by Matt Sherwood, Head of Investment Strategy, Perpetual Investment Management Limited
- In 2016, risk markets have had their worst start to the year in several decades and global economic recession risks are now increasingly being priced into markets. While the China slowdown is at the forefront of market communications, no new data point over the past month has prompted investors to question previously held assumptions about growth. Instead, tightening US financial conditions are at the epicentre of the market volatility and this is constraining global growth and having investors question the sustainability of elevated valuations and optimistic earnings forecasts in regional markets. Given that the US dollar is likely to appreciate more in 2016, US and global financial conditions will further tighten and this indicates that volatility will remain elevated.
- The combination of debt, demographic and disruptive technology continues to weigh on private sector spending and has culminated in a world where inflation has declined to its lowest level in three generations and nominal global growth is only half the levels recorded in the three global recessions prior to the GFC. Despite consistent flawed forecasts of impending improvement from central banks and consensus, we are now in a low-growth world and investment markets are likely to continue to adjust to this new norm in 2016 and returns will be low and risks higher than has been seen in several years.
Prior to the GFC, portfolio choices were simple. Slowing economies from higher interest rates meant investors could park money in term deposits and government bonds to gain shelter from equity market volatility and the corrosive effects of inflation. However in 2016, risk markets have had their worst start to the year in several decades and investors have had to decide whether to purchase historically expensive government bonds or invest in cash which is yielding next to nothing. They make these choices in an environment where global economic recession risk is being increasingly priced into markets, although it is more evident in some asset classes (such as high yield credit and commodities) and regions (emerging markets) than others.
FINDING THE CULPRIT
Investors have examined the catalysts for the recent market turmoil and while an apparent Chinese growth moderation is often mentioned as the spark for the volatility, no new data point over the past month has prompted a major re-assessment of the 2016 growth dynamics in the world’s second largest economy. Instead, tightening US financial conditions are constraining growth in global economic output and corporate revenue and this is prompting investors to increasingly question valuations and the current optimistic earnings outlook priced into markets, as nominal growth remains scarce in the world. US financial conditions have tightened over the past few years because the US dollar has appreciated sharply, the US Fed has ended its QE programs and began its tightening cycle, and lower oil prices have lifted the US currency and widened credit spreads. This matters for two reasons; firstly, the global financial system is denominated in US dollars, and secondly debt in all economic regions has increased by vast amounts since 2009. Indeed, only five of the 60 economic sectors in the G20 economies (namely households, corporations and government in each economy) have reduced debt. Nearly all the others have increased it. Just as importantly, the US Fed is apparently not near the end of its tightening cycle and will look to add to the December 2015 interest rate increase at an appropriate time this year. Rate increases here are important as USD4.4 trillion of US dollar denominated debt has been issued over the past seven years by countries outside of North America, and a higher cost of capital and a rising US dollar will amplify any strains associated with debt serviceability for these borrowers.
THE CHANGING WORLD
While the global economy continues to expand, the pace of growth 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. This has culminated in a world where inflation has declined to its lowest level in three generations and nominal growth is only half the average level recorded in the three global recessions prior to the GFC (see Chart 1). This matter for equity markets as earnings growth is a nominal concept and rising US rates always leads to valuation contraction. More importantly, the anaemic nature of nominal global growth is likely to persist (given the three D’s) despite constant flawed forecasts of impending improvement from central banks and market consensus.
CHART 1: GLOBAL GROWTH AND INFLATION ARE EXTREMELY LOW AND UNLIKELY TO REBOUND
LESSONS FROM HISTORY
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 grew an average +14%. In 2016, I remain cautious about US (and global) valuations, as my base case is that the US dollar strengthens further, we have a US Fed which acts and a US economic outlook which is not set to improve very much. Accordingly, valuations are likely to trend lower in line with the historic average (see Chart 2), but US earnings growth this cycle will be much harder to find because the US, and the world, remains a weak place.
CHART 2: THE US EARNINGS UPSIDE IS ANAEMIC AND IS LIKELY TO BE SWAMPED BY VALUATION DECLINES
2016 US EQUITY RETURNS ARE LIKELY TO BE NEGATIVE
Corporate revenue growth is anaemic or declining in both the developed and emerging economies, and cost-side savings are limited. 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 – a level well below the historic average which means that US sharemarket returns in the first year of a tightening cycle may be negative for the first time since the mid-1980s cycle, which will weigh on returns in other regions.
ECHOES OF KODAK?
Countries which have high debt, low population growth, declining productivity and uneven wealth distribution are destined for weak growth. While this was first evident in advanced economies ten years ago, it has now spread into the emerging markets meaning that the trend is broader and policy options are more limited, which means global growth has to structurally moderate. This should prompt a reduction in return expectations, but some investors seem to believe that the old world will return if the optimal policy settings can be reached. The more they think this, the more they sound like Kodak executives clinging to their film.
IMPLICATIONS TO INVESTORS
2016 is shaping up as a tough year for investors relative to the past two decades as growth and inflation expectations are elevated, US financial conditions are tightening, debt is at record highs, policy options are very limited and Chinese growth and global leading indicators are already heading south. In this world it is hard to envisage how expectations of an acceleration of global economic growth in 2016 can be realised and how the consensus forecast of +8% global EPS growth will be achieved. The world remains in a weak and fragile state and central banks are less able, and likely, to come to the rescue. Consequently, I remain skeptical of optimistic consensus growth forecasts, which display a persistent upward bias and are likely to be revised down as the 2016 landscape is revealed to be similar to the past four years. Markets are worried about the economic outlook, but I remain doubtful about global recession calls as contractions always occur after global policy tightening cycles.
While the global economy is more likely to expand than contract, the odds of a downturn are considerably higher than normal, and as investors found out in 1987, 1994 and 2011, market don’t only decline when economic output declines. Nevertheless, market volatility is likely to persist for an extended time and any short-term serenity is less likely to be the end of volatility, and more probably just the end of the beginning. For investors in this environment, it is important to have the flexibility to shift between opportunity sets as risk-reward dynamics between asset classes and within asset classes change rapidly. Overall, investors will need to be more selective with the assets they have high conviction will do well, and should not be constrained to hold assets that are expected to either decline or underperform. This environment in particular lends itself to a multi-faceted investment approach which includes active asset allocation, relative value opportunities and the selective use of portfolio protection. Strong balance sheets and robust operating models are clearly desirable at the stock level as these are the easiest and by far the best form of risk management.
This analysis has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 for the use of financial advisers only, it is general information and is not intended to provide you with financial advice. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act. Any information referenced in the article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.