Quarterly Market Update – October 2015

…It is worth reflecting that the Chinese stock market is up 31.16% over 12 months and currency depreciation against the US dollar is only 3.88%. …

At the start of the year we were cautiously optimistic but our concern was the number of potential problems brewing.

The meltdown in the Chinese market in August, caused world markets to react with panic. Interestingly the falls were the same in June and yet the global markets did not react.

Looking a little deeper we can see that the Shanghai Stock Exchange is up 31.16% over a 12 month period and down just 5.62% in 2015. (Source: Bloomberg). So in reality all is neither doom nor gloom.

August tends to be a difficult month for markets when many people are away and therefore there is a greater chance of large fluctuations due to low trading volumes. Policy moves by the Chinese government unsettled the market and everyone ran for the exit. The fear was the slowdown in China would lead to a wider global deceleration and this of course may happen.

So this uncertainty is front and centre, and is compounded when the Fed seemingly pointed to the state of the global markets for its non-move on interest rates. Uncertainty is something the markets hate and clearly it’s unclear at the moment.

If we then add to the mix the scandal surrounding VW, Skoda, Seat, Audi (and whoever else joins the party) and the potential impact that could have on European manufacturers, and the collapse in share prices for commodity companies like Glencore you then have a messy outlook.

Our view in macro terms is that volatility in the market has been artificially dampened down in recent years and this is now returning. We have indicated for the last couple of years that we think returns will settle back around average 5 to 8% and that the markets are adjusting to this.

In this update we will go behind the headlines and explore what is actually going on in China, about why the Fed delayed interest rate rises as well as a look at the Eurozone and in the UK, FTSE 100 and Glencore.

Our conclusions might surprise you.

Cash

In this part of the update I want to touch briefly on fixed interest investments and cash. Some investors have moved from cash to fixed interest in the search for income. For some time we have expressed our concerns about fixed interest investments, and we are now getting some interesting feedback.

In various discussions with fixed interest managers it is clearer that this market is becoming more complex. One manager argued that in a world of zero inflation a yield (income) of 1.5% to 2% is no different to receiving 7% in a 5% inflation world. That is something that cannot be argued with. However, when inflation rises then this low yield could end up delivering negative real returns.

What is interesting is the volatility in bond prices. In one day the price of a German Bund moved by 5%, and from its high is down nearly 25% (source Kames). The point being that it depends when you purchased the bond as this will determine the returns and there is a real risk that although the yield may seem healthy, capital is being eroded. To illustrate further one strategic bond fund manager we met recently has delivered negative returns over the last five years (I suspect they might not be the only ones)!

We also feel that a time to be concerned is when the FCA starts looking at the market; this has already started as they are focusing both on volatility and liquidity.

Lower yield (income) and greater volatility tends to be the main focus but liquidity is a crucial element. In 2007 there was 100% liquidity in the market. What this means is that if you wanted to sell it was easy to do (because there were more bonds available and people were still looking to buy). Now this is below 40% (because there are less bonds available and fewer buyers).

It is not a time to panic because there will always be buyers (but it is at what price). But managers freely admit it is harder to trade, although it is manageable. Their concern is if there is a rush to the door because at that time there is a potential problem with liquidity and this is why the FCA are watching this carefully.

We have highlighted that managers are taking more risk and one area they are turning to is high yield to get returns, but this market is small and so emphasises liquidity issues. One additional thought is how QE has distorted the bond market and what the impact will be as we return to a normalised scenario.

Certainly many would say it is not a time to panic but it is a clearly complex market.

On that gloomy note how about cash?

Zero inflation is actually good news! A 1.6% interest payment is 1.6%, so it is a positive ‘return’. Even if you take the interest the capital is not depreciating because inflation is nil. But once inflation rises this means capital is depreciating and interest payments are less in real terms.

Many cash investors are excited about the prospect of an interest rate rise. But the reality is that if they go up next year then the change will be minimal. It is also worth considering that rates are expected to normalise at between 2 and 3%.

Putting this into context. Currently according to savingschampion.com the best rates are between 1.6% and 3.06% (easy access to a 5 year fixed rate). With a 0.25% rise this will only move to between 1.85% and 3.31%. An income of 3.31% might seem attractive but there is no scope for growth on capital and with inflation likely to rise it will mean over a five year period capital could fall in value.

There is no doubt that rates will go up but the big question is when? Holding some cash is a wise option certainly for short term goals and perhaps providing some protection in a down market, but its growth is limited and like any investment careful management is needed to ensure that the best returns are achieved.

Bringing this to a close again little has changed in our view, cash although appearing to give protection is giving minimal ‘returns’ and this is unlikely to change any time soon. Equally there are challenges in the fixed interest space both in terms of return and risk. We will cover equities in the next sections.

USA

The message on the ground about rate rises was interesting because the markets had priced in a December rate rise, and didn’t expect them to go up in September.

