Strategy: A quieter week, but the issues remain

28 Jan 2016

  • China risk has grown amid low global growth
  • Expectations for monetary policy are shifting
  • Tactical overweight in developed equities persists

After the steep sell-off up to mid-January, equity markets now appear to be bottoming. Admittedly, there was another blip on 26 January when Chinese equities plunged by a further 6.4%, but developed equities shrugged this off, gaining about 1% in the following trading session. This could be seen as an indication that the uncertainty about the outlook for China is now discounted, but we have seen such a market reaction before, so there is no guarantee that markets are now able to stomach further wobbles in China. We too see the risks from slower growth in China and from more tepid growth in the US and the eurozone, but we also think that markets are too negative about the recent developments. Developed equities are still trading below the levels at which we implemented our overweight, but we have held on to the position.

WHAT HAS CHANGED?

We think there are three prime drivers. One is the uncertainty related to China and the perceived loss of control over the economy by the authorities. The second is disappointing economic data in the US and the eurozone. The third is the plunge in crude oil prices.

To start with China, the uncertainty about the extent of the authorities’ control is not new. In our view, the strategy to use the equity market as a new source of funding for companies after corporate debt had surged failed. Currency management is another area. The recent move to a more flexible currency rate should be beneficial as it would enable the central bank to cut interest rates. However, allowing market forces to work still scares policymakers, so we have seen currency market intervention and we are hearing talk of attempts to curb capital outflows.

IN POOR SHAPE: NOT JUST CHINA…

We would probably not be talking so much about China if the rest of the global economy was in good shape. But it isn’t. The recessions in Russia and Brazil show hardly any signs of easing. Exports from South Korea, Taiwan, Indian and Indonesia continue to fall.

More importantly, the US economy has slowed. Fourth-quarter growth will be released on 29 January, but it is clear that the manufacturing sector is suffering and producer confidence is generally weak. Housing is a bright spot, with strong existing home sales and construction data. Mortgage rates have not moved much, but for the economy as a whole, the stronger US dollar, wider credit spreads, lower equity prices and some tightening of banks’ credit standards for business loans point to tighter financial conditions.

In the eurozone, the concerns over growth have been sparked by weakness in data such as retail sales and industrial production. The composite PMI is still quite firm, but below the average for the third and fourth quarter of last year. Consumer confidence remains in a broadly sideways trend. The German Ifo business climate index has registered its second straight monthly decline with a pronounced drop in the expectations component.

Overall, we do not think that the US or eurozone economies are on the brink of a sharp slowdown, but we have become more cautious. The main point is that in a modest growth scenario, any risks generally have a bigger impact on markets.

..BUT ALSO OIL

Finally, there is the drop in oil prices. This should be positive for the US, Europe, Japan, China and some other Asian economies which together make up the bulk of the global economy. There is some concern that the US consumer is not spending the oil windfall, though in fact, consumers have only saved part of the bonus.

However, low oil prices have caused investment in the energy sector to collapse. It has also lowered inflation expectations, which raises the risk of deflation. And the problems that low oil prices cause for the governments of oil-producing countries have led to some of the selling pressure coming from sovereign wealth funds. Technically, there could be a rebound in oil prices at some point, but fundamentally, we see no reasons for a sustained rise.

MONETARY POLICY: TIME TO EXPECT LESS FROM THE FED?

The recent weakness in risk assets and the data disappointments have led to pronounced changes in investor expectations of monetary policy. The probability of the US Federal Reserve raising policy rates again in March has more than halved and two-year yields have fallen, although in the latest FOMC statement, policymakers kept all the options open while acknowledging that growth had slowed late last year.

The current market turmoil is too short-lived to signal a pause in March in the as-yet young tightening cycle, in our view. Fed policy remains data dependent. If labour market and core inflation data stay strong, a March rate increase cannot be ruled out. Still, the four increases that the median of Fed policymakers expected in December’s FOMC dot plot now look quite unlikely. But we believe the one rate hike that markets now discount for this year is too little.

AND MORE FROM THE ECB

In the eurozone, president Draghi has hinted at more easing during the ECB policy meeting in March, though his latest comments are difficult to interpret. Draghi lost credibility in December. This time, he repeatedly said that the ECB should review and possibly reconsider its monetary policy stance in March and insisted that this line of communication was unanimous.

A further cut in the deposit rate looks like the least controversial option since the resistance in December was limited. Changes to the asset purchase programme are also possible. The euro and German yields fell after the remarks, but current levels do not presage major changes.

AND LITTLE FROM THE BOJ AND THE BOE

Bank of Japan policymakers meet later this week. With the economy muddling through, but the labour market tightening and core inflation trending higher, we do not expect any action. The BoJ is aware of the negative impact of more quantitative easing and could opt to wait until the growth and inflation forecasts in March. Market inflation expectations have fallen and the BoJ may want to show its determination to lift inflation before the next round of wage negotiations.

In the UK, the Bank of England has ruled out higher rates for now. The economy has weakened somewhat. Especially wage growth, which accelerated from mid-2014 to the middle of last year, has changed direction lately. As a result, sterling has weakened quickly versus the euro.

ALLOCATION: MORE POSITIVE TOWARDS RISKY ASSETS

While we have become more positive on risky assets, the global risks are clear. In our outlook for 2016, we highlighted the risk of bouts of volatility. We see this as opportunities to take tactical positions.

Our overweight in developed equities is primarily driven by recent market moves and investor positioning. We think markets have moved quite far in the direction of a possible US recession or a hard landing in China. We do not expect that to happen. We think a close-to-record volume of short positions shows that many investors have discounted most of the negative news.

But the investment climate is definitely challenging. In the US, earnings growth is surely being dragged down by the struggles in the energy and basic materials sectors, but so far it has also been poor in industrials, consumer goods, financials and information technology.

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Please note that this article can contain technical language. For this reason, it is not recommended to readers without professional investment experience.