An interesting article written by Matt Sherwood that addresses the recent market volatility.
The Sherwood Market View, 14th January 2016
IDENTIFYING THE EPICENTRE OF GLOBAL MARKET VOLATILITY
The selling pressure in global sharemarkets has intensified over the past week despite the delivery of some positive economic data in China (the December trade balance) and the US (December non-farm payrolls). This has culminated in the worst calendar year opening for global sharemarkets as far back as indices go, with all regions down sharply in the first eight trading sessions and the key questions for investors at this point is what is causing the volatility and is it likely to persist.
THE ‘THREE Ds’ CONTINUE TO LIMIT NOMINAL GROWTH
While the global economy continues to grow, the pace of the expansion is considerably less than that seen in previous cycles as debt, demographic and disruptive technology (the three D’s) continue to weigh on private sector spending decisions. This has culminated in a world where inflation has declined to its lowest level in three generations, and nominal growth is below the levels recorded in the three global recessions prior to the GFC. More importantly, the anaemic nature of nominal global growth is likely to remain that way despite constant flawed forecasts of impending improvement from central banks and consensus. While the economic data released over the past month has on balance not been particularly upbeat, it has not been disastrous either and has only confirmed already well established views about where the growth dynamics are at, and what the risks to that outlook are. Indeed, no material data point was been released and sparked a major reassessment of growth prospects with the global expansion set to be around +2.7% this year, with little improvement in 2017 either.
THE KEY ISSUE IS TIGHTENING GLOBAL FINANCIAL CONDITIONS
While no new data points have prompted investors to question previously held assumptions, several ‘half issues’ have combined into the perfect storm to knock regional sharemarkets off recent elevated levels. While China and oil are dominating discussions about what’s happening, I don’t believe they are at the epicentre of the volatility. Instead tightening US financial conditions are constraining global growth and are increasingly having investors question the sustainability of elevated valuations and optimistic earnings forecasts in regional sharemarkets. US financial conditions have tightened over the past few years because the US dollar has appreciated sharply and the US Fed has ended its asset purchase program and began its tightening cycle – something it will add to in the next 12 months. US financial conditions matter because the US dollar dominates the global financial system and around USD4.4 trillion of US dollar denominated debt has been issued over the past seven years by countries outside of North America.
ELEVATED VALUATIONS AND OPTIMISTIC EARNINGS FORECASTS APPEAR UNSUSTAINABLE
Tightening financial conditions matter for growth and investment returns. The region which is most exposed to US financial conditions, falling commodity prices and has issued a large amount of US denominated debt over the past seven years, namely the emerging markets, have led the pace of global declines, falling -8% in local currency terms in the first eight trading sessions of the year. This has been followed by the US (-8%), Asia (-8%), Japan (-7%), Australia (-6%), UK (-5%) and Europe (-5%). These are among the worst start of year performances in history in each one of these markets. The primary issues here is that sharemarket valuations are elevated, the earnings outlook is anaemic and financial conditions are less constructive. Over the past seven US tightening cycles dating back to the mid-1970s, valuations for US shares have declined an average -12% in the first year after a tightening cycle begins, but markets have risen over the 12 months because US earnings per share has risen an average +14%.
VALUATION DOWNSIDE IS LIKELY TO TRUMP ANY EARNINGS GROWTH
In 2016, I remain cautious about valuations, as my base case is that the US dollar strengthens further, we have a Fed that acts several times and we have a US economic outlook which is not likely to improve much. Accordingly, valuations are likely to trend lower in line with the historic average, but earnings growth this cycle will be much harder to find because the world remains a weak place. Indeed, corporate revenue growth is anaemic or declining in both the developed and emerging economies, and cost-side savings are diminishing. A structurally weak expansion means that corporates have a smaller growth pie to feed on and that it is very hard to generate inflation, which has historically accounted for half of global earnings growth since 1950. As such, US earnings growth this year is likely to be very low single digit, at best – a level well below the historic average.
IMPLICATIONS FOR INVESTORS
So what can investors do in a world of high valuations, optimistic earnings growth and tightening financial conditions? Investors need to remind themselves that while markets are declining and sentiment is very fragile, some constructive positive long-term trends remain in play such as the US consumer, Chinese services sector and Japanese exporters. Consequently, this sort of environment lends itself to a multi-faceted investment approach and funds with a flexible investment approach, a broad investment opportunity set and with no strategic asset allocation framework are ideally placed. This enables the fund manager to totally remove allocations to any asset class, to use options to obtain downside protection with upside potential and to take advantage of relative price movements between markets. This is an advantage to simply holding cash when the majority of asset classes look unattractively valued.
Regards, Matt Sherwood Head of Investment Strategy, Multi Assets