September 2015 – Markets are Bruised, Not Beat
The end of August saw global equity markets undergo their steepest declines in more than four years as a repricing of global growth sent share prices sharply lower. While emerging market equities were already down some 13% before the sell-off, developed market (DM) equities had been relatively unscathed. That changed when China’s benchmark index posted its biggest one day loss since 2007 on August 24, closing 8.5% lower. This prompted selling across risk markets and resulted in the first correction (10% decline) in the S&P 500 since 2011.
When assessing macro-driven market moves, it is important to distinguish between the backdrop and the catalyst. The backdrop to the late-August sell-off was an environment of tepid global growth, collapsing commodity prices, and broad-based declines in global capital expenditures. Emerging markets stand at the epicentre of this, which are expected to grow at just 4.2% this year, well below their potential of 5.5%. The collapse in certain emerging market currencies such as the Malaysian ringgit and Indonesia ruppiah which are at their weakest levels since the Asian financial crisis of 1998, exemplify this growth dynamic. Import revenues from commodities have dried up and global trade contracted at its fastest pace since the Great Financial Crisis in the first half of this year. This stands in stark contrast to the fundamentals of developed markets which are the strongest they have been in years.
It is no coincidence then that the catalyst of the mini-crash was to be found in the emerging world. We believe China’s shock devaluation of the Renminbi was the main culprit.
The move weakened China’s currency by around 2%, bringing it more in line with market fundamentals but raising fears about a global currency war. The irony of this situation is that China’s devaluation is a policy consistent with the liberalization of its financial markets and is probably beneficial to the country’s economic transition in the long -run. Yet long-term gain means short-term pain, especially if it is not met with support from the People’s Bank of China to cushion the volatility.
The broad based equity market sell-off that ensued was characterized by a high degree of anxiety among investors. We attribute this to the fact that previous growth scares which took place during this six-year bull market were often “short-circuited” by central bank policy intervention. The usual suspects were the U.S. Federal Reserve, European Central Bank (ECB) and Bank of Japan (BoJ) all of which were able to soothe markets through additional quantitative easing or forward guidance. A re-pricing of growth which emanates from emerging markets requires an emerging market response. This adds additional uncertainty to the market. We believe that the People’s Bank of China will continue to add liquidity and attempt to defend a floor on equity markets through additional cuts in the amount banks need to set aside and cuts to its benchmark interest rate. Other emerging markets however will require not just liquidity but a policy response to boost investment and stimulate domestic demand which will not occur overnight.
So what does this all mean for our asset allocation? We believe that great bull markets do not die in a period of two weeks and the current correction is taking place within the later stage of a secular bull market. That being said, this correction did enact a not-insignificant bruising to the market and investor confidence. While we believe that equity markets will finish the year higher, the slope of that move probably got a little less steep.
We continue to have a favorable view towards European equities and increased our exposure at the expense of U.S. equites in the midst of the sell-off. As we have written about in the past, U.S. equities are challenged by relatively higher valuations, record high profit margins and the absence of earnings momentum. European equities look more attractive from a macro point of view, especially as central bank policy diverges. Eurozone PMI numbers are holding steady and are close to recovery highs. Meanwhile, earnings revisions have also improved over the last month, save for the most EM-exposed firms. Continued QE by the ECB, stronger demand for credit and domestic demand, as well as more attractive equity market valuations underpin our view that European equities will outperform their U.S. counterparts in the medium-term.
Our view on Japan also remains firm as the fundamental drivers continue to support equity markets: expansionary monetary policy, firm earnings growth, and buybacks. In addition, the merging of the country’s public pension programs which officially begins in October should see additional pension funds (aside from the Government Pension Investment Fund) increase their allocation towards domestic equities. While the yen could strengthen in the near-term on “riskoff” trades, we think its trend of depreciating against the USD remains intact.
Credit markets have also come under pressure as of late, especially in the U.S. as weaker commodity prices weigh on high yield. Despite losing more than 2.6% over the last three months, the Bank of America-Merrill Lynch HY Index is still up 1.1% on the year. We expect that HY spreads will end the year tighter and absorb the increase in U.S. Treasury rates as the broader macro-environment in the U.S. finds solid footing. We have a less sanguine view on investment grade credit as record-issuance has led to spread widening. While we also expect investment grade spreads to end the year tighter, much will depend on whether September sees another large round of major issuance.
Undoubtedly, the last three weeks have complicated the calculus for the Federal Reserve. The market is now pricing in a 38% chance that the Fed raises rates, down from 48% in mid-August. We are less convinced the Fed will “lift-off” in September should equity market volatility remain at elevated levels. That being said, on its own, the U.S. economy appears ready to begin normalization. Second quarter GDP was revised upwards to 3.7% on an annualized basis from 2.3%. More recently at a speech in Jackson Hole, Fed Vice Chairman Stanley Fischer said “there is good reason to believe that inflation will move higher”, another indication the Fed is on course to raise rates this year.
A 10% correction in equity markets is not fatal. The key challenge lies in determining how much of the sell-off is warranted by a change in the fundamentals and how much is a function of markets overshooting. On this basis, we continue to identify opportunities amid a landscape which has become more uncertain. This environment is complicated by divergent monetary policies, heightened currency volatility and loftier valuations on financial assets which has incentived greater risk-taking among market participants. 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. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.