Global equities have suffered their worst start to a year since the Great Depression, credit markets have seized up, and there has been a rush towards traditional safe havens. Investors seem petrified. But of what? And, crucially, will the market turmoil persist?
Chinese growth and policy uncertainty
The Chinese authorities’ reputation for being skilful economic managers has been badly damaged by the ineffectiveness and opacity of their latest policy measures. Firstly, Beijing was forced into an embarrassing policy u-turn after the introduction of ‘circuit breakers’ intended to smooth stock market swings actually exacerbated volatility.
Secondly, the government recently announced that it would begin to measure the renminbi against a trade-weighted basket of currencies rather than just the US dollar. However, it failed to provide definitive guidance about the new currency regime. This raised concerns that China might resort to a significant devaluation of its currency to boost its economy, prompting large-scale capital outflows and fanning fears of global deflation. These ill-judged policies have led investors to question whether Chinese policymakers have the ability to manage the country’s economic slowdown.
Growth concerns are no longer confined to China and Emerging Markets. A tepid US 4Q15 GDP report, manufacturing sector contraction, and evidence of ebbing momentum in the services sector have sparked fears that economic weakness is also spreading to the world’s largest economy. Such weakness is perhaps unsurprising, given that the broad dollar effective exchange rate has risen by about 20% since mid-2014 – the greatest dollar shock in recent decades. This has caused financial conditions to tighten by around 250bps, which should have already curbed annual GDP growth by around 1-1.5%. After the seemingly premature rate hike by the US Federal Reserve in December, investors worry that financial conditions will tighten even further, potentially dragging the US economy into recession.
If a US recession were to occur, it would likely begin in the corporate sector, where profits are down almost 3%, investment has slowed, and credit conditions have deteriorated. High-yield spreads started to back up towards the end of last year, initially reflecting pain among energy producers, but there is evidence that tighter borrowing conditions are spreading beyond the hard-hit energy sector and beginning to impact corporate America more widely.
Dwindling firepower of central banks
Just as fears are mounting about global growth momentum, there is a loss of confidence in the abilities of central banks to counteract an economic slowdown. Conventional policy is exhausted across much of the world. To provide additional monetary stimulus, most central banks can turn only to more quantitative easing or experimental measures such as negative rates. With quantitative easing apparently becoming less effective, several central banks have felt compelled to take interest rates below zero. Sweden, Switzerland, Denmark, the eurozone and most recently Japan – constituting almost a quarter of the global economy – have all introduced some form of negative interest rate policy in an attempt to fight deflationary forces, weaken their currencies and stimulate growth. Some believe the Federal Reserve will have to follow suit, despite its move to raise rates in December. Unfortunately, investors view these experimental measures as an alarming reflection of dwindling central banking firepower, and many argue that the latest weapon could do more harm than good.
That is because banks struggle to pass negative interest rates on to depositors, most of whom would simply convert their deposits into cash if asked to pay for their accounts. Thus, negative rates are likely to squeeze bank margins, threatening profitability and potentially curbing bank lending. This has exacerbated fears that lower quality European banks may be unable to generate sufficient earnings to enable non-performing loans to be written off. These fears are manifest not only in the precipitous falls in bank stocks since December, but also dramatically so in the firesale of many contingent convertible bonds. If the ‘CoCo’ market and other sources of funding continue to dry up, then fresh equity or even government rescues may again be required.
Commodity price weakness
While the rapid collapse in the ‘CoCo’ market has spooked investors, the prolonged slide in commodity prices also continues to weigh on risk appetite. This decline is imposing economic and fiscal stresses on commodity-exporting countries. Such pressures are causing sovereign wealth funds to liquidate assets in order to fund these fiscally challenged governments, draining Petrodollars from the financial markets. Though the oil price has shown signs of stabilisation recently, unless there is a significant recovery from here, some oil-producing countries and regions will never be the same again. We believe that US shale losses are containable within the system, given their size relative to the deepest capital market in the world. The real issue for banks will likely stem from Brazil, Russia and the Gulf, where the property markets and banking sectors look particularly challenged.
Weak commodity prices could also spark geopolitical tensions, especially in commodity-producing emerging economies. This adds to a growing list of geopolitical risks facing the global economy. In the US, there is a chance that the next president will be a hardline populist. Similarly, populist extremism is on the rise in Europe as the region comes to terms with unprecedented waves of immigration, potentially calling into question the future of the EU. Regional unity faces a more immediate test in the form of Britain’s referendum on leaving the EU, which might give fresh impetus to other independence movements. Then there is the growing threat of conflict between major powers, with Russia and China both becoming more assertive in recent times. All these factors serve only to increase uncertainty, intensifying the general ‘risk off’ sentiment in markets.
So where do we find solace amid the gloom? For
all the fears of a US recession, the data has not been too bad. Indeed, while
the US manufacturing sector is clearly struggling, consumption and employment
data remain reasonably buoyant. If recession fears subside, high-yield bonds
may rally from oversold levels, loosening credit conditions for corporate
America. Moreover, though we regard renminbi depreciation as a major risk,
after meeting with the PBoC last month we are more confident that the Chinese
authorities are alert to the concerns of international investors and will
adjust the currency with reference to a trade-weighted basket. This should
gradually reassure investors that Beijing has not lost control of its currency.
It also seems premature to conclude that central banks have run out of
After all, there is an
enormous amount of political capital invested in the situation and nobody will
want to admit that they have been getting it wrong. More unconventional
policies are likely to be implemented, perhaps even including measures such as
‘helicopter money’. This would attempt to combat the world’s chronic demand
deficiency by putting money directly into people’s banks accounts. Finally,
despite the problems facing European banks, we do not believe this is a sequel
to the 2008 crisis, when markets doubted banks’ solvency, banks struggled to
fund themselves, and credit markets collapsed. Today European banks are better
capitalised and have access to massive amounts of liquidity thanks to the ECB.
In our view, markets
should gradually recover as investors gain more clarity on the issues outlined
above and begin to find value amid oversold conditions. But this will take
time. In the near term, we expect a period of continued uncertainty and associated
volatility, with investors looking to sell the rallies rather than buy the
dips. In this environment, and more generally in a world of low growth, it will
ultimately be very lucrative to own high-quality companies with strong earnings
visibility and avoid the structurally challenged and over-leveraged. Crucially
however, investors should set their sights lower. Strong gains achieved in
equities and fixed income in the years since the financial crisis are unlikely
to be repeated. At this late stage in the cycle, when markets have risen
substantially and beta expectations are lower, alpha is likely to make up a
substantial proportion of total returns. Thus, active management remains an
attractive proposition in today’s investment landscape.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).