25 February 2016 /
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Since the beginning of this year there have been sharp falls in many asset prices, notably equities and credit. These declines mark an acceleration in trends that had been evolving in the latter part of 2015. As is the often the case when markets turn bearish the explanatory factors become numerous. We believe the key fears concerning investors are: the economic slowdown in China and the possibility that China will allow its currency to fall sharply; the negative consequences of lower energy prices on economic growth and the loan portfolios of banks; a recession in the developed economies leading to lower than expected corporate earnings growth; the move to negative interest rates in a number of countries and fears of another systemic banking crisis in Europe.
In the second part of 2015, we became more cautious on the outlook for financial markets because of the ending of quantitative easing in the US and valuations of some equity markets. We maintained high cash levels but kept equity invested in areas that we believed were appropriate for a slowly growing world where corporate earnings growth would be hard to achieve. The equity exposure was focussed on Europe and Japan where liquidity conditions remained generous and valuations reasonable. Style exposure was adjusted where appropriate to a combination of defensive and growth-oriented companies. Defensive companies being ones which paid dividends, are financially robust and were likely to survive the harshest of economic conditions; and growth companies positioned to exploit the fast changing corporate landscape through the use of disruptive technology or just by being more nimble than their larger competitors. Portfolios held minimal exposure to interest rate risk as nominal yields on government bonds were too low. However, in February we invested in inflation-linked government bonds because their pricing reflects a five-year annual inflation that appears extraordinarily low even in a slow growing world, especially when we consider that the bulk of the fall in the oil price now behind us.
There are three key questions we are asking ourselves today. The first is: Has the world changed so significantly in six weeks to warrant all of the following: a 10% reduction in the S&P 500, an 11% fall in the value of the US dollar against the Japanese yen, a 15% reduction in the Euro Stoxx 50, a 21% decline in the Nikkei and a 40% decline in the market value of major European banks?
The answer in our view is no, on the basis of the data releases so far this year. The data available so far suggests to us that the US economy is mixed. Overall industrial output is slowing but this is caused by just 20% of the sector, the remaining 80% is expanding. The service sector is growing, along with employment and income trends. European trends seem set fair. The Japanese economy flips in and out of recession and there is no reason to expect anything different. The growth rate of the Chinese economy is slowing but that is old news. There is capital flight from China complicating the re-positioning of the economy but this has long been expected.
Recessions are normally caused by central banks raising interest rates to choke-off inflationary fears. This is not the case today. One can inconclusively debate the rights and wrongs of the Federal Reserve’s interest rate hike in December. For the record we thought it was ill-advised but not significant. Whilst attending an economic conference in Washington D.C. just ahead of the December meeting the overwhelming call by participants was for the Fed to tighten or else they would lose all credibility. No doubt the view will be different today but reflects the vacillating views of professionals and the complexity of the economic landscape. Just as economists can change their views so do investors and that is what has happened this year. The facts have not changed but the fear factor has increased because after seven good years of investment returns suddenly the upside appears limited. If the upside is limited then investors reason that the downside risks must be greater and a spark of doubt is enough to start a self-feeding spiral of both fear, marked by selling to protect existing capital, and greed, as short sellers drive prices down for profit. Meanwhile so-called automated trend-following strategies serve to exaggerate price movements in uni-directional markets.
The second question for us now is: Will the marked change in asset prices and investor risk appetite affect the real economy? In our judgement, as that is all it can be, the answer is not yet and it is probably unlikely as that is not the way recessions occur. The critical issue is whether the supply of credit to the real economy will cease. We know that the banking and credit markets have been damaged by the Great Financial Crisis of 2008, hence the rise of bank lending funds, direct lending, peer to peer platforms and so on. However, an economy still needs a banking system and a capital raising infrastructure which is why central banks have been the necessary counterweight to the onslaught of regulators in paring back the risk-taking ability of commercial banks. The evidence for 2015, as there is no data for 2016, is that bank lending to non-financial institutions in the Eurozone was starting to expand after a period of contraction between 2012 and 2014. We will be watching this carefully. US credit trends, meanwhile, are strongly positive as banks’ balance sheets expand.
The third question is: What would make us change our mind? In our view the proverbial canary in the mine is the price of government bonds. It is remarkable that, even allowing for the massive bond buying programmes of central banks, top rated sovereigns can borrow money for 10 years at a nominal cost of less than 2% per annum. This is despite fears that Quantitative Easing will result in sharply higher inflation and the continuing high borrowing requirements of governments. This demonstrates an extraordinary faith in both the fiat system and the credit worthiness of governments. The day this credibility is lost is when the economic system will be severely challenged and protecting assets rather than growing them will be the absolute priority.
In the investment world, views are often polarised between perennial bears, who believe that the weight of debt will eventually crush the economic system, and perennial bulls, who believe in the innate creative and survival instincts of mankind. Markets are pulled between these two axes. Our investment strategy is based on a recognition that: there is a secular slowdown in global economic growth; disinflation is more prevalent than inflation; the financial system will need the crutch of central banks for a long time; there is an absence of international policy co-ordination; and the digital revolution is causing massive challenges to the labour market. Against this, the world economy’s purchasing power has never been so large; a larger proportion of society is more closely engaged than before in enterprise creation; and scientific advancement is accelerating. Importantly, a large pool of capital is available to fund these ventures. In addition to safely navigating the public markets we are actively tapping into the longer time horizon of such investments where they match the investment aspirations of clients.
The investment message from Sandaire today is that we have substantial cash, and a balanced public equity exposure oriented towards Europe, Japan and long term growth. We have kept our modest exposure to European banks because with prices at 60% of book value there is potential for gains even if the estimated book values are wrong by 50%, which seems unlikely. We are not expecting the market to make good its losses quickly, nor do we rule out further declines in the short term. We are, however, confident in the long term value of the assets we hold and we are alert to opportunities created by the market sell-off, into which we may cautiously deploy the cash we currently hold.
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