Investment Outlook 02.2016
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Financial meltdown or buying opportunity?
The year started with a brutal sell-off of risky assets. China, the perceived root cause of the global growth slow-down and financial instability, suffered from the most severe equity sell-off, with the CSI300 falling 21% in January. The Nikkei225 fell 8%, the S&P500 5.1%, and the German Dax 8.8%. Also, credit spreads widened, led by high-yield, and followed by emerging markets and high-grade bonds. The fact that financials underperformed in the sell-off may indicate that markets have been concerned about systemic risks.
Safe-haven assets rallied, government bond yields fell significantly, 10-year German Bunds fell 30 basis points to 0.33% and 10-year US Treasuries fell 35 basis points to 1.92% at the end of January. The Gold price surged by 5.4% in January and rose even further to levels above 1,200 USD/oz.
The EUR and the JPY did not move much in January but strengthened by 2.8% and 6.1%, respectively in the first half of February. Interestingly, the CHF weakened despite its typical safe-haven character.
The Bank of Japan surprised us on 29 January when it introduced negative interest rates on bank deposits. The rate was reduced from 0.1% to -0.1%.
Statements put out by both the ECB and the Fed were dovish. The probability of a Fed rate hike fell from almost 50% end of December to almost 0% end of January.
Without doubt, the observed market moves reflect rising recession anxieties and increasing fear of another 2008-like financial system collapse. In the following we try to assess whether fundamental data justify this pessimism. However, we are also very cognizant that the mere fact of falling asset prices can have negative repercussions on the economy, and this makes the assessment of the current situation significantly more difficult. Falling asset prices may reflect underlying and not so obvious adverse developments, not yet reflected in the usual leading indicators. Furthermore, falling asset prices have the potential to drag down consumer and investor sentiment and slow down economic activities. In addition, a drop in asset prices has a negative wealth effect, which impairs the ability to spend and invest.
A closer look at January’s macro indicators confirms our base-case scenario of a slowly growing global economy. It does not indicate, in our view, elevated recession risks. The US ISM index rose slightly to 48.2 from 48.0, the Chinese PMI increased to 48.4 from 48.2. At the same time we saw the European PMI fall to from 53.2 to 52.3 and the Japanese PMI, drop to 52.3 from 52.6.
Looking at the overall health of the US economy, the Services PMI still remained in expansion territory at 53.2 in January, although it fell from its December level of 53.7. The US economy overall continues to create jobs, with non-farm payrolls at +151,000 and a further decline in the unemployment rate from 5.0% to 4.9%.
Meltdown or buying opportunity?
The million dollar question currently is whether we are heading towards a 2008-like scenario with a major recession and financial distress, probably triggered by defaults in the commodities sector, or whether the current sell-off will be short lived and sound fundamentals will prevail, convincing market participants that current price levels provide buying opportunities.
As already mentioned above, as an investor you always have to balance different considerations and scenarios. While the recession and bear-market risk has certainly risen, not least due to the potential of self-reinforcing market moves, we need to reassess our fundamental view, critically analyze the underlying hypotheses, and then come to a rational conclusion.
After doing this exercise in our investment committee, we came to the conclusion that the financial system underwent a major deleveraging after 2008 and looks much healthier and more robust today. Also, while we do see a slow-down in some critical parts of the global economy, most noticeably in the US and Chinese manufacturing sector, we nevertheless see encouraging data from other sectors and a robust development in Europe. The energy price slump certainly hurts the oil producers around the world, but it benefits the majority of the energy consumers. Overall, one would expect a net positive growth impulse from falling oil prices. On top of this, central banks continue to be very accommodative and may even decide on additional monetary stimuli.
As a result, we decided not to reduce our exposure to risky assets. We have rather even increased our equity exposure slightly. We have also added some exposure to high yield bonds, since valuations appear to be attractive to us.
As discussed, some major macro indicators have been weak in recent months, especially in China and the US. The outlook for the US is somewhat ambiguous since the weakness in the manufacturing sector is accompanied by a robust services and construction sector as well as healthy job creation overall. In Europe and Japan we observe better growth data. Company earnings, despite an across-the-board decline, still look healthy. We also take some comfort from more attractive valuations after the recent price decline.
As a result, we remain cautiously constructive for equity markets. We also think that especially the high-yield market offers interesting spreads. In our view, the spread levels are consistent with a very high recession risk and an elevated number of expected defaults. Since we think that those spread levels are exaggerated, we have taken an overweight position in high yield bonds.
Bond yields have gone too far and inflation expectations look much too low for us. We therefore remain underweight in bonds overall and especially government bonds.
We think that the recent USD weakness will be short lived and we expect the USD to rebound. The CHF, however, will continue to weaken, in our view.
We are skeptical about the recent gold strength and would, for tactical reasons, take profit on long gold positions.