Threat of further volatility stalks global stockmarkets

Investors hoping for a calm start to 2016 were in for a rude awakening. No sooner had the New Year’s celebrations finished than global markets were off on a rollercoaster ride as fears over continued low oil prices, a possible slowdown in China and risks of a US recession combined to drive markets down. The Dow Jones had its worst opening day since 2008, China implemented, then withdrew, its circuit breaker system designed to smooth market volatility but only made matters worse, and global equity markets succumbed to weeks of turbulence that saw them hit lows not seen since the global financial crisis.

Markets have regained most of those losses, but is this a temporary pause and what does this mean for the asset class going forward?

“These are as difficult markets as I can remember since the financial crisis,” says Iain Tait, head of the private investment office at London & Capital. 

“The world is absolutely quagmired in prolonged, multi-year, if not multi-cycle, financial repression. With so much debt swimming around, there is an inability to meaningfully raise interest rates, and we expect continued anaemic growth globally, with pockets of recession, and against that backdrop you aren’t going to see much inflation and it is difficult to see stockmarkets going anywhere.”

Nevertheless, equities will continue to attract fresh inflows for three reasons, believes Amin Rajan, CEO of the Create research consultancy. “First, fixed income assets are heavily over valued currently, due to ultra-low low rates. Second, pension investors are beginning to favour equities, as one of the ways to reduce their persistent deficits. Third, most investors now want high liquidity, in case they are turned into forced sellers, and equities are a very liquid asset class.”

Overall, investors are willing to give equities the benefit of the doubt, in the belief that ultra low rates and deepening recoveries in Europe and Japan will provide the necessary earnings boost, he adds. Mr Rajan expects to see the “bondification” of equities, as investors chase stocks with good dividends, less debt, strong pricing power, free cash flow and high return on equity. 

Despite the poor macro situation, there are opportunities within equities if you pick the right sub classes, agues Mr Tait at London & Capital, highlighting consumer staples and consumer discretionary in the US.

“I wouldn’t want to own the market as a whole,” he cautions. “I think just grabbing an ETF and expecting this re-rating that we have seen in the last four or five years from stocks is wrong. That is yesterday’s story. It is a stockpickers’ market now.”

London & Capital has been perfectly happy using ETFs in the past, claims Mr Tait, as they perform in the right markets and are a low-cost option for clients. But this should be the environment for equity long/short managers, hedge funds and other alpha generators to excel, he believes.

Earnings growth rather than broad multiple expansion will drive market performance, says Adam Schor, director of Global Equity Strategies at Janus Capital, a Denver-based asset management firm in the US. 

“Against this backdrop it is important to find the right companies. In a slow growth economy, investors should reward companies that are innovating or using smart capital allocation to drive expansion. Passive investment will not distinguish between companies facing a wide range of outcomes.”

Active fund managers have struggled in the past five years as central banks were falsifying true market prices, claims Didier Saint-Georges, a member of the Investment Committee at Carmignac, but the best ones will have more opportunities to shine going forward. 

“Just playing beta, on the back of liquidity-propelled markets, will not be enough anymore. The beta now needs to be managed actively as market risks are significantly more elevated. By the same token, since the market won’t be lifting all boats anymore, alpha generation will be more decisive.” 

Central banks will be hard pressed to keep up the faith in their capacity to have a real impact on the economy, believes Mr Saint-Georges. At some point, markets will have to question the discrepancy between financial assets and the real economy. “The first whiff of such questioning came a few months ago. More will come,” he warns.

Indeed the market’s response to the announcement on March 10 by Mario Draghi, president of the European Central Bank, of more aggressive than expected measures including cutting rates and expanding quantitative easing, saw markets quickly go into reverse before recovering. Are markets finally coming to the realisation that central bank action will not be enough to drive the global economy?

“We currently have the impression that remedies in place are not functioning anymore,” says Christoph Riniker, head of equities strategy at Julius Baer.

“Central banks continue to take bold actions but market participants no longer believe in the remedy. Further volatility lies ahead.” The Swiss bank recommends a balanced sector approach or lower-risk investments styles, for example targeting dividend-paying companies.

Investors were understandably jittery early in the year, reports Frédérique Carrier, director, European equities at RBC Wealth Management, although the situation has improved. “People are now moving towards taking on a bit more risk,” she explains, and there are pockets of value to be found. 

“The banking sector in Europe has been hugely oversold and de-rated very sharply,” says Ms Carrier. “A lot of European banks are trading at below book value. We would encourage investors to take advantage.” 

There is strength in the consumer space in both the US and in Europe believes Chris Dyer, director of global equity at Boston, US-based Eaton Vance, which manages more than $300bn. Stocks in this sector are far from cheap, but do offer solid earnings growth, he claims. 

“The consumer really is the driver of the overall economy in the US and their outlook is strong,” says Mr Dyer, arguing that falling unemployment should begin to translate into higher wage growth. He also identifies opportunities in US healthcare, which has been out of favour due to a focus on drug prices by politicians seeking nominations for the upcoming presidential election, as well as in railroad and trucking companies.

“It might not feel like it, but volatility is your friend when you are an active value manager,” says Edinburgh-based Dylan Ball, who runs the Templeton Growth fund. He aims to hold stocks for a five-year period, and looks for discounts in the market which offer potential of doubling client’s money over that timescale. “When we enter periods of volatility, then we do a bit more trading in terms of buying into our new ideas.”