The potential outcome was that if the Fed did raise rates this would have rattled markets (even though they had said they would do it). If they did nothing then the status quo would remain.

But then ‘China’ happened…

The Fed decided to do nothing and the markets reacted badly even though they had been expecting it, so why was this case?

It appears to be all in the wording. On one hand the Fed indicated their confidence in the US economy, but on the other it raised concerns on external risks and financial market developments. Some may argue that moves by the Chinese government may have forced this decision. The reality is that China in terms of trade has minimal impact on the US economy. This uncertainty in wording spooked the markets.

We indicated that we thought it might be the end of the year when rates go up but we were becoming less certain of this. If I am honest it really is a guessing game and we need to just listen to the words coming from the Fed.

Some are now predicting the first quarter of 2016 which will push back the UK rate rise. To some extent they just need to make the move to show that we are moving to a more normalised situation. Any increase will be minimal and future rises slow.

Some things to look out for which might indicate a rate rise include:

  1. Labour market indicators – the two specifics are improvements in labour market conditions and signs of an acceleration in wages
  2. Inflation and inflation expectations – a reversal or bottoming out of inflation
  3. Financial conditions – easing coming from the US dollar, equities and credit spreads
  4. Fed speak – greater clarity on what they plan to do

The reality is that little has changed with the US, growth is steady but clearly the focus on international activity when making the decision on interest rate rises has unsettled the markets.

UK & Europe

There is a lot of positive news coming from the UK but we shouldn’t underestimate the volatility that will occur in the market as we come closer to a referendum on Europe (that will be the subject of future quarterly updates).

Secretly I think there are concerns about the new Labour leader because whether you like him or not, he is talking a language which appeals to many and it is unclear whether the policies could do harm to the economy. However the next election is not for a few years so no need to worry at this stage, if at all.

Unemployment fell to 5.5% but the total hours people worked fell as both full-time and part-time workers reduced their working week slightly. Average earnings are now 2.9% higher than a year ago and there are signs that workers are in a better position to secure higher earnings going forward.

The total number of vacancies rose to 740,000 and redundancies dropped to 4% approaching a cycle low.

Turning to China and a potential global slowdown it is worth considering that exposure to individual emerging markets is relatively small and broadly spread across all global markets. China is just 3.7% with the US and the Germany being the main trading partners. In fact 70% of all trade is with those economies where the growth outlook is much better.

Also the UK is a household consumption dominated economy with exports making up 28% of GDP and consumer spending 62%. The concern, if there is one, for investors is the FTSE 100 where 75% of profits come from abroad and 35% of that from outside Europe and the US. As we have seen with Glencore the concentration in commodities and materials means the FTSE 100 is vulnerable during a downturn in emerging markets. It highlights the need to be careful when selecting investments.

There is some good news in the Eurozone with annualised growth at 1.5%. Some of the highlights include Germany, Spain, Portugal and Greece (YES I DID SAY GREECE). France has disappointed with stagnation over the last quarter.

Cheaper oil is good news but this hasn’t started to feed through to consumer spending. A slowdown in China and Emerging Markets is of greater concern for Europe. In Europe 26% of GDP (outside of the Eurozone) comes from exports. In comparison exports as a percentage of GDP in the US are half of this and in Japan 19%. Of this 33% comes from the Emerging Markets, but some countries have greater exposure – Finland (over 40%) and Germany (37%).

So Europe is vulnerable to fluctuations in global trade and demand. Another concern is the VW saga which has spread to other manufacturers within the group (Audi, Skoda, Seat). Automobile make up a large proportion of European manufacturing and exports. Any slowdown could have a negative impact. We also don’t know whether other manufacturers have used similar technology.

In summary there are positive growth numbers coming out of Europe, the impact of a global slowdown could potentially impact the region and in particular those countries with greater exposure to emerging markets. Equally manufacturing could suffer negatively from the VW saga. Turning to the UK it seems things are much more positive but care needs to be taken when investing, especially in the FTSE 100 which gives the greatest exposure to emerging markets and therefore will suffer more in any downturn. Interest rates in Europe are unlikely to move anytime soon but in the UK we could see a rate rise with the next couple of years.

Asian, Frontier and Emerging Markets

I have been an advocate of Emerging, Frontier and Asian Markets for some time but it is hard not to question your judgement when times are tough.

Let’s start with China. With all the bad news you would have expected the stock market to have fallen sharply and extreme currency depreciation.

The reality is that over the short term this is correct, but over 12 months the Chinese stock market is up 31.16% and currency depreciation against the US dollar is only 3.88%.

So with this in mind why the concerns?

China faces many complex issues including a slowdown in growth and investment, environmental issues, debt within the local government sector and the challenge of bringing down real interest rates.

