Equity markets slide as a risk-off mode takes hold among investors
Amid extreme short positioning, we think it is time to overweight developed equities
Exhibit 1: Major equity market indices fell during the period from 01/01/2016 to 21/01/2016
Equity markets have had a poor start to 2016 with falls in the major indices such as the S&P500, the EuroSTOXX 50 and the Nikkei. Market volatility has increased amid persistent investor concerns over the global economic outlook in general, and the prospects for China in particular. Although there are reasons for caution, we do not believe that the world economy is about to fall off a cliff. Any talk of new recessions is, in our view, premature.
Investor Sentiment at a low ebb
The gloom has been tangible in the opening weeks of 2016 and not just in equity markets. Spreads on high-yield corporate bonds have increased. US high-yield credit has been particularly hard hit due to heavy issuance in recent years by the energy companies now reeling from the relentless drop in crude oil prices to a 12-year low. This plunge reflects market concerns over the sluggish pace of global growth, and thus demand for oil, but also the prospect of increased supply from Iran now the sanctions have been lifted.
Our analysis suggests to us investors are now extremely short equities, particularly US equities, but we don’t see any trends at this point foreshadowing a global or US recession. We assess the global economic outlook, liquidity and the earnings outlook as neutral for developed equities. Monetary policy and corporate M&A are generally positive factors, while the geopolitical situation is negative.
Exhibit 2: Evolution of the risk premium for high yield corporate bonds (from 01/01/15 through 19/01/16).
Adding Equity Risk
We implemented an equity overweight in mid-January 2016, but so far we have not benefited from it as markets have focused on the negative implications of lower oil and commodity prices, the slowdown in China (and other emerging economies) and the latest US data. Concerns over capital outflows and dwindling currency reserves in China have also been advanced as explanations for the market’s poor start to the year.
Tighter global financial conditions through higher spreads on corporate and emerging market bonds, exacerbated in the US by a stronger US dollar and tighter standards on commercial and industrial bank loans, have also hobbled global markets.
Our equity overweight position should be seen as tactical. We see the structural drivers of global equities as broadly balanced and the concerns over the global economy and the equity sell-off as overdone. We have left emerging equities out of the overweight given the absence of a better economic or earnings outlook.
We prefer US equities for their relative growth outlook, corporate M&A and investor positioning, while Japanese equities should benefit from generous monetary policy by the Bank of Japan as well as corporate M&A. For investors with a European bias, we would also recommend they go overweight European equities.
China’s growth disappointing, but not plunging
Recent economic data for China has been weaker than expected. GDP growth for 2015 came in at the slowest pace in more than two decades, while the GDP deflator, the broadest price measure in an economy, remained in deflationary territory. While consumption has been holding up, it has not offset slower investment growth. So, overall growth is moderating. At the same time, credit is growing twice as fast as GDP. Worryingly, China’s non-financial debt as a proportion of GDP has risen by more than in any of the 39 countries covered by BIS data, except Hong Kong.
Exhibit 3: Evolution of Chinese GDP (for the period from 01/01/10 through 19/01/16).
Market hopes centre on more fiscal stimulus and measures to address the overcapacity in heavy industry. Government spending has indeed risen more strongly lately, but tackling overcapacity could run into local government opposition to job losses. Anyway, if fiscal stimulus were visible anywhere, it would be in infrastructure investment.
We remain cautious, but monetary and fiscal stimulus, low oil prices and currency depreciation should help stabilise growth. With the Chinese New Year and the typical data distortions coming up, it will take a few months before we will get more clarity on the economy’s direction.