Another Summer of Volatile Stock Markets

The economic recovery remains boring, below-par, bumpy and brittle

They say that one swallow doesn’t make a summer; well a raft of mini-crises certainly ruins ours. When one adds uncertainty over corporate earnings, the likely outbreak of a worldwide geopolitical event in Syria and seemingly endless flashpoints in the Eurozone to the mix, it is understandable that markets have swooned in the summer sun.

Perhaps the most important place to start is the discussion over diversification, which led to a difficult Q2 for asset allocators. Interestingly the last week or so has seen a resumption of diversification working efficiently and effectively.

Perceived low-risk assets, such as core government bonds, gold and investment grade credit have all performed robustly, renewing their credibility as assets to hold when markets are tough. This breakdown in correlations is certainly helpful to all those who, like us, pursue diversification in portfolios. Let’s hope it stays that way.

The Global Economic Recovery

I find it hard to believe that I am about to say this, but clearly the global economic recovery has become even more confusing over the last few months. The US, which was reassuringly strong, has seen some questionable data over the last few weeks, particularly from the housing market. Europe is improving and the UK is undeniably strong at this point in time, which will help compensate for the US slowdown. Chinese growth has also been more resolute over recent weeks than the Bears were roaring it would be, whilst useful leading indicators, such as Korean exports, have started to gather momentum. Japan has slowed from March and clearly more help is needed there, which we expect from the Abe administration when the Diet re-opens in September. In short, the economic recovery remains boring, below-par, bumpy and brittle but there are still enough positive signs for our forecast that the global economy could return back towards trend growth at some point in 2014. 

Change in US Monetary Policy 

The waves of summer volatility were first triggered by the US Federal Reserve’s hints in May that they would start to “taper” their bond purchases (QE) at September’s policy meeting. This in effect “let the cat out of the bag” and global financial markets quickly moved to price in a new trajectory of policy; bonds fell, yields rose, equities wobbled and money started to flow from the emerging markets and back to the US dollar. However, there surely now have to be some doubts over whether the Fed will actually start to wind up QE in September, particularly given the rise in mortgage rates and slowdown in housing activity. This 'will they, won’t they' discussion has become the investment world’s most boring but sadly important debate. Our weakly held view is that they will taper in September, as to backtrack now would undermine confidence even further. However, markets have definitely moved too quickly to price in rate hikes, which we don’t see happening until 2016 at the earliest. This loose monetary policy is vital to keep the economy moving, credit flowing, mortgage rates under control and confidence high. If the Federal Reserve mess this up and communicate their path unconvincingly then we could be in for a rocky few years. The fact that it seems that Larry Summers, a supposed anti-QE economist is about to take over at the Fed, muddies the water yet further. The 'great' debate continues…

The Great Deceleration in Emerging Markets 

We have been surprised by how poorly emerging market (EM) assets have performed on a relative and absolute basis over the last year. This has led to plenty of opportunities for long term investors, but patience will be required. Over the last week, my team and I have held five conference calls with our EM managers to try and ascertain whether what we are seeing in Southeast Asia and India is a repeat of what we saw in the Asian Financial Crisis of 1997. Thus far, we have been relieved to hear that nobody believes that it is. However, it would be naïve to suggest that the capital flight we are seeing from markets like India and Indonesia is anything but negative. Drastic action is required by the affected Asian central banks. We should note that we have no exposure to Southeast Asian or Indian equity markets. As long as the recent events are not the prelude to a major crisis, which at this point we don’t believe is the case, then EM assets are broadly cheap and have great potential to recover. Our central view is that investors have swung the sentiment pendulum to negative too aggressively. However, we will be watching on-going developments hawkishly and are ready to act accordingly. It is worth noting that our investments in China have recently recovered very well from their distressed valuation levels at the end of June as the country has amazingly become considered a safe haven!

The Syria Crisis 

We always say that it is very hard to prepare investment strategies for events like the unfolding human tragedy in Syria. We also cannot add a huge amount of insight to what you will have all heard and read in the media. However, diversification is helping soften the blows that are being caused to markets by the threat of a military strike, as gold, the US Dollar, US Treasury bonds, the oil price and energy company shares have all gained strongly over recent days. If the Syria crisis spirals out of control, which is possible, and creates further shockwaves in the Arab world, then holding the aforementioned assets will be very sensible.

The Never-ending Eurozone Story 

Amazingly, Europe has fallen to fifth in the list of worries that is plaguing investor sentiment, but it is not something we should totally dis-regard, given the political issues in Italy, the fact that another bailout is required in Greece, perennial debt issues in Portugal and a structural lack of growth in France. However, we are more positive on the wider Eurozone growth outlook, as there seems to be a tacit approval of austerity reduction and we believe that Frau Merkel and her coalition will get the victory they desire at next month’s elections. While we are not as optimistic as some, who believe that Merkel’s win will open the German liquidity taps to flow to the Med, we are more positive than the many Bears who claim that there is no hope for the Eurozone. Things are gradually getting better, if admittedly from a low base, and we are seeking to increase our exposure to Eurozone equities that are undoubtedly cheap relative to the US.

Equity Valuations/ Corporate Earnings 

There are definitely question marks appearing about the relaxed attitude of analysts towards US corporate earnings as this year progresses. The last reporting season was patchy, with only really the financial sector surprising to the upside. Analysts are still expecting earnings growth of close to 10% in the last three months of the year, which we find difficult to marry to the global economic situation. US equities to us look expensive, with the S&P 500 trading on 15 times price/earnings. We are also concerned about the incessant flow to defensive US equities and the uniformly optimistic consensus. Globally, the corporate results season was solid, if unspectacular. From a valuation perspective, Europe is much cheaper than the US on 11 times P/E and we believe that earnings in the region should recover in the coming years. Broadly the same rationale applies to Japan, where we believe that investors are too obsessed with the currency and ignoring the long term earnings growth potential of Japan. There is an obvious valuation opportunity in EM equities, as companies across the emerging world are trading at a material discount to the US and other developed markets, ignoring the possible growth of these companies’ earnings. Our views are contrarian, but we feel confident that value, both from a regional and a sectoral standpoint, will start to work powerfully in the coming years.

Market Outlook 

As long as our economic prognosis is not wildly errant, then our base case remains that 2014 should be a positive year for equities and, after the recent sell-off, other risk assets, such as high yield credit. Assets that have been hit very hard, such as EM bonds, are also under close review. In the short term we are more cautious and our asset allocations reflect this. In fact, we have become even more uncertain about the immediate outlook over the last few weeks, recognising that markets have a number of factors to overcome, as I hopefully described effectively above. This near term anxiety is somewhat assuaged by the number of attractive long term opportunities we can find, particularly in EMs, Europe and Japan, but this is not a time to be a hero.