concern has risen materially amid the 24% decline in the Shanghai Composite this year and the uncertainty regarding the pace of the renminbi’s depreciation. It is important to understand that China’s equity markets are an Imperfect gauge for assessing the fundamental economic picture; just as the 65% rise in the Shanghai Composite in the first half of 2015 did not mean China was returning to double-digit growth, the rapid sell-off does not mean China is on the brink of recession. Momentum-driven retail flows, margin-financing and policy missteps, including the implementation of a failed circuit-breaker system, are the more likely contributors to China’s equity market volatility.
China’s transition from an investment-driven, export-oriented growth model to one based on services and domestic consumption is the more important story for investors. On that basis, a deceleration in growth towards 6.0-6.5% is a natural part of this process. While China’s most recent statistics showed that growth rose 6.9% in 2015, the fact that services accounted for 50.5% of growth, its highest on record, is indicative of this transition.
A gradual liberalization of China’s financial markets, which includes a progressive depreciation of the renminbi against the U.S. Dollar is part of this process. We believe current investor anxiety over the currency depreciation has more to do with its unintended consequences and lack of clarity over its amplitude, than it does the policy itself. These include the impact such a depreciation will have on China’s competitors for exports and the prospect of currency wars. On this basis, greater policy clarity and communication from the Chinese government can go a long way towards restoring confidence in its approach. On the growth front, we expect the government will continue to maintain easy monetary policy, and could introduce other measures, including the possibility of a large fiscal package to support growth should conditions deteriorate further.
The second major driver of market weakness has been the sharp fall in the price of crude oil which was down 28% on the year before last week’s rally. We believe January’s sell-off had more to do with near-term issues than the larger, and more influential, supply and demand picture. These shorter-term drivers included the earlier-thanexpected removal of sanctions against Iran which could result in an additional 500,000 barrels of oil per day coming to market this year, as well as an abnormally warm winter in both the U.S. and Europe which increased inventories of heating oil and other refined product. Of greater importance is the medium-term supply and demand picture which we believe will be brought into balance this year.
While Saudi Arabia is unlikely to make substantial cuts to its production this year as it continues to fight for market share, we expect higher-cost U.S. shale producers to cut around 700,000 barrels per day in production. This includes cuts from so-called stripper wells which produce no more than fifteen barrels of oil per day but together produce around one-tenth of U.S. production. As global demand continues to rise, albeit moderately, U.S. production cuts will help balance the market. According to The Economist, energy firms have already cut around $380 billion in capital expenditures for new projects. The prospect for a consolidation in the sector through merger and acquisition activity later this year will also play a role in rationalizing supply.
Against this backdrop, the direction of global monetary policy has eased as the fight against deflation continues. At the most recent meeting of the European Central Bank (ECB), President Mario Draghi indicated that fresh easing measures were likely as soon as March, which could include another deposit rate cut to -0.4% or an expansion of the asset purchase program from EUR 60bn to EUR 80bn per month. This is meant to stabilize inflation expectations which at 0.5% according to the German 5-year breakeven rate, are well below the current inflation target of “below, but close to, 2%.”
The Bank of Japan meanwhile surprised markets by introducing negative interest rates at its meeting on January 29th. While the share of deposits that will actually earn -0.1% will remain low, the introduction of this regime is more of a signal indicating that the Bank of Japan can pursue alternative means, aside from pure balance sheet expansion, to ease monetary policy and curb the strength of the Japanese yen. Since its bottom, the Nikkei is up 11.5% while the yen has weakened 3.8% to 121.4. We expect this negative correlation will continue to support Japanese equities.
The U.S. Federal Reserve meanwhile is highly unlikely to raise interest rates this March. While its most recent statement was not particularly dovish, it noted “global economic and financial market developments,” which at least at this point are likely to keep the Fed on hold. Given benign price pressures in the U.S. with core PCE inflation at 1.2% and the ramifications of a stronger U.S. Dollar on global growth, we do not think the Fed will hike rates more than twice this year and may wait until after June for its next hike.
What does this all mean for our asset allocation? We continue to favor a pro-risk portfolio and believe the current correction in equity markets will subside as the conditions for a U.S. or worse, global economic recession are not present. Global PMIs remain in expansionary territory and credit growth continues to expand in the U.S. and eurozone. We continue to favor European and Japanese equities on the basis of a strong monetary policy backdrop and earnings momentum as both markets should deliver high singledigit earnings growth this year. While we believe U.S. equity markets will end the year higher, we continue to have a more cautious view given more expensive relative valuations, weaker earnings, and higher costs of capital. While valuations on emerging market equities are optically cheap at 1.2x price-to-book for the MSCI Emerging Market Index, we remain underweight until we see more encouraging signs of growth.
The U.S. high-yield market continues to send the loudest recessionary signals, as spreads hit their cycle peaks in January but finished the month lower at 777 basis points. This is largely a function of the energy sector, which makes up around 16% of the high-yield market and yields 17.8% according to Bank of America. While we continue to expect an increase in default rates to around 4.5%, this is largely priced into the market. We expect high-yield to deliver mid-single digit returns but prefer European high yield given better balance sheet fundamentals and less exposure to the commodity sector.
While the global economy is not booming, it is also not falling into recession as many parts of the market suggest. If anything, the most recent weakness reflects a host of near-term market dislocations than it does a massive adjustment to the fundamental outlook. We think the fundamental conditions are ripe for a market bounce but require a catalyst to restore the much-eroded investor sentiment, whether in the form of a more sustained commodity rebound or improvement in emerging market growth. In the near-term, we continue to assume a more tactical approach to asset allocation to take advantage of financial markets which have gotten ahead of economic fundamentals. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance.