It has been a rocky start to 2016 as markets continue to digest macroeconomic concerns including a slowdown in global manufacturing, an oil supply glut and disappointing earnings growth. Investors worldwide are faced with some critical questions as markets remain stuck in a cycle of volatility, irrationality and pessimism. The question is whether we are possibly heading to a global recession which would drag down corporate profits or not? Emotions can affect how people interpret real information about the economy or companies’ prospects. Today, the prevailing emotion is fear, fear is telling investors to not trust anything, to sell first and ask questions later.
“Better to take a loss today and live for tomorrow” has become the mantra du jour.
Some investors are seduced by a market narrative that sees cheap oil prices as a sign of weak global demand. This suggests a spill over from cuts in jobs and Capital Expenditure (CAPEX) in the energy sector to cause a recession in the broader economy, and that sees looming debt defaults by energy companies as another 2008-style system-wide credit crunch. Additionally, there is a perception that China’s manufacturing slowdown reflects an economy grinding to a halt and that China is faced with uncontrollable capital flight. Although this narrative has come to dominate media headlines to some extent, crushing investor risk appetites, it still remains inaccurate in many ways.
Oil prices have fallen, but this mainly reflects a supply glut (caused by OPEC production and US shale production growth amongst other factors – see: Is the best cure for oil really low prices?) rather than a radical slowdown in oil demand in the world as a whole.
Equity markets may react to economic data releases but what they really care about is corporate profits. Forecasts for 2016 earnings remain relatively stable for the S&P 500, falling approximately 2% since the beginning of the year. The S&P 500 is used as a stand-in for stocks as it is the most heavily referenced indexes in the world’s largest economy.
Average company valuations declined by approximately 15% globally in just two months as uncertainty around China, oil prices, credit and central bank potency increased. However, the economy and earnings look relatively stable and may actually begin to accelerate later this year, based on key leading indicators. Additionally, a weaker or more stable US dollar could add significant upside to current S&P 500 estimates. Nevertheless, equity markets are unlikely to revalue significantly higher until there is more clarity around some of the uncertainties mentioned above, or the vicious cycle of fear subsides. While shares may have fallen in value, the dividends from the market as a whole have continued to increase. So the cash income flow receivable from a well-diversified portfolio of shares has continued to remain attractive, particularly against bank deposits.
Oil consumption is growing steadily and there is little evidence to suggest that today’s weaker oil prices are an indicator of weak demand. According to the International Energy Agency (IEA), 2015 saw one of the highest volume increases in global oil demand this century. Lower capital investment in oil-related industries are to be expected, but markets have lost a sense of perspective. For example, energy accounts for only around 1% of jobs in the US, and energy-related CAPEX (after falls in the last year or so) is only around 0.5% of GDP. Moreover, global systematically important banks have very little exposure to the energy sector, and are far better capitalised than in the financial crisis. Bad loans in the energy industry only amount to a fraction of these banks’ loan portfolios.
“The exposure at the top 20 banks is manageable even in the most unthinkable scenario”
RBC financials equity analysts
As for China, its economy is modernising at an extraordinary pace, shifting from low-end manufacturing and infrastructure investment that have driven its growth in the past few decades, towards a greater emphasis on services and consumption. Thus, investors might want their portfolios to be exposed to this growth once the current turmoil dies down. China continues to enjoy a massive trade surplus and substantial foreign direct investment; these inflows, together with China’s deep reserves, offset the capital outflows that are inevitable as China’s currency regime liberalises. The Renminbi’s total fall against the US Dollar since the exchange rate regime was liberalised is a little over 5%. Sterling on the other hand has devalued by around 7% against the Dollar in the same timeframe.
Investors appear to be over-emphasising short-term asset price volatility and ignoring the importance of market fundamentals. Volatility matters in investment decision-making, but the increasing prevalence of investment strategies that focus on particular ranges of volatility may lead to vicious circles of selling: a spike in market volatility can push some holders of assets into selling, regardless of fundamentals or valuations, in order to avoid a breach of their short-term volatility limits – thereby causing further volatility and further selling.
The big picture
After the systemic meltdown during the 2008 financial crisis, there is a tendency for investors to overestimate the likelihood of another cataclysmic event. Periods of panic are a natural feature of markets and it is hard to predict when the current panic will pass, but it is clear that investor behaviour is showing signs of extreme pessimism that is very rarely justified, and that signs of activity in the real economy and in the health of companies around the world are far better than markets would have us believe.
The optimal strategy during times like these is to stick to a rational investment process, whilst keeping an eye on the fundamental health of assets to build strong long-term returns once recovery comes. It is also important to choose a suitable and diverse asset allocation mix. For example, more risk-averse individuals are likely to be more susceptible to being overrun by the fear dominating the market, and therefore their exposure to equity securities should not be as great as those who can tolerate more risk. Likewise, longer-term investors will remember that equities not only yield more than bonds, they also offer a growing income stream as opposed to fixed-rate coupons. The extra volatility is the price investors must pay for potentially higher returns in a financial environment driven by fear rather than fundamentals.