Our Burning Issues Team Calls In the Experts for Views on the Macro Environment After This Autumn’s Turmoil. Not All of Them are Bullish
The panellists were responding in mid-November. Since then, most equity markets have gained although sentiment has remained jumpy.
The gyrations of the last two months have shaken some analysts’ perceptions deeply. In a few hours on 15th October the VIX volatility index soared from a numbingly low level to the highest peak in nearly three years, as the Treasury yield spiked alarmingly on the realisation that QE was finally ending in the US, and that we could say goodbye to a vast amount of liquidity that had been supporting the investment markets.
Meanwhile the bad news from Europe kept on coming, with practically the whole Mediterranean in trouble and with even Germany looking recession in the eye. For a few tense hours, Greece’s ten year debt was yielding 9%. That sort of panicky mood doesn’t happen by chance. Something was up – but what?
Then, as quickly as it had ended, a hesitant bounce-back began. A massive new quantitative easing programme from Japan put new heart into commodities and Far East markets. But only the US market seemed to really respond. The oil price bottomed, the Russian rouble lost its support, and the IMF turned sour on global economic growth. And, as Barack Obama settled in for an outnumbered final two years of office, sentiment remained deeply wary.
What could it mean? For Europe, for China, for the US, for Britain? There was nothing for it. It was time for IFA Magazine to call in the experts:
- John Redwood, Chairman of the Investment Committee at Charles Stanley Pan Asset
- Jade Fu, Investment Manager at Heartwood Investment Management
- Justin Oliver, Deputy CIO at Canaccord Genuity Wealth Management:
- Tom Elliott, International Investment Strategist at deVere Group
- Graham O’Neill, Investment Director at Rayner Spencer Mills Research
1) Was the October panic mainly about liquidity and the end of QE, as some have suggested, or do you favour a more conventional explanation?
John Redwood, Charles Stanley Pan Asset:
The sharp sell-off in shares in September and early October was not just about the ending of US Quantitative Easing. This, after all, had been well advertised, and QE had been on a falling trend for many months. More important was the continuing disappointing news from the Euro area, where French and Italian economic performance was poor and even Germany experienced a sharp slowdown.
There have been regular worries about China, with a slower rate of growth and uncertainty over parts of the banking and local authority finance systems. To cap it all, in Brazil the re-election of the President was not what a lot in markets wanted to see, and the financial news remained poor from that large emerging market nation. Markets needed some better news, which later emerged with more Japanese reflationary action, and the hope of something more to come in the EU.
Jade Fu, Heartwood:
Markets are scared about the “D” word – deflation – more so than inflation, at least near term. That has driven the fear factor, with the eurozone being the epicentre. Deflation concerns have been accentuated by fears that any premature withdrawal of Fed liquidity would lead to a further plunge in global demand, placing more pressure on fiscally fragile economies, especially those in the periphery eurozone, which could spark another tail risk event.
Markets calmed down at the end of October on stronger conviction that the US economy is showing positive momentum, shifting the focus away from disinflationary trends. Reassuring comments from Federal Reserve policymakers may have also helped to allay concerns.
Tom Elliott, deVere Group:
Certainly there was fear about the end of QE3, but investors weren’t surprised by this. The tapering began early this year. Rather, it was fear that the US economy may be slowing due to weak wages growth and poor labour participation, against a background of weak inflation, that prompted the sell-off. Once started, the sell-off triggered profit taking in equities after what had been a surprisingly strong year-to-date performance in many developed markets.
Justin Oliver, Canaccord:
Ultimately, all of these concerns grew at a time when valuations have become ever less supportive and there had not been a set-back of any meaningful degree for some time. There was not one particular catalyst.
We believe that the recent setback reflected a shorter term sentiment change, rather than any fundamental adjustment to the economic or investment landscape.
The fact that inflation globally remains low, and that Europe appears increasingly susceptible to a period of mild deflation was a contributory factor, as was the forthcoming ECB bank stress tests and asset quality review, which brought with it an uncertainty regarding capital issuance in the European financial sector. The strength of the US dollar is having a negative impact on commodities, and by extension commodity producing nations. Continuing emerging market imbalances, political risks, ebola and the fact that September/October have, historically, been the least supportive months from a stockmarket perspective, made it apparent that investors had many reasons to take some risk off the table.
