Widespread fears over ongoing stock market and currency weakness in China, the falling oil price, geopolitical tensions, overvalued assets and an end to fiscal stimuli have led to stock markets plunging around the world. The bear appears to have his claws out and investors with shorter memories may well be spooked.
Oil prices have once again played a key part in this fresh round of market sell-offs, with Brent crude slumping to a little over $27.5/barrel on 20 January – down 75% from its June 2014 high of $112/barrel and 39% off the $45/barrel price we saw as recently as November 2015. Indeed, there are fears that the rock-bottom oil price may even put some oil companies out of business.
Bear markets are typically defined by a broad range of indices falling by 20% or more from their most recent peaks. At the time of writing, at 5,673 the FTSE 100 index is 20.3% off its April 2015 peak of 7,122, while the Dow and the MSCI AC World indices are not far behind. If a bear market is also defined as one where investors should expect further sell-offs, then we may well be in the bear’s claws.
Ironically, the drivers of this bear market may be found in economic policies aimed at stabilising global economies. Volatility has been artificially low in recent years due largely to quantitative easing (QE), with markets settling into a pattern of reassurance that modest earnings growth would continue all the while asset prices were being boosted by QE.
I’ve previously referred to this as markets ‘resting easy as they drank from the punchbowl of QE’, but recent events indicate that markets have perhaps had their fill and, even if the QE bowl is not yet empty, it might as well be.
This should not have come as a shock to investors
The recovery of financial asset prices from the nadir of the last financial crisis has been dramatic; indeed, it has been one of history’s most fruitful periods for investors. The six years ending March 31 2015, for example, stand at the apex of historical six-year returns for the US stock market.
The Greek debt crisis made markets sit up and take notice – reminding them that bull runs do not last forever – while in December the US Federal Reserve embarked on a tightening of policy which eliminated one of the financial markets’ greatest tailwinds. The era of asset price reflation, fueled by both post-crisis undervaluation and aggressive central bank easing, is over and we cannot rely on our returns being flattered by QE or other valuation recovery dynamics.
At a global level, expected earnings are lower than they have been for five years while prices are much higher even if, while volatility is high and rising, it is not in territory that typically marks capitulation and is some way off the levels of volatility we saw in 2008.
China, of course, remains a key driver of volatility. Its economy is slowing as it desperately tries to rebalance (even if the recent rate of decline is not as bad as many feared – for example, its recent quarterly GDP figure indicated growth of 6.9%, marginally better than many analysts expected). This slowdown has already resulted in currency depreciation and stock market woes, which have spilled over into other Asian markets and across the world.
Yet fears over China are also not new and we have warned for some time that the ongoing slowdown in the country would pose challenges not only for Asian and emerging markets investors but for financial markets globally.
Now is not the time to throw in the towel
Dollar strength, liquidity, credit spreads and Brexit also remain key concerns. Yet this is not the time for investors to throw in the towel, as some pugilistic analysts and doom-mongers have suggested.
Investors should be aware that 2016 will be a low growth, low return world, with corporate margins pressured by weak end demand and overcapacity in a number of industries.
The outlook for emerging markets (EM) remains challenging, particularly for those countries that have built their economies to serve Chinese demand for commodities. The outlook for these countries is downbeat, and weaker currencies may not help to lift demand for EM exports where consumer and corporate demand is subdued. A world where the US tightens policy but other central banks retain an accommodative stance should mean a stronger dollar, all else being equal. That is likely to be a further headwind for EMs, as there is a strong inverse correlation between the dollar and emerging markets.
Active managers using multi-asset allocation strategies are well-placed to ride out short-term shocks in markets. The rising tide of global QE that had lifted all boats will begin to ebb, and in that environment it will make sense to differentiate within and across asset classes. In this world, a focus on valuations and fundamentals – ‘old school’ investing if you like – should be more important than it has been in recent years, when markets were backstopped by abundant and growing liquidity.
Longer-term investors know that what can feel like an emergency in the short-term may not hold as much significance some years down the line, so a focus on old school investing values makes particular sense in such a volatile world.
Tackle the bear
But if we are to tackle the bear, we would ideally like to see some markers of stability. If China and its investors could accept the country’s need to rebalance its economy, we might see a smoother stock market ride. Oil price stability would also help, but the situation in the Middle East is difficult to fathom, defined by Saudi Arabia’s continued willingness to pump oil even at current prices and its squabbles with Iran. With demand falling, partly as a result of US shale oil flooding the market, oversupply remains a key issue and it remains to be seen how the geopolitical factors in play will pan out.
Even if the prospect of further interest rate rises have been pushed a little further towards the horizon, they arguably remain one of the key threats. The macro and company indicators that we are seeing at the moment – subdued growth and inflation, soft final demand and a deteriorating outlook for corporate earnings – are not the kind of the things that one would expect to see when the world’s most important central bank, the US Federal Reserve, is starting an interest-rate tightening cycle.
It is clear that the Fed is very keen to start normalising interest rates, but if one simply looked at the data in isolation, it is hard to come to the conclusion that the Fed needs to raise rates quickly or aggressively. The recent US jobs data releases have been strong, but they need to be set in context – labour participation rates in the US are still at 40-year lows. Markets do expect the Fed to act, and we expect the FOMC to do so in a controlled and sensible manner. If the Fed loses control of its own narrative and policymakers are seen to ‘flip-flop’, markets could react strongly.
What does all this mean from an asset allocation perspective? In terms of valuations, we still regard equities as more attractive than bonds and expect to retain that positioning for now in our asset allocation portfolios, although with less conviction than we have done for some time. However, compared to their longer-term history, equities still offer better value than bonds.
Mark Burgess is CIO EMEA and Global Head of Equities at Columbia Threadneedle Investments.
