Market Comment 07/04/2016
Market Commentary & Investment Outlook - April 2016
The first quarter of 2016 saw stock markets across the globe falling sharply before staging a strong rally by period end. Hector Kilpatrick reviews recent market volatility and explains why we see potential in Emerging Markets.
At one point, the FTSE All-Share Index had fallen by 11.5% before rebounding to finish the three month period down just 0.4%. Similar volatility was also seen in credit markets, where higher risk corporate debt prices sold off sharply relative to government bonds, before staging a recovery.
Investors initially took fright as commodity prices (and especially the oil price) reached new lows, threatening an increased level of corporate bankruptcies. The equity and debt of several sizeable stocks linked to the American coal and steel industries traded at levels indicating imminent bankruptcy. However, the imposition of tariffs on steel imports during the period under review helped alleviate some of this pressure.
Concerns that the Chinese debt bubble was in the process of bursting also hurt sentiment. To compound all this, investment banks reported dire fourth quarter revenues as they continue to shrink their capital and cost bases.
New Chinese lending numbers for January showed a remarkable pick-up in activity and the oil price troughed as the Russians announced that they intended to withdraw from Syria.
Midway through the period, however, sentiment turned. New Chinese lending numbers for January showed a remarkable pick-up in activity and the oil price troughed as the Russians announced that they intended to withdraw from Syria. In addition, some US manufacturing companies began to talk cautiously of seeing better end demand which suggests the manufacturing slowdown witnessed in the US last year may well have been due to destocking rather than something more structural. Towards the end of the period, the Chair of the Federal Reserve made it very clear that they would only increase interest rates very cautiously going forward.
During the three months under review, the FTSE World Ex-UK Index rose 3.2% in Sterling terms, materially outperforming the FTSE All-Share Index (-0.4%). Notably strong contributions came from Emerging Market and Asian ex Japan equity markets (MSCI EM (£) Index +8.4%, MSCI Asia Ex Japan Index, +4.4%). In local currency terms, the moves were more prosaic and, therefore, Sterling weakness against these respective currencies accounted for a lot of the excess return. For the UK based investor, Japan was the worst performing market. In local currency terms, the MSCI Japan Index fell 12.7% during the first quarter, however Yen strength against the British Pound reduced the losses to UK based investors to -4.1%.
The FTSE Gilts All Stocks Index rose 4.9% during the period, significantly outperforming high yielding corporate debt (BAML £ HY Index, +1.2%).
The Brent Crude oil price started the year at $37.3 per barrel, swiftly fell to $27.9, before rallying to $39.6 (a rise of 6.2%) by quarter end.
Given our rather gloomy commentaries of late, it may surprise you to learn that we are feeling more confident in the short term outlook for asset prices.
Given our rather gloomy commentaries of late, it may surprise you to learn that we are feeling more confident in the short term outlook for asset prices. Central to this view is a recent speech made by Janet Yellen, Chair of the Federal Reserve, in the United States.
Since she assumed office in early 2014, confidence in the Federal Reserve has declined and concerns have been raised about her leadership and policy communication skills. However, in late March Yellen made a speech where she explained her views clearly and cogently, which has helped to re-assert her authority. During the talk she was clear that a prematurely strong US Dollar was not desirable given its potential impact on US exporters, commodity prices and emerging market economies with currencies and/or debt tied to the US Dollar. She also referenced stability in foreign economies and markets as a test to help guide the Federal Reserve Committee as to the appropriate time to increase interest rates in the US.
The clear ‘take home’ message that Yellen conveyed was that the Federal Reserve would prefer to see the economic upcycle become entrenched before lifting interest rates meaningfully.
Whilst we have consistently expressed concerns about the wisdom of such a policy, it is important to acknowledge that this is going to be the policy going forward and as such Yellen has probably been successful in arresting the momentum behind the strengthening US currency, at least in the short term. This has global consequences and will help support the prices of equities and corporate debt.