This is not something new, we have known this for many months so little has actually in terms of economic fundamentals. We also know that the Chinese economy is gradually rebalancing towards being consumption led and less commodity driven; this takes time.

PMI data shows expansion in the service sector and retraction in manufacturing. So the signs are there that they are doing the right things. However, the way the government has reacted has made some consider that they are not fully in control of the outcome and that we are heading for a hard landing (whatever that might mean, some say a hard landing would see growth of around 3 to 4% a year but do we really know). Speaking to fund managers they believe that the government is more control than perhaps the markets think. Equally they do not believe in a hard landing scenario but think growth will settle somewhere in the 5 to 6% region.

China is slowing similar to any country making that transition. The falls in August were no different to those in June but the market just became more concerned that the moves by Chinese policymakers were a sign of panic, and therefore any significant slowdown would impact across emerging markets.

Clearly there is an impact, we have seen a slide in commodities (particularly oil) and this has fluctuated widely this year. At the start of the year it was $46 then it went to $66 in June and down to $42 at the end of August. This does have a positive and negative effect.

Saudi Arabia is the biggest exporter of crude oil but the US is the largest producer. Saudi Arabia seems to be able to cope with the lower oil prices but the likes of Russia and Venezuela cannot. Any rational economy in their position would say ‘turn the taps off’ to allow prices to recover, but they simply cannot afford to do it. On the flipside you have the likes of India which is a big importer of oil and have benefited from this.

Across the Emerging Markets there are challenges. Growth in household debt has slowed consumption growth in Malaysia, South Korea and Thailand. Also rising interest rates in the US could see capital outflows in emerging markets and add to the funding costs of companies issuing debt in US dollars. A strong dollar could also lead to a sharp depreciation in emerging market currencies and force central banks to raise interest rates.

And so we could go on but there are positives.

The whole region is cheap with low valuations and there are opportunities. India as an example has had mixed results with reform but has seen other recent reforms fail to get through parliament. The main bill was the Goods and Services Tax which they wanted in place by 2016 but many believe this will change and these bills will go through. Growth is around 7%, interest rates have been cut, infrastructure spend is up and low oil prices are benefiting the economy.

Other economies doing well include Vietnam. It has an economy of 90 million people, it is just starting to allow foreign investment, inflation is low and growth is nearly 7% p.a. Bangladesh is another economy seeing rapid urbanisation with average growth of 6% p.a.

So all is not bad across Asia, Emerging and Frontier Markets investors just need to be selective. There are cheap valuations for good reason. Commodity based economies (especially oil) are struggling but others are benefiting from cheaper commodities. Patience is the best approach.

Japan

Japan is like marmite. Depending on who you listen to you will get widely differing views. It will either succeed or it won’t.

Taking a look at what is happening the data is mixed; the second quarter GDP figures contracted to 0.4%, consumer sentiment has fallen, and core CPI slowed to zero.

But there are positive signs.

A core strategy is weakening the Yen and it has fallen 30% since 2012, additionally unemployment figures continue to fall, there are healthy job opening-to-applicant levels and the service purchasing managers indices rose to their highest level since 2013.

The weakness in China may have an impact as they are a major trading partner. We are seeing weaker export growth and sluggish industrial output which may be a sign of this impact.

Japan was never going to see overnight change, there is plenty still to be done and we continue to watch this carefully.

Conclusion

For the last two updates we have said we remain cautiously optimistic however this last quarter has tested us. It has been the biggest quarter fall in four years; but we shouldn’t forget four years ago there was a lot more to be worried about.

In August of the 39 major non-currency asset classes, 33 were down. The VIX which is a measure of volatility at one point rose above 40 which hasn’t been seen since 2008.

We appear to be moving towards a more normalised world and away from markets which have been fuelled by policy makers. A natural consequence of this means the markets are trying to find their feet. It also means that we need to accept that bad news is bad news, rather than bad news being turned into good news by the pumping of money into the system.

Emerging markets and the impact on global growth is important but is less important than it once was. In 2004 it accounted for 54% of global GDP, it is now 43%.

We have said for some time that we think growth will normalise at between 5 and 8% and we believe this is what the markets are adjusting to. As part of this we have been used to controlled volatility, we are now seeing this change and this applies across all asset classes.

What are the risks that we can see (there are undoubtedly those we can’t)? There are four main ones – the slowdown in China being greater than we expect, European politics, migrant issues both in the short and long term and policy maker (Fed, ECB, BofE etc) decisions as we wean ourselves away from the safety harness.

As we draw this review to a conclusion, we have seen in the past a bad quarter like this is followed by a strong quarter. Of course we don’t know but it will be interesting to see if history repeats, and if it does we can breathe a bit easier again!

Source: Charts have been sourced from Morningstar. Other data sourced from Schroders, Templeton, Standard Life, Invesco, Kames, Alquity, BlackRock, Old Mutual and JP Morgan.

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