The “great unloved” stocks of today are in the energy sector, claims Mr Ball, with many of those in Europe, where the Templeton fund is more than twice overweight compared to benchmark. However most of the earnings of these companies come from outside Europe, he claims, as these companies are selling into China, Latin America and the US. “I am able to get that US exposure, but at European prices.”

Many investors have shied away from emerging markets in recent years, despite attractive valuations, but Mr Ball senses an opportunity. “Rolling the clock forward a couple of years I think we will slowly reel in our European exposure as we find new ideas in China, Hong Kong, even South Korea, and potentially in Japan. On a three to five-year view, emerging markets are where the opportunities lie.”

Slowdown in Chinese growth as the country’s economy rebalances has worried many investors, but HyungJin Lee, head of Asian equities at Barings Asset Management, is more optimistic.

“Growth has to slow,” he explains. “China is already the second largest economy in the world. It can’t keep growing at 10 per cent a year.” However, certain sectors continue to expand at an impressive rate, and are even accelerating, says Mr Lee. 

The key when investing in China, and indeed across the region, is to focus on “New Asia” rather than “Old Asia”, he says. The “New” refers to the next generation of companies emerging across the region, which can deliver robust growth over the longer term, found in industries including tourism, healthcare, consumer discretionary, consumer staples, education and beauty.

The MSCI index in China holds a lot of “Old Asia”, with consumer staples, which is where Mr Lee believes the growth story will be found, a relatively small part. Valuations in “Old Asian” companies might be low and tempting, but is that really where investors should be positioned, he asks. 

“Some of these other, new, stocks might look expensive, but by looking ahead it is still possible to find value.”

Asia as a whole looks attractive, says Mr Lee, who does not believe China is heading for a hard landing and that the region’s fundamentals look sound compared to other parts of the global economy. “Asia has high savings rates, government surpluses and so on. These economies are not dependent on commodity prices or monetary policy to drive growth.”

Hong-Kong based Arthur Kwong of BNP Paribas Investment Partners also talks about New and Old Asia, but for him the definition is slightly different. “The penetration rate is the way to define new and old economy,” he says. “Smartphones should be viewed as an old economy investment in China as they have already penetrated 75 per cent of the market. There is no more room for players in the sector to grow, they can only take market share off each other.”

Mr Kwong highlights insurance companies and automobile manufacturers as examples of sectors which are trading cheaply but have plenty of room for growth.

Although the country is facing problems, the situation in China is not as bad as many have made out, he says, and stockpickers should be able to find opportunities. “And besides China, almost everyone else in Asia is doing well,” adds Mr Kwong. “Don’t forget that a low oil price is great for the region.”   

Political uncertainty

“In normal circumstances political events add to the noise but do not impact where we allocate, but I am not so sure now,” says Iain Tait, head of the private investment office at London & Capital. He points to a number of issues “bubbling together” – possible Brexit, the US election, Angela Merkel leaving office in 2017 – adding to the climate of uncertainty. 

“Should that dictate an equity investment? You would want to think that it shouldn’t, but there is enough going on this year that certainly the retail investor will be delaying investment decisions.”

Political developments in Western democracies are ratcheting up the tension, says Didier Saint-Georges, a member of the Investment Committee at Carmignac. “In particular, non-mainstream parties or leaders are gaining traction, and seem to be advocating more and more protectionist postures, which do not augur well for global trade and economic growth.” 

In Europe, the migrant crisis is adding to economic woes to trigger more divergent forces, he says, while Brexit would only add fuel to this fire.  

Brexit is already impacting economic growth in the UK, claims Frédérique Carrier, director, European equities at RBC Wealth Management, as there are already delays in capital investment decisions. 

VIEW FROM MORNINGSTAR: Investors reduce equity exposure

The volatility that marked 2015 continued into the first quarter of 2016. Global indexes corrected 10-15 per cent before recovering some losses and investors in general reduced equity exposure. European asset flows tracked by Morningstar show the asset class saw net outflow of $7.7bn in January, followed by another $8.3bn in February. Still, with close to $2.8tn in total assets under management as of 29 February 2016, equities remain Europe’s largest asset class. 

With $365bn in assets, the Morningstar Global Large-Cap Blend Equity Category is the dominant equity category. In contrast to general market trends, this category posted net inflows in January and February 2016, albeit just $0.2m and $0.6m respectively. The global large cap equity categories with a style tilt towards value and growth are also among the largest equity categories, having $63bn and $55bn in assets respectively. Both categories posted outflows in the first two months of 2016.

The largest global large cap equity fund is Templeton Growth, which despite what its name suggests, sits in the Global Equity Large Cap Value category. The $6.9bn strategy has had a rough time in recent years, driven by its underweight in US stocks and overweight in unpopular sectors like energy. Nevertheless, manager Norman Boersma posted strong returns in the first years since he took the helm in 2011, so the fund should not be written off yet.

Silver-rated Orbis SICAV Global Equity, with $2.4bn in assets, is one of our favourite funds in the Global Large Cap Blend Equity category. William Gray is lead manager in a team-based approach. We think the team’s strength and its longevity are two distinguishing features. The contrarian approach can result in a strongly deviating portfolio (and hence performance) from the benchmark, which requires a long-term holding period in order for investors  to benefit from the potential this fund has to offer. Over a five-year horizon, the fund achieved an annualised total return of 5.94 per cent in dollar terms, outperforming the category average by 266 basis points.

Jeffrey Schumacher, senior manager research analyst, Morningstar