Strategy: Markets at a low ebb amid oil glut, dearth in China

21 Jan 2016

SUMMARY

  • Equity markets slide as risk-off mode persists
  • Amid extreme short positioning, we go overweight developed equities
  • Fundamentals for US consumption still look favourable despite recent disappointment
  • Chinese growth slowing as consumption fails to counter more sluggish investment

Investing in equities has not been profitable so far this year. The S&P500 index is down almost 9% since the start of 2016, the EuroSTOXX 50 down 9% and the Nikkei down 12%. Market volatility has increased amid investor concerns over the global economic outlook in general, and China in particular. Although we agree that there are reasons to be cautious, we do not see the global economy falling off a cliff.

NEGATIVE SENTIMENT

The gloom is visible not just in equity performance. Spreads on high-yield corporate bonds have increased. US high-yield credit has suffered more due to its higher share of issues by energy companies suffering from the relentless drop in crude oil prices to a 12-year low. This plunge reflects market concerns over the pace of global growth, but also increased supply by Iran now that the sanctions against it have been lifted.

Investors are now extremely short equities, particularly US equities. Admittedly, there are reasons to be concerned, but we cannot see any trends foreshadowing a global or US recession. We see the fundamental factors for equities as evenly balanced. While valuations do not look attractive, we assess the global economic outlook as neutral for developed equities and view liquidity and the earnings outlook in the same light. We think monetary policy and corporate M&A activity are positive factors, while the geopolitical situation is negative.

Given this equilibrium, we see the recent sell-off as an opportunity for an overweight in developed equities. We prefer US equities for their relative growth expectations, corporate M&A activity and investor positioning, while Japanese equities should benefit from a generous monetary policy and corporate M&A activity. For investors with a European bias, we would also recommend they go overweight European equities.

US CONSUMER HOLDING BACK

For most of 2015, consumption was the bright spot in the US economy, but recently the housing market has been more mixed, sentiment among homebuilders has fallen and new home sales have trended lower. Since mortgage rates did not rise after the Federal Reserve rate hike in December, the lull in home sales may be temporary. Household net worth fell slightly in the third quarter, but this was the first decline in four years. Real estate, the most important asset for most US households, continued to increase in value.

So we cannot clearly explain the retrenchment in consumer spending. Lower oil prices should be positive, but perhaps consumers worried about reports of weakness in the global economy and in US manufacturing. We do not expect the manufacturing slowdown to cramp the whole US economy. A rebound in GDP growth looks likely in the first quarter, weather permitting.

CHINA DISAPPOINTING, BUT NOT PLUNGING

Recent data has been weaker than expected. GDP growth for 2015 fell to 6.9%, which was the slowest pace in more than two decades, while the GDP deflator, the broadest price measure in an economy, remained in deflation territory. While the economy is rebalancing, consumption is holding up without compensating for slower investment growth. Thus, overall growth is moderating. At the same time, credit is growing twice as fast as GDP. Worryingly, non-financial debt as a proportion of GDP has risen by more than in any of the 39 countries for which the BIS has data, except Hong Kong.

The latest market buzz about China has concerned fiscal stimulus and steps to address the overcapacity in heavy industry. Government spending has indeed grown more strongly lately, but tackling overcapacity could run into local government opposition to job losses. Anyway, if fiscal stimulus were visible anywhere, it would be in infrastructure investment.

We remain cautious, but the economy is not falling off a cliff. Any monetary and fiscal stimulus should be supportive in the near term, although the imbalances have largely been left untouched. Low oil prices and currency depreciation should also help. With the Chinese New Year and the accompanying data distortions coming up, it will take a couple of months before we will get more clarity on the economy’s direction.

ALLOCATION: ADDING EQUITY RISK

We implemented our equity overweight last week, but so far we have not benefited from it as markets focus on the negative implications of lower oil and commodity prices, the slowdown in China (and other emerging economies) and the latest US data. Concerns over capital outflows and dwindling currency reserves in China have also been prime drivers. Furthermore, Chinese markets have fallen further despite liquidity injections by the People’s Bank of China.

Tighter financial conditions through higher spreads on corporate and emerging market bonds, and in the US through a stronger US dollar and tighter standards on commercial and industrial bank loans, have not supported global markets either. A recent ECB survey showing that eurozone banks eased the terms and conditions on company and household loans offered no relief.

Our equity overweight should be seen as tactical. As said, we see the structural drivers of global equities as broadly balanced and the concerns over the global economy and the equity sell-off as overdone. We have left emerging equities out of the overweight given the absence of a better economic or earnings outlook.

We have kept our underweight in emerging market debt in local currencies. The sell-off in risk assets has pushed German yields to below 0.5% for the first time since December. Since we expect the eurozone economy to hold up relatively well, we are now short duration in Bunds, but only in portfolios with a high bond exposure.

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

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