Market Update: August 2015
Given the recent big moves in equity markets we thought we’d give you an update on the markets as we see them today, what has been behind the moves and the opportunities we see for your portfolio today.
First the drama: Chinese equity markets have fallen over 40% from their peak in June of this year. At first this sell-off remained contained to emerging markets but in the middle of August it spread to developed markets. The US S&P 500 equity market fell 9% in 3 trading days from the 18th August, one of the sharpest 3 day falls since records began. These sorts of moves generate headlines in the broader press which you may well have seen. Since Monday 24th the markets have steadied somewhat but the question for us remains: is this an opportunity to buy at lower prices or a warning that fundamentals in markets have changed and so there is worse to come?
But first some context is helpful. Though these sorts are events are rare they are also part and parcel of investing. As you may know we run our portfolios through a series of stress tests to make sure they are robust in markets such as the ones we’ve had in the last few weeks (and in fact all the worst market events we’ve seen since the 1980s). Though short, sharp declines are always unpleasant they are ultimately not a surprise and so far our portfolios have performed in line with our expectations. Our focus on diversification has helped with our property focussed investments holding steady and a number of our absolute return focussed funds making money. Where do we go from here though? To answer that we must look at what triggered the downturn in the first place.
Analysts are pointing their fingers at two main culprits. The first is that interest rates were expected to rise in the US this September. The argument is that rising interest rates would slowly mean the end of the easy money policies that have been a feature of global markets since the end of 2008. At some point this reality would have to hit home and cause a sell-off in equity markets. The second explanation is the slowdown in China. The Chinese economy has been trying to shift from infrastructure and investment led growth to a more consumer focussed economy. This transition was never going to be easy, not least because much of the previous investment boom was financed by debt, some of which would eventually and inevitably turn bad as the investment boom ended. China’s slowdown in infrastructure spending has also hit commodity prices hard: the Dow Jones Commodity index is down almost 40% from its 2015 highs and, incredibly, oil has fallen over 60%. This meant that the bust quickly moved from China to many commodity producing emerging market countries that ultimately depend on it.
We find the China slowdown explanation to be far more convincing. The markets have known for a long time that interest rates will eventually rise. Longer term interest rates (which are more important anyway for many borrowers) already price these increases in. Central banks have been clear that the pace of rises will be slow. It is hard to see what new news came out in August to trigger the sell-off we saw. On the other hand, the pressure of the China slowdown and its implications for other markets have slowly been building. Commodity producers (like Russia, Brazil and Venezuela) have seen their economies come under pressure and their currencies collapse. The Chinese authorities were also forced to devalue their currency in early August as capital sought to flee the scene of the accident. This created uncertainty and sharp market moves. Add to the reduced market liquidity that is due in the holiday month of August and you have the recipe for a nasty market event.
If the culprit really is the Chinese slowdown then – to our eyes – this is not all bearish. Remember first that the Chinese equity collapse is focused on relatively small mainland equity markets that are not open to international investors. Though large, China remains a relatively closed and independent economy and there are still many areas that have good economic momentum behind them and may in fact benefit from some of the developments above. We list three below:
- Cheaper commodities are unambiguously good news for regions that import, say, oil, but do not produce it. Japan and the Eurozone are the most obvious examples but so are some parts of Asia. Even in the UK petrol prices may yet go back down below £1 per litre. Falling oil prices are a wealth transfer from (often rich) oil producing countries to global consumers. As consumers typically spend the extra income they get this is likely to be a boost for the regions above and probably the global economy as a whole.
- Interest rates on US higher yielding corporate debt have risen back up to around 8%. We still think the outlook for the US economy looks good and corporate balance sheets remain in decent shape. Rising yields – particularly sectors with little or no exposure to falling energy prices – look like an attractive opportunity to us and we think this sector should make good returns for clients over the next 12 to 24 months.
- Finally, at some point (but not yet) emerging market credit, which is in many ways at the centre of the storm today, should prove to be an attractive hunting ground. As with every crisis there are always opportunities in the debris of the bust. This area could well be an attractive investment for clients in 2016 and maybe beyond.
These, though, are by their nature medium term opportunities. In the short term, we caution that there may yet be more volatility to come. Partly because of changes made to banking regulation post 2008 and partly because of the rise of computer based trading there can be less day-to-day liquidity in many financial markets, especially in times of stress. This means that there may be more days like Monday 24th, when it briefly looked like there was no bid at all for many equities (JP Morgan opened over 20% down as an example). In other words, higher volatility may well be here to stay. While this may mean more short term ups and downs in your portfolio valuations, there will still be plenty of longer term opportunities to focus on. We will continue to try and have as many of them in our clients’ portfolios as we can.