With many indices now labelled bear markets after a traumatic start to the year, Andrew Parry, Head of Equities notes it is important to recognise that long-term investment returns are gradually rising, not falling, and that an adjustment was needed, as global quantitative easing had led to elevated valuations in most asset markets.
US rates more influential than China turbulence: Previously, we have said that elevated volatility was the only market prediction that we were certain about. We maintain this view largely because of the “denominator problem”: with official rates hovering near zero and longer term rates suppressed, small changes in interest rate expectations can lead to significant swings in asset prices. It is no surprise, therefore, that the latest bout of volatility can be traced back to the first rise in US rates since June 2006. Indeed, the start of the rout in many asset categories, including commodities, high-yield credit and emerging market currencies, originated when the US Federal Reserve (Fed) ended quantitative easing in October 2014 and the trade-weighted US dollar started to rise. This, more than events in China, is the current source of the turmoil in global markets.
Divergent dangers: While expectations for growth in most major economies have not shifted dramatically over the last year, though the trend in the global GDP growth rate remains relentlessly lower, markets have become subject to changes in sentiment spurred by central bank policy moves. When the Fed reversed monetary policy in December, even by a meagre 25bps, it created a divergence in policy with other major central banks, all of which are either keeping rates low or even inclined to loosen further (see chart below). When rates are so low, such divergences can lead to far more elevated volatility than changes in the underlying economic fundamentals might suggest. The recent announcement by Mark Carney, Governor of the Bank of England, that UK rates are unlikely to rise in 2016, was an indication of the mindset of policy makers. After six years of economic expansion, an inflation-prone economy like the UK was not deemed robust enough to increase rates from 0.5%, reflecting the uncertainty that surrounds markets and economies.
Sovereign bond yields: the US has split from the pack
Back to zero: We believe that the tightening cycle in the US will be short, shallow and ultimately reversed and that there is a strong probability of the US having zero or negative policy rates within 18 months. We were going to suggest the purchase of two-year US treasuries, as a yield of 0.83% was a bargain if you accepted our view that the Fed would reverse its tightening cycle in the face of global market turmoil, mounting deflationary pressures and a downturn in the US business cycle. It also provided a low cost put option on the weakness in real asset prices. With the yield now at 0.81% and global markets down by double digits, much of the juice in this trade has been extracted and long-term investors would be best off waiting for a good entry point in risk assets once the inevitable capitulation occurs.
A correct correction: Low interest rates had driven many investors to embrace a level of risk that was well above their natural tolerance as they strived to meet their liabilities in the hope that central banks would provide a “put” through continued monetary easing. The Fed has shaken that conviction and asset prices are adjusting to valuations, which are more appropriate for the level of risk that the uncertain outlook for global GDP would warrant.
The outlier: In these conditions, we still believe that European stocks have three factors going for them: an emerging domestic earnings cycle after years of disappointment, a policy arbitrage that is in their favour and a valuation that is realistic, if not a bargain. With negative official policy rates, a dividend yield on the broad index of about 3.75% on European stocks provides reasonable compensation for uncertain but positive growth. The challenged outlook for global trades means that selectivity is still paramount. We favour quality compounding-growth stocks, which we believe are the best route to navigate through the rocky shoals of strong competition and deteriorating global pricing, backed by selective self-help stories. With the risk of a Brexit very real, the eurozone may well turn out to be a safe haven, especially now its equity market is nearly 25% down from last year’s peak.