It also supports some of the ‘Alice in Wonderland’ firsts that we have seen in the markets in recent months, such as (i) the Euro denominated 100 year Irish Government bond issued with a yield of 2.35% per annum (ii) the issuance of a negative yielding (-0.16% per annum) Euro denominated 3 year bond from a German bank (iii) the Japanese Central Bank issuing a 10 year government bond with a negative yield (-0.02% pa), and finally (iv) a custodian bank quoting a rate of -4% per annum to hold ‘excess’ Swiss Francs overnight.
The Federal Reserve will continue to do all in its power to support asset prices, regardless of whether this is in the long term interests of the economy.
Whilst we feel distinctly queasy recounting these events, Yellen’s signal is deliberate and clear. The Federal Reserve will continue to do all in its power to support asset prices, regardless of whether this is in the long term interests of the economy. Notwithstanding this, there are other factors which suggest that being too pessimistic in the short term could be a mistake.
Firstly (and remarkably), the Chinese authorities have decided to increase, still further, the amount of debt being released into the Chinese economy. In the near term, this delays the moment when the authorities will be obliged to confront the multiple issues arising from a credit binge which has engulfed the local government and private sectors of the economy.
Secondly, with the Russians claiming to be leaving Syria and significant diplomatic activity between the Saudi, Russian and Iranian energy ministers evident, it is just possible to believe that a deal to support the oil price could be forthcoming at a meeting scheduled for the 17th April 2016 in Qatar. If an agreement was announced that market participants believed would support oil prices above $45 per barrel, then the threat of debt default in related sectors could fall significantly and this would be taken positively by investors in most risk assets.
Finally, having had a disappointing end to last year, some manufacturing companies are sounding cautiously optimistic that the destocking cycle has run its course. If true, the outcome for earnings this year may not be as bad as many fear and this could help support markets.
This time last year we held next to nothing in Emerging Market equity (or debt). Our concerns centred around excessive levels of manufactured stock in the US, plummeting demand for commodities and also the possibility of a significant Yuan devaluation.
...we have more allocated to emerging market equities than at any time during the last five years, with half of this exposure allocated to Latin American equities.
Fast forward to today, and we have more allocated to emerging market equities than at any time during the last five years, with half of this exposure allocated to Latin American equities. So why is this?
As mentioned, the Chinese have bought time by pulling the debt lever once again and US policymakers have signalled that a strong Dollar policy is not in their interest, thus relieving the pressure the Chinese were under to devalue. These initiatives provide considerable respite in the short term and it is clear that despite investor fears, the Chinese economy is experiencing something of a revival.
Latin American equities became one of the most ‘over hated’ asset classes last year as commodity prices fell, currencies devalued, central banks put up interest rates and economies went into reverse. However, equity valuations became compelling and this was enough for us to start building a larger position in the region. Recent political events in Brazil suggest that change may be on its way, supporting both the Brazilian currency and the stock market.
It should be noted that our more constructive stance concerning equities is tactical as we continue to fear the consequences of a Chinese economic crisis and the continued tightening of bank’s lending standards to businesses in the United States.
As an insurance policy against these concerns, we have added gold to portfolios. Numerous developed economies now have negative interest rates and, should economic growth disappoint, the list of countries that embrace a negative interest rate policy is likely to lengthen. In such an environment, the opportunity cost of holding gold reduces substantially. Furthermore, if central banks revert to type they will confront slowing growth by printing more money and debasing their currencies still more. If this occurs, gold will be perceived to be a useful store of value.
Issued and approved by Cornelian Asset Managers Limited (CAML). You should remember that the value of investments and the income derived therefrom may fall as well as rise and you may not get back the amount that you invest. Past performance is not a guide to future returns. This material is directed only at persons in the UK and is not an offer or invitation to buy or sell securities. Opinions expressed represent the views of CAML at the time of preparation. They are subject to change and should not be interpreted as investment advice. CAML and connected companies, clients, directors, employees and other associates, may have a position in any security, or related financial instrument, issued by a company or organisation mentioned in this document.
Chief Investment Officer