Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Lars Kreckel, equity strategist in Legal & General Investment Management’s Asset Allocation team, considers some of investors’ concerns about the markets they are leaving behind.
Many investors are concerned that China’s stock market falls will spill over into other regions, but we think it’s an isolated event that won’t significantly impact international markets.
Bull markets don’t die simply of old age
Three reasons for this. Firstly, most of the volatility in China has been in A-shares, a category dominated by domestic investors. Few domestic investors have access to international stocks, and so it’s unlikely we’d see redemptions in other markets or assets to shore up losses from Chinese equities. Secondly foreign investors are also unlikely to become forced sellers of global equities as they did not participate in the rally.
This fundamental argument is backed up by empirics as there was virtually no correlation between the S&P 500 and EuroStoxx and the Chinese market on the way up, and similarly little correlation on the way down. Thirdly, let’s not forget that the Chinese market is still up 80% to 90% year on year. A small group of high net worth Chinese investors may be nursing losses, but many are ultimately sitting on gains from investing in equities over the last year or two.
This isn’t to say we aren’t closely watching the behaviour of wider Chinese markets and the economy, and it is certainly one of the risks we keep a close eye on, but a hard landing as a result of the equity bubble imploding looks unlikely.
Another concern we hear is that the equity bull market is poised to end, given we are around six years through. But looking at history, bull markets don’t die simply of old age. Nor do high valuations necessarily trigger a market correction.
There’s a strong link between valuations and long-term returns, but not so strong a link over the short term. It is recessions that cause bull markets to end; 12 of the last 14 have been triggered by or closely followed by a recession, and with a low risk of recession currently, the end of the equity bull market should not be a top concern.
Greece and a potential Grexit has been up there with China and equity valuations on investors’ worry list recently. But ultimately European equities haven’t moved much throughout most of Greece’s debt negotiations.
What we do think should be a cause for concern is how markets react to the first Fed interest rate hike. This could be in September, although December is a more likely point at which rates will move higher. There are historical precedents for this, and they point to a drop of 8% in equity markets as a likely outcome.
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