Graham O’Neill, Rayner Spencer Mills:
This needs to be viewed in the context of a market which had seen extremely low volatility and no 10% correction in US equities for three years. Over the last few years equity markets, especially in the States, have re-rated upwards to a level most commentators view as fair value to expensive. The combination of a market set-back together with likely fund redemptions, especially in Europe, caused many investors to head for the exit at the same time.
2) Wall Street’s relative success over the last year has owed more to the lack of convincing news from other global economies than to any particularly encouraging trend in the US. Truth or travesty?
Tom Elliott, deVere Group:
Only partially true. The low/no growth seen in much of the Eurozone and Japan certainly makes asset allocation favour the US stock market. However, US stocks are trading at a premium to other developed markets, and this limits the power of the ‘buy US because there is nowhere else to go’ type of argument. Particularly given that US profit margins are at cyclical highs.
The strong USD this year has also attracted global investors into US equities. This is another story of relative strength, since the USD is up because of the ending of the Fed’s QE3 program whereas the Bank of Japan has just announced an expansion of its QE program and many expect the ECB announce its own QE program soon.
But I think there has been interest in the US stock market this year simply because of the quality of the US growth story, which would attract investors at any time.
Jade Fu, Heartwood:
On the face of it, true. US equities have become the market of choice over other regions, which are exhibiting weaker economic fundamentals. Although US stocks are expensive based on historical measures, they are supported by a stronger macroeconomic backdrop relative to other developed economies. All considered, US equity valuations are probably fair at current levels.
John Redwood, Charles Stanley Pan Asset:
Wall Street has made good progress both by comparison with others and because of underlying domestic strengths. It is true the market is now dearer and valuations higher than a couple of years ago.
However, the US has the solid achievement of self-sufficiency on oil and gas emerging from its new shale provinces. It remains the world technological leader, with a great capacity to develop new ideas and large companies based on them. It has also got further than other advanced countries in mending its banks and allowing them to sustain better growth. The good advances of the US were justified by events.
Graham O’Neill, Rayner Spencer Mills:
The success of Wall Street’s relative out-performance does owe a large part to the improved performance of the US economy, which has benefited both from cheap energy and a fully healed banking system All this has meant that company profits growth has been stronger in the US than in other areas and this justifies the region’s out-performance.
Justin Oliver, Canaccord:
There is certainly an element of truth to this statement. The US had led the way economically, at a time when other regions are either stagnating (Europe, Japan), or expanding at a slower pace than markets have historically been used to (China). That said, it should be remembered that, by historical standards, even the US’s growth can be referred to as “sub-trend”.
The latest reading for year on year, real GDP in the US is 2.3%. This is significantly below the post 1945 average of 3.5%. [And] that growth is also below the post-recession average of 4.5%. By historical standards, the US recovery is anaemic, faltering and not yet self-sustaining.
So too, it must be remembered that a stronger US dollar represents a headwind for the economy, and the continuing sequester will ensure that federal government discretionary spending will continue to decline as a share of GDP for the next few years. Ultimately, it is possible that the US economy may end up growing slower than the Bloomberg consensus of 3% in 2015.
3) Over the last five years the Chinese equity markets have hardly correlated at all with strong economic growth. Now that average p/es in Shanghai are close to 6 and yields are nudging 5%, can the decoupling continue?
Jade Fu, Heartwood:
Economic growth doesn’t always translate into earnings growth and equity returns – China is an extreme example in this sense. It is true that many companies across the emerging markets are not as efficiently run as their developed market peers, and have traditionally relied too much on economic growth to generate revenues – that’s why profitability has declined over the last few years and share prices have fallen.
With that said, the situation is slightly different with the China A-share (shares in mainland China-based companies) because of capital controls. Liquidity is driven more by domestic retail investors in mainland China and is heavily influenced by short-term sentiment, which has been pretty negative due to weak economic conditions. Given this phenomenon, and the fact that the A-share market has huge depth and breadth, arguably there are a lot of mispriced (cheap) stocks.
The Hong Kong-Shanghai stock connect programme is designed to give foreign investors, in particular sophisticated institutional investors, more access to the China A-share market. In time, we expect the valuation in Shanghai to catch up and be more reflective of company fundamentals than short-term macro concerns.
Justin Oliver, Canaccord:
There has always been a specious connection between economic growth and stockmarket performance – there is far from a positive correlation between the two. That said, we would likely agree that investors are likely too bearish on China at present – and, while economic growth is almost certain to slow, current valuations appear to be discounting the possibility of a major financial crisis and hard landing. This does not appear likely.
The key to unlocking this value is China’s monetary policy. In our view, this remains too tight, with real lending rates well above GDP; without monetary easing, the Chinese economy is unlikely to accelerate.
Structurally, China has reached “middle-income” status, with per capita GDP at around $7k – $8k. Historically, once an economy has reached this level of income, growth tends to downshift to a 6%-8% pace. We believe that Chinese equities trade at attractive valuation levels -but, until such a time as Chinese authorities loosen monetary policy, much of this value may go unrewarded.
Tom Elliott, deVere Group:
There is only a loose connection between GDP growth and share price growth – not just in China, but globally. This reflects several variables that blur the relationship between growth in the overall economy: corporate turnover growth, profit growth, and share prices.
One key variable is the price/earnings ratio, which has its own independent cycle and is driven by the outlook for future profits growth and the relative attractiveness of other assets such as bonds. We are currently seeing economic growth decelerate, leading to falls in long term profit expectations. Not until we have a positive growth surprise, which raises the long term growth outlook, will we see a new P/E cycle in China begin. This could be some time away, given the problem the economy faces with its debt burden and overcapacity / oversupply in many areas of its economy.
John Redwood, Charles Stanley Pan Asset:
China looks cheap, as it has done for some time. It has performed a lot better this year. It is now under-owned in the west, with many people holding bearish thoughts about Chinese banks, the Chinese growth rate, the property market and total debts. We think this is overdone, but sentiment is taking time to improve with many doubters still critical of the slower growth now being recorded.
Graham O’Neill, Rayner Spencer Mills:
China, especially the state-owned enterprises (SOE), have suffered from over-capacity and a declining return on equity over the last five years. As a result of this, despite strong economic growth, the equity market has been a poor performer.
4) It will all be over by Christmas”. That’s what advisers would probably like to be able to tell their clients. But current sentiment seems to be driven by macro factors rather than market fundamentals. Would you agree?
Graham O’Neill, Rayner Spencer Mills:
After the recent turbulence, investors may well see a seasonal year-end rally, but the prospects for 2015 could be challenging as there is likely to be some sort of normalisation of monetary policy in both the US and UK. Investors should remember that the December / January periods are typically seasonally strong for equity markets, even in times of challenging economic conditions.
Jade Fu, Heartwood:
Performance trends over the past few weeks suggest that the market is responding more to macro factors, but to a large extent these factors are also driving corporate fundamentals. If we take Europe (ex UK) as an example, stock valuations in this region remain cheap (for example, versus the US) with earnings and profit margins slow to recover back to their historic norms. The lack of improvement is primarily due to the weak macroeconomic environment, but should we see a positive turnaround in the macro-economy, earnings and corporate profitability should start to improve alongside a share price recovery.
Justin Oliver, Canaccord:
We expect that increasing volatility will be a feature of financial markets moving forward – the general downward trend which has been in evidence over the past few years cannot persist indefinitely and more frequent, sharp moves in asset prices can be expected. The tailwinds which have driven the performance of many assets – near zero interest rates, moderate inflation, positive but not excessive economic growth and supportive central bank policies will come to an end to varying degrees during 2015 – and markets, being forward looking, will increasingly discount the removal of these headwinds as next year unfolds. Consequently, we believe that asset allocation will become more, not less important to delivering attractive returns.
John Redwood, Charles Stanley Pan Asset:
There is no reason for anything to be all over by Christmas. December 25th may be a big day in most family diaries, but it has no special market significance.
