The Perfect Storm?
It has been a harsh start to 2016, but the pain is likely to be front-end loaded rather than persist throughout the year argues Richard Buxton, head of UK equities at Old Mutual Global Investors.
It appears we’re facing something of a perfect storm, with the sliding price of oil, once again, firmly at its epicentre. The real circulatory theme around the effects of a stronger US dollar on falling commodity prices, coupled with the heavy-handed attempts by the Chinese authorities to devalue their currency against a stronger greenback has led to renewed panic in equity markets.
For investors the wider question is this: are we in the grip of a sharp correction, or do the falls we’ve seen year to date represent the official rolling over of the bull market which, in terms of length, has far exceeded its long-term average?
Let’s look at the evidence so far.
Never before have we seen such a rate of deceleration in US manufacturing without an accompanying recession. And yet the polarisation between declining industrial production on the one hand, not just in the US but throughout much of the Western world, and the relative buoyancy of consumption and employment data is puzzling to say the least. It also begs the question as to what extent will industrial weakness infect broader corporate sector confidence, and sap consumer appetites?
Or could the prevailing industrial weakness turn out to be a one-off adjustment to a lower level of demand from China and resource companies, exacerbated by an inventory cycle, the likes of which we have never before seen? And that once we have worked through this painful period of adjustment we will return to some sort of normality?
So, against the background of slowing growth expectations globally and what appears, after an initial pick-up, a fizzling out in UK real wage growth, Governor Mark Carney has decided now is not the right time to raise UK interest rates. (This in effect leaves Janet Yellen, chair of the US Federal Reserve, looking even more isolated in her decision to fire the starting gun on US interest rates at the end of last year).
UK growth may be sluggish but is not a disaster, with GDP growth rates of around 1.5 to 2% achievable. But, for the moment, the real issue facing UK investors is one of confidence. Brexit worries, currently manifesting themselves in a weaker pound, are not helpful for those overseas investors choosing to invest in the UK. Historically, the UK has been seen as something of a safe haven for investors. In the short term at least that status is being challenged.
But poll-reading can be a notoriously tricky business, as the result of the last General Election showed. Once again, I reiterate my view that Brexit will not happen. The British people are too conservative – with a small ‘c’ – to countenance the upheaval such a change would bring. And Prime Minister David Cameron will likely obtain sufficient concessions from Chancellor Merkel to satisfy the British electorate. Yet, in the meantime, delaying crucial investment decisions as a result of political uncertainty over Brexit is potentially damaging at a time when UK profits are already under pressure.
And so to equity market valuations.
With growth at such a premium, the valuation gap between growth stocks on the one hand and value on the other remains excessively stretched, with no noticeable catalyst in sight as to how this could be reversed. Value stocks, recovery stocks, commodity stocks, mega-cap stocks – if it doesn’t have positive earnings momentum, investors just do not want to know.
And yet we are reaching a point where I believe investor enthusiasm for expensive growth stocks is reaching a dangerous level, whereas the current aversion to large cap value is a distinct opportunity.
While investors increasingly question the sustainability of dividend payments in some resource stocks, given the current level of the oil price, there is value to be found in big oil, notably BP and Shell. You can if you wish ignore the protestations of management that the dividends will be held, assume payouts are halved and yet still find yields attractive relative to bonds or other equities.
We are also seeing good value and dividend growth within the banking sector as the legacy issues of the past several years, notably PPI claims, dwindle and capital buffers are restored. Those banks with domestically geared loan books such as Barclays and Lloyds should weather the current storm better than those with exposure to emerging economies.
So, all in all, a harsh start to 2016 but the pain is likely to be front-end loaded rather than persist throughout the year. Within a relatively short period, investors will get a better sense of how the authorities will respond to market falls and the economic outlook. Fed policy will be clearer. Investors may be reassured that the Chinese authorities have not lost control of their currency and that fears of a credit-induced hard landing are overdone. A focus on the medium term is essential, as after a painful beginning, markets are likely to recover during the balance of